The Distortionary Effects of Central Bank Direct Lending on Firm Quality Dynamics

77 Pages Posted: 1 Dec 2020 Last revised: 9 Jan 2021

See all articles by Wenhao Li

Wenhao Li

University of Southern California - Marshall School of Business

Ye Li

Ohio State University

Date Written: November 24, 2020

Abstract

Bypassing the banking systems, central banks around the world lent to nonfinancial firms on an unprecedented scale during the Covid-19 crisis. Effective and necessary as it is, direct lending is subject to credit mispricing given central banks' lack of information on individual borrowers. Our dynamic model characterizes a downward bias in firm quality distribution that is self-perpetuating: Direct lending in the current crisis necessitates a greater scale of interventions in future crises, which in turn cause more severe distortion of firm quality distribution. Such effects are amplified by firms' forward-looking investment decisions in normal times. Low-quality firms overinvest to take advantage of underpriced central bank credit in future crises while, on a relative basis, high-quality firms underinvest. The distortionary effects can be mitigated by central banks' use of market information, collaboration and regulation of informed banks, and coordination of direct lending and conventional monetary policy.

Keywords: credit policy; firm quality; central banking

JEL Classification: E5, G0

Suggested Citation

Li, Wenhao and Li, Ye, The Distortionary Effects of Central Bank Direct Lending on Firm Quality Dynamics (November 24, 2020). USC Marshall School of Business Research Paper, Fisher College of Business Working Paper No. 2020-03-028, Charles A. Dice Working Paper No. 2020-28, Available at SSRN: https://ssrn.com/abstract=3737511 or http://dx.doi.org/10.2139/ssrn.3737511

Wenhao Li

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd
Los Angeles, CA California 90089
United States

HOME PAGE: http://www.wenhao-li.com

Ye Li (Contact Author)

Ohio State University ( email )

Fisher Hall 836, 2100 Neil Ave
Columbus, OH 43210
United States

HOME PAGE: http://yeli-macrofinance.com

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