DP14838 Policies to support firms in a lockdown: A pecking order

Author(s): Anatoli Segura, Alonso Villacorta
Publication Date: June 2020
Keyword(s): COVID-19, Financial Intermediation, firm's leverage, Government interventions, liquidity
JEL(s): G01, G20, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14838

We analyze government interventions to support firms facing liquidity needs during a lockdown in a competitive model of financial intermediation. Banks and firms have legacy balance sheets at the lockdown date. Firms' liquidity needs can be financed by banks that are subject to risk-weighted capital requirements and funded with insured deposits. An increase in firms' overall claims to external investors aggravates moral hazard problems and reduces expected output. The government can support firms directly through transfers or indirectly through guarantees to new bank loans or reductions in the capital requirement. As a result of the diversification of idiosyncratic firm risks conducted by banks, a reduction in the capital requirement only creates costs for the government following negative aggregate shocks that lead to banks' failure. A pecking order on the government policies that maximize output as a function of the government's budget is derived. For low budget, a reduction in capital requirements is optimal and is fully transmitted to firms through increases in banks' leverage. For medium budget, the capital requirement reduction becomes slack and needs be combined with transfers to firms or loan guarantees. For high budget, transfers are strictly necessary.