Government Banks and Interventions in Credit Markets

We study a large scale intervention in the Brazilian banking sector, characterized by a sudden increase in the supply of credit provided by commercial government banks. Theoretically, the effect of this type of policy is ambiguous: the effect of the policy is beneficial if credit is inefficiently low, or harmful if public banks finance riskier firms with unproductive projects. We use confidential credit registry data to document a series of empirical facts and test if the policy alleviates inefficient underprovision of credit. We show that while the policy leads to a reduction in private banks interest rates and to an increase in total credit, public banks experience worsening of loan default risk. However, after the policy was implemented government banks subsidized more levered firms, and loans to indebted firms explain the increase in loan default in public banks relative to private banks. Moreover, neither the increase in total credit nor the reduction in interest rates by private banks has any observable effects on GDP or employment growth. Our results suggest that the policy increased credit misallocation, and that adverse selection did not play a significant role in the allocation of credit in Brazil.