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

Wenhao Li and Ye Li
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Wenhao Li: U of Southern California
Ye Li: Ohio State U

Working Paper Series from Ohio State University, Charles A. Dice Center for Research in Financial Economics

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.

JEL-codes: E5 G0 (search for similar items in EconPapers)
Date: 2020-11
New Economics Papers: this item is included in nep-cba, nep-fdg, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:ecl:ohidic:2020-28

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