We find strong evidence of moral hazard in bank behavior under public loan guarantees, using a unique natural experiment in Japan during the COVID-19 pandemic. Specifically, exogenous variations in loan rates occurred across Japan’s 47 prefectures. This experiment arose from the central government’s so-called “zero-zero” loan program, which was introduced to support small and medium-sized enterprises by providing 100% guarantees on bank loans and full reimbursement of interest expenses. At the same time, prefectural governments independently set limits on loan rates. This institutional setting allows the authors to investigate how banks respond to generous public guarantees and the resulting incentives for bank lending behavior.
