Firm Quality Dynamics and the Slippery Slope of Credit Intervention

82 Pages Posted: 1 Dec 2020 Last revised: 19 Oct 2021

See all articles by Wenhao Li

Wenhao Li

University of Southern California - Marshall School of Business

Ye Li

Ohio State University (OSU)

Date Written: October 4, 2021

Abstract

Crises have cleansing effects: Low-quality firms face greater financial shortfalls and invest less than high-quality firms. Public liquidity support preserves the overall production capacity. However, by dampening the cleansing effects, it distorts the quality distribution and reduces the total productivity. The trade-off between quantity and quality determines the optimal size of intervention. The distortionary effects on quality are self-perpetuating: A downward bias in quality necessitates interventions of greater scales in future crises, implying further distortions. The distortions are also amplified by the expectations of liquidity support that motivate low-quality firms to overinvest pre-crisis. Finally, the size of optimal intervention is larger and the distortionary effects stronger in a low interest rate environment where the low yield on savings discourage firms from self-insurance against crises through internal liquidity accumulation.

Keywords: heterogeneous firms, firm distribution, credit intervention, liquidity facility, unconventional monetary policy, collateral, limited commitment, corporate liquidity management, disaster, financial crises, Covid-19 pandemic

JEL Classification: E0, G0

Suggested Citation

Li, Wenhao and Li, Ye, Firm Quality Dynamics and the Slippery Slope of Credit Intervention (October 4, 2021). 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 (OSU) ( email )

Blankenship Hall-2010
901 Woody Hayes Drive
Columbus, OH OH 43210
United States

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