Public Funding of Banks and Firms in a Time of Crisis

Abstract

We study public funding of banks and nonfinancial firms in a time of crisis. We find that bank capitalization is more effective in stabilizing the economy than direct funding to firms, but it also creates larger distortions. We show that the optimal, social-welfare-maximizing, structure of a public funding program depends on its size. Small funding programs should target banks, while large programs should be directed at nonfinancial firms. We provide an interpretation of the result in terms of dominated and undominated policies under genuine uncertainty.