This paper aims to present proposals for improving public lending design in an economic crisis. It combines casual empirical observations, institutional analysis and normative theoretical modeling. We obtain casual evidence from the analysis of the emergency lending scheme offered by Germany’s national development bank (NDB) KfW during the COVID-19 crisis. We identify obstacles to efficient contracting in these two-tier lending relationships, involving the NDB, the participating commercial banks, and the ultimate firm borrowers. Theoretical arguments and empirical evidence based on this case study help to understand major incentive risks of subsidized public lending schemes. To counter these risks, we propose a smart set of public lending contracts which induces banks to refrain from applying for public support for financially strong firms and for non-viable zombie firms. For firms which need financial support, we propose a set of public contracts from which the firm chooses the contract which maximizes its subsidy, reveals its rating, and obtains public funds according to its crisis-induced needs. This partially revealing signaling equilibrium implies higher interest rates for firms with a need for more public funding, thereby mitigating information asymmetries. In order to ensure incentive alignment, banks should retain a share of borrower default risk.
Franke et al. (Thu,) studied this question.