Firm-bank Linkages and Optimal Policies in a Lockdown

Abstract

We develop a novel framework featuring loss amplification through firm-bank linkages.
We use it to study optimal government support in a lockdown that creates heterogeneous
revenue losses to firms that must borrow from banks. Firms’ increase in debt reduces
their output due to moral hazard. Banks need safe collateral to raise funds. Without
government support, aggregate risk constrains bank lending, amplifying output losses.
Optimal support provides sufficient aggregate risk insurance and is implemented with
firm-specific transfers, fairly-priced guarantees on bank debt, and procyclical firms’ taxation
to achieve a fiscal surplus target. Our results shed light on suboptimality features in the
actual policy responses.

Keywords: Covid-19, lockdown, firms' debt, moral hazard, bank equity, aggregate risk, government policies

JEL Classification: G01, G20, G28