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

Author

Listed:
  • Li, Wenhao

    (U of Southern California)

  • Li, Ye

    (Ohio State U)

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.

Suggested Citation

  • Li, Wenhao & Li, Ye, 2020. "The Distortionary Effects of Central Bank Direct Lending on Firm Quality Dynamics," Working Paper Series 2020-28, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    • Handle: RePEc:ecl:ohidic:2020-28
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    Cited by:

    1. Archanskaia, Elizaveta & Canton, Erik & Hobza, Alexandr & Nikolov, Plamen & Simons, Wouter, 2023. "The asymmetric impact of COVID-19: A novel approach to quantifying financial distress across industries," European Economic Review, Elsevier, vol. 158(C).

    More about this item

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G0 - Financial Economics - - General

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