Finance and Economics Discussion Series (FEDS)
Designing a Main Street Lending Facility
Banks add value by monitoring borrowers. High funding costs make banks reluctant to lend. A central bank can ease funding by purchasing loans, but cannot distinguish which loans require more or less monitoring, exposing it to adverse selection. A multi-tier loan pricing facility arises as the optimal institutional design setting both the purchase price and banks' risk retention for given loan characteristics. This design dominates uniform (flat) structure for loan purchases, provides the right incentives to banks and achieves maximum lending at lower rates to businesses. Both the multi-tier and flat structures deliver welfare gains compared to no intervention, but the relative gain between the two depends on three sufficient statistics: the share of loans requiring monitoring, the risk-retention ratio, and the liquidity premium.
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