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Public Development Banks and Credit Market Imperfections

This paper analyses the role of a public development bank when banks use a costly screening technology to make credit decisions. We explore two issues: 1) which types of firms should be optimally targeted by public financial support; and 2) what type of mechanism should be implemented in order to efficiently support the targeted firms’ access to credit. We show that, in the presence of costly screening, there will be underprovision of credit. The market imperfection results from the inability of banks to appropriate the full benefits of projects they finance. This implies that the misallocation of credit is more pronounced for high value projects. This central result, and its implication that PDBs could play a central role in the financing of high value projects, contrast with the usual emphasis on credit underprovision for relatively weak projects/ firms (SMEs, young firms, those without collateral, etc.). We show that a public development bank may alleviate the inefficiencies by lending to commercial banks at subsidized rates and targeting the firms that generate high added value. This may be implemented through subsidized ear-marked lending to the banks or through credit guarantees which, in "normal times", we show to be equivalent. Still, when banks are facing a liquidity shortage, lending is preferred, while when banks are undercapitalized, a credit guarantees program is best suited to alleviate the constraints banks face. Direct lending by the PDB to the targeted industries could be superior to these subsidies to private lending, but only if the PDBs corporate governance is strong enough to counteract the temptation of political targeting.

Marcela Eslava y Xavier Freixas
Palabras clave:
Public development banks; governmental loans and guarantees; costly screening; credit rationing.