Credit Availability in the Crisis: Which Role for Public Financial Institutions?

In this paper we develop a moral hazard model to investigate whether and how public financial institutions can mitigate a credit crunch problem caused by the financial crisis. Public institutions provide instruments that work to reduce the financial capital cost of private banks. This facilitates the access to credit, but may induce borrowers to invest in bad projects. We find that stimulating competition among banks is welfare-enhancing in that it disciplines borrowers. Alternatively, a concentrated banking sector can increase welfare through monitoring, provided that public intervention in the form of credit guarantees does not undermine the incentive to monitor.