Aligning Incentives in Public Lending: The KfW COVID-19 Experience—Proposals for Improving Public Lending

This paper looks at an emergency lending scheme offered by Germany’s national development bank (NDB) KfW during the Covid crisis. We analyze the design of the KfW scheme and 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 help to understand the main risks of subsidized public lending schemes. We propose a smart set of public lending contracts which induces banks to refrain from applying for public support if firms don’t need the funds because they re financially strong, or if they don’t deserve the funds because they are zombie firms. In the lending scheme, a firm chooses the contract which maximizes the subsidy, reveals its rating, and obtains public funds according to its crisis-induced needs thereby mitigating information asymmetries. In order to ensure incentive alignment, banks retain a share on borrower default risk. This co-insurance component should increase with crisis duration in order to contain moral hazard, i.e. zombification risk.