Article: Thursday, 14 May 2020

Central banks and treasuries around the world have announced unprecedented measures for emergency lending and other financial support for businesses in the wake of the Covid‑19 pandemic. Governments have started to lend directly to firms, with and without the involvement of the traditional banking sector. Professors Wolf Wagner (Rotterdam School of Management, Erasmus University) and Charles Kahn (University of Illinois, Gies College of Business) researched when direct lending is optimal, and when it can be combined with traditional lending.

In the USA, more than US$4 trillion in state loans and guarantees will be extended through programmes such as the Paycheck Protection Program and the Main Street Lending Program. Funding is directed to small- and medium-sized firms as well as firms in specific sectors particularly affected by the crisis, like cargo and passenger airlines. The Federal Reserve System (the Fed) has started to buy corporate bonds (including recently downgraded bonds), and purchase commercial paper and short-term, unsecured loans obtained by businesses for everyday expenses. At the same time, the Fed has also provided traditional liquidity support to the banking system, through measures such as emergency interest rate cuts and by setting up various new borrowing facilities. All the more reason to spend that money effectively.

Different problem but same policy response

The policy response to the crisis is unprecedented in its scale, but largely follows standard practice in that governments and central banks provide loans at low interest rates in time of macroeconomic slowdowns.

However, several commentators have noted that the needs for funding in the wake of the pandemic differ in significant ways from the problems faced before (for example, Boot et al. (2020), Brunnermeier and Krishnamurthy (2020) and Didier et al. (2020)). Unlike the case of an economic downturn, the goal is not necessarily to get all businesses in the economy up and running as soon as possible. The fear is that a restarting of business activity will cause a new jump in disease and mortality; so a simple general provision of low interest loans will be unlikely to be the correct solution.

"The fear is that a restarting of business activity will cause a new jump in disease and mortality; so a simple general provision of low interest loans will be unlikely to be the correct solution."

Traditional versus direct lending?

The measures introduced during the Covid‑19 pandemic differ in the degree to which the funding is decided on directly by the government or central bank, versus left to the discretion of traditional lending institutions. The decision to delegate authority to the private institution or to leave it with the public institution represents a trade-off. The private institution will have expertise in the quality and viability of the borrower; but it will generally not be prepared to take into account the additional considerations that make the emergency lending desirable or undesirable. This includes the externalities, positive or negative, that the activities of the borrower impose on the rest of the economy.

An analysis of optimal lending

Professors Wagner and Kahn analysed under which circumstances it is optimal to use direct lending during a pandemic, and for which firms. They also examined how traditional lending through the banking sector should be combined with direct lending, and how the central banks should set interest rates during a pandemic. The researchers’ theoretical model considers heterogenous firms that have immediate liquidity needs to fund production. Production by these firms causes externalities. Externalities arise when agents directly involved in production or consumption go on to infect other agents in the economy. Our main interpretation of this is that during a pandemic, the production and consumption of goods and services contributes to the spread of the virus. (Eichenbaum, Rebelo and Trabandt (2020) and Bethune and Korinek (2020)).

Direct lending is preferred if firms differ significantly in their externalities

The researchers first analysed the polar cases of all liquidity being channelled through the banking system ("traditional lending") versus being directly allocated by public authorities ("direct lending). In the latter case liquidity is directly supplied to firms, while in the former case the central bank supplies liquidity to banks who then use it to make lending decisions. This shows that direct lending is favoured if the variability of externalities across firms exceeds the variability of returns and derive implications for under which conditions direct lending is preferred. It also shows whether, during an epidemic, this should happen at early or later stages, and for which segments of the economy direct lending is most advantageous.

Optimal liquidity provision in three ranges

An optimal programme for liquidity provision can partition projects into three ranges, determined by their externalities. 

1. Low externality range

Direct lending to all firms in the low-externality range

2. Intermediate externality range

The central bank provides a liquidity line to banks to fund firms with intermediate externalities

3. High externality range

Funding is prohibited in the range with high externalities, effectively a government shutdown of production

In some respects, this partitioning outcome resembles actual lending during the Covid‑19 crisis. High externality sectors are shut down by government decree whereas for the rest of the economy both direct and traditional lending coexist. The research results suggest that within these sectors, direct lending should focus on serving the low-externality firms. Wagner and Kahn note that this is not how Covid‑19 lending programmes are designed, as eligibility for these programmes does not appear to condition on externalities, but rather on the existence of an immediate funding need.


Several commentators in the Covid‑19 crisis have noted that a pandemic causes an unusual problem. As production contributes to the spread of the virus, there are firms that we would clearly prefer not to produce during the pandemic. However, many of these firms have in principle a viable business, so we would like them to return to production once the pandemic is over (Boot et al. (2020), Brunnermeier and Krishnamurthy (2020) and Didier et al. (2020)). This requires firms to preserve their productive capacity in the meantime; such "mothballing", however, is costly – companies need to pay leases and rents, retain workers and maintain customer relationships.

"The research results suggest that within these sectors, direct lending should focus on serving the low-externality firms."

Co-ordination is needed

Optimal liquidity policies require both setting a range where direct lending takes place – and where lending is prohibited – and also setting interest rates. Wagner and Kahn’s analysis provides a new perspective on how central banks should set interest rates during crises. Interest rates have a dual role in our model: they should be set to correct externalities in production but also have to correct mothballing incentives. The consequences are that interest rates are not necessarily low during the crisis, but should be promised to be low for when the crisis is over. The latter argument relates to the practice of central banks to provide forward guidance for interest rates, to steer inflationary expectations (e.g., Swensson, 2015).

In practice, these decisions are often taken by different authorities. Results from this research emphasize the need for co-ordination among these authorities as optimal interest rates depend on the usage of direct lending. For example, if the treasury increases direct lending, the central bank should raise the interest rate on its liquidity facility. The reason for this interdependence is that an expansion of direct lending eliminates low-externality projects from the pool, hence increasing average externalities when banks do the lending.

Standard policies are counterproductive

The standard policy response to funding problems at firms is a swift provision of cheap liquidity. Such a policy is undesirable in the context of the pandemic. It may incentivize mothballing, but at the same time it will also encourage a return to full production. The research shows that an optimal liquidity policy requires promising attractive funding conditions for when the pandemic is over, coupled with a standard liquidity facility for immediate funding needs at an interest rate that reflects production externalities. This provides incentives for firms to "hang-on", that is, neither to go out of business nor to return to (full) production immediately.

New challenge, new policies

The Covid‑19 crisis poses unique challenges that are unlike the ones faced in traditional recessions. The danger is that policy makers simply resort to their standard toolsets, applied in previous recessions. This is not only suboptimal in the sense that it may waste public resources, but can even be counterproductive. The policy response to the crisis has to be tailored to its specific challenges.

Prof. Wolf Wagner

Professor of Finance

Rotterdam School of Management (RSM)

Profile picture of Professor Wolf Wagner.

Prof. Charles Kahn

Professor Emeritus of Finance

Gies College of Business

Profile picture of Professor Charles Kahn.
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