Can Government Paternalism Prevent Credit Market Failure?∗

This paper investigates how the possibility of government subsidies to firms affects lending and managerial incentives. We develop a model that shows that government support can perform as implicit insurer of firms, which leads to two main effects: lowering incentives of managers and increase of incentives to finance. The equilibrium with government intervention can be more efficient than one without intervention. We test the model predictions on Russian enterprise-level panel data for 1996-2000. Empirical evidence supports two predictions: 1) the probability that a firm gets external financing increases with increase of government’s care about firms’ survival; 2) firms with intermediate performance get subsidies.