Discussion Paper Details

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Title: Firm-bank linkages and optimal policies in a lockdown

Author(s): Anatoli Segura and Alonso Villacorta

Publication Date: June 2020

Keyword(s): COVID-19, Financial Intermediation, firm's leverage, Government interventions and liquidity

Programme Area(s): Financial Economics

Abstract: We develop a novel framework that features loss amplification through firm-bank linkages. We use it to study optimal intervention in a lockdown that creates cash shortfalls to firms, which must borrow from banks to avoid liquidation. Firms' increase in debt reduces firms' output due to moral hazard. Banks need safe collateral to raise funds. Without intervention, aggregate risk constrains bank lending, increasing its cost and amplifying output losses. Optimal government support must provide sufficient aggregate risk insurance, and can be implemented with transfers to firms and fairly-priced guarantees on banks' debt. Non-priced bank debt guarantees and loan guarantees are suboptimal.

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Bibliographic Reference

Segura, A and Villacorta, A. 2020. 'Firm-bank linkages and optimal policies in a lockdown'. London, Centre for Economic Policy Research.