Central banks should use direct lending in shocks – BIS paper

Direct central bank lending to firms may be a more effective tool than short-term interest rates during a financial shock, a paper published by the Bank of international Settlements argues.

“Credit policy should be deployed before the interest rate reaches the effective lower bound,” Fiorella De Fiore and Oreste Tristani write. “Interest rate cuts instead should be considered only when the scope for credit policy is exhausted.”

De Fiore and Tristani study the optimal combination of interest rate policy and a central bank credit policy when financial shocks impair the efficiency of private banks in providing credit.

They find that direct lending could result in a welfare loss of 0.11% compared to the steady state, as opposed to 0.75% if only interest rate policy is used. If both were used the welfare loss would be 0.09%, they find.

Direct lending is desirable because it offsets increases in credit spreads caused by the deterioration in banks’ ability to audit borrowers, they say. Households also benefit because the policy does not lower returns on assets such as bank deposits.

In contrast, lowering short-term rates is less desirable, they argue, as it lowers the return on households’ bank deposits. This induces savers to “sub-optimally change their intertemporal consumption patterns”.

Implementing a credit policy is not desirable in all types of financial shocks, but only when it impairs a bank’s ability to provide credit, the authors say.