Firm Quality Dynamics and the Slippery Slope of Credit Intervention
Charles A. Dice Working Paper No. 2020-28
78 Pages Posted: 1 Dec 2020 Last revised: 8 Jun 2021
Date Written: June 7, 2021
Central banks and fiscal authorities around the world lent directly to nonfinancial firms on an unprecedented scale during the Covid-19 crisis. Credit support is subject to mispricing due to the potential lack of information on individual borrowers' credit worthiness or the political constraints on discriminatory credit pricing. In a dynamic model, we demonstrate that the mispricing of credit support generates a downward bias in the firm quality distribution that is self-perpetuating. As a result, intervention in the current crisis necessitates future interventions of greater scales, which in turn cause more distortions in firm quality dynamics. Such effects are amplified by firms' forward-looking investment decisions in normal times. Low-quality firms over-invest as they expect underpriced credit support in crises, while, on a relative basis, high-quality firms under-invest. The slippery slope of intervention is a necessary evil, as we show that when carefully designed, credit support still improves welfare.
Keywords: central bank direct lending, lending programs, credit intervention, credit policy, liquidity facilities, heterogeneous firms, firm distribution, unconventional, monetary policy, quantitative easing, corporate cash holdings, financial crises, Covid-19 pandemic
JEL Classification: E5, G0
Suggested Citation: Suggested Citation