The spread of coronavirus (COVID-19) and the ensuing containment measures have spurred monetary and fiscal responses aimed at alleviating the economic impacts of the health crisis, some of which are implemented through banks. This post argues that the role of banks, qua lenders, in screening and monitoring their borrowers has become all the more important in the current situation. There are, however, problems of positive externalities that prevent banks from performing this role at a socially optimal level. To achieve a socially optimal and efficient level of lending, it is proposed that governments should use contingent contracting to capitalise on banks’ screening and monitoring role while also addressing countervailing positive externality problems.

COVID-19 and Banks’ Screening Role

Banks are an important source of funding for businesses, especially small and medium-sized enterprises (Armour et al 2017). This role is important not only from the point of view of corporate managers, but also governments, as illustrated by the different fiscal policies taken to provide funding support to businesses. The Federal Reserve, for instance, lends ‘directly’ to investment-grade companies under the Primary Market Corporate Credit Facility while support to SMEs or, more accurately, to their employees was given by providing 100 percent-guaranteed loans to banks backed by the Paycheck Protection Program. By giving a full guarantee, the government essentially uses banks as passive conduits to channel funds to businesses; banks are essentially confined to ensuring that borrowers meet the schemes’ eligibility criteria, eg employing 500 or fewer employees. While these measures may be justified as emergency responses to the economic effects of the pandemic, it is unlikely to be sustainable in the long- or even medium-term given, as the OECD Secretary General warned, their cost and the debt that governments have to take on to support it.

One obvious solution is to get banks to fulfil their traditional role of allocating available funds to projects that promise the highest returns possible through the process of screening and monitoring. In their capacity as private lenders, banks screen their prospective borrowers and monitor their loan performance to maximise expected returns (Armour et al 2017). In doing so, banks develop knowledge about their borrowers’ prospects which are relationship-specific (Slovin, Sushka and Polonchek 1993), saving time and costs of ‘screening’ applications for loans or for extending the maturity of existing loans, and enhancing the accuracy of the assessment of these applications.

In the current crisis, the significance of this role is amplified. Banks with relationship-specific knowledge and understanding of borrowers’ business models are better-positioned to assess their borrowers’ post-crisis viability. This may be enhanced due to banks’ industry specialisation. The implication is that banks’ insight into the industry or borrowers’ businesses may help avoid wasteful lending to ‘zombie’ companies. This term generally refers to companies that are so heavily indebted that they have no incentive to make investments. In the context of this crisis, countries like China may emerge out of a lockdown as a ‘90% economy’. Consequently, ‘zombie’ companies may also refer to those operating firms that produce goods or provide services for which there is no demand because of (permanent) changes brought about by the crisis and, therefore, investing in them would inefficiently slow the recycling of labour and capital.

Positive Externalities and Credit Crunch

Given that banks and their shareholders can exploit the margin between the costs of screening and monitoring and the benefits of investing in ‘good’ projects, the question becomes: why not let private order rule the day? The answer follows the same logic as the rationale for capital requirements. Bank failures impose costs not only on the failing bank but also on the wider financial sector and the real economy. These ‘social costs’ do not feature in the calculation of expected returns from given projects. Therefore, bank managers, acting in the interest of their shareholders, may undertake projects that have a negative net present value for the society as a whole. Regulatory capital can be seen as aiming to address this market failure arising from negative externalities. It increases the amount of loss borne by banks’ shareholders, forcing banks, ex post, to internalise some of the social costs and, thereby, ex ante, constraining their excessive risk-taking.

Similarly, bank lending gives rise to benefits that accrue not only to banks’ shareholders but also to wider society, generating ‘positive externalities’ (Armour et al 2017). These benefits are amplified in this crisis. The COVID-19 lockdown has resulted in the dry up of revenues of many businesses. While the hope is that these revenues will resume when the lockdown ends, this would only be the case if these businesses have not gone bankrupt—that is, they still exist post lockdown, having secured access to funding to continue financing outflows during the lockdown period. Banks’ lending can help towards these ends and, in doing so, contribute to the preservation of economic ties, eg between firms and workers, increasing the likelihood that the economy will pick up quickly once the acute phases of the pandemic pass, smoothing the effects of economic fallouts caused by the containment measures (IMF, 14 April 2020).

In ‘good’ states of the world (say, in the case of a V-shaped recovery), the benefits of speedy economic recovery will accrue not only to the banks’ shareholders but also to the society at large. These ‘social benefits’, however, do not feature when banks calculate expected returns from a given lending decision. On the other hand, in ‘bad’ states (W-, U- or L-shaped recovery), businesses may not be able to pay back their loans and banks’ shareholders will bear the costs of decline in asset values. These costs may be in the form of a restriction on distributions until the capital buffer is rebuilt (BCBS, June 2011). More drastically, if these losses push banks into insolvency, potential government bailouts would result in significant dilution of banks’ existing shares as seen in the 2007/8 global financial crisis (Morr, October 2018). These anticipated costs may outweigh private gains from returns that could be expected predominantly only in the case of recovery, resulting in banks’ lending at a socially suboptimal level. This will likely lead to a ‘credit-crunch’ as the lack of (affordable) credit forces businesses to reduce investment and employment, resulting in spiralling contractionary consequences for the economy (Hanson, Kashyap and Stein 2011).

Contingent Contracting

The amplification of the positive externality problem in this crisis can be viewed as stemming from exogenous risks. It is beyond banks’ control to prevent a ‘second wave’ of coronavirus, necessitating another lockdown and resulting in a W-shaped recovery, or the longer-than-expected or even permanent slump in demand that may result in a U- or an L-shaped recovery. To optimise banks’ lending, it has been convincingly argued that the costs of these exogenous risks should be borne entirely by the government. At the same time, governments’ budget constraint considerations give rise to the need to make sure that banks bear the costs of endogenous risks, such as those incurred by making investments to businesses that are not viable even in the case of speedy economic recovery.

These countervailing needs could be addressed by capitalising on banks’ screening role through contingent contracting. Payouts under governments’ 100 percent guarantees on loans that banks issue to businesses can be made contingent, for instance, on the overall economic recovery as measured by the GDP in 2021 or on whether governments impose another lockdown. This should limit the downside risks of losses in ‘bad’ states of the world while incidentally helping to preserve banks’ resilience, as these losses do not weigh down banks’ balance sheet. Where 100 percent guarantees are already available, the outcome under this proposal could be less, rather than more, lending. It is therefore worth emphasising that the proposed solution aims not at more lending by banks per se, but at more efficient lending—capitalising on banks’ infrastructure to reduce the risks of financing ‘zombie’ companies. The granularity of the conditions of governments’ payouts would be determined at a level where the benefits gained from the avoidance of wasteful support for ‘zombie’ companies thanks to banks’ screening role, the speedy recovery due to preserved economic ties, and the avoided costs of credit crunch equals transaction costs, eg those incurred from the initial drafting and subsequent enforcement (Coase 1937).

Conclusion

So far, banks have been used as passive conduits to channel liquidity support from governments to businesses. Given the infrastructures in place, eg the existing bank-borrower relationship and the accompanying relationship-specific knowledge of their borrowers’ business models, a more active role of banks can be envisaged whereby banks help to allocate governments’ constrained budgets more efficiently, to value-creating rather than ‘zombie’ companies. Although this role may be undermined by the positive externalities banks’ lending activities give rise to, this problem can be overcome by governments contracting to bear the costs of exogenous risks, reducing banks’ downside exposure so that the resulting calculation of  expected returns from lending would steer banks to lend at a socially optimal and efficient level.

This post is the winner of the ‘Oxford Business Law Blog Prize for the Best Essay on the Covid-19 Crisis’. The essay competition ‘The Covid-19 Crisis and Business Law: Legal Problems and Policy Challenges’ was open to current Oxford postgraduate research, BCL, MJur, and MLF students. The members of the jury were Horst Eidenmüller, Luca Enriques, Wolf-Georg Ringe, Umakanth Varrotil, and Kristin van Zwieten.

Mo Sasitorn Suksaisakulsakdi is an MSc in Law and Finance candidate at the University of Oxford.