On-site inspecting zombie lending

Zombie firms have received a lot of attention from academics and policymakers in the aftermath of the last global financial crisis. These are firms that are non-viable, but they remain artificially alive through the rollover of bank loans. This typically happens in low interest rate environments, when banks have fewer incentives to recognize losses in their balance sheet. By lending to these zombie firms, banks are not allocating scarce funding to firms with viable projects, thereby leading to a misallocation of resources in the economy.

In the early weeks of the COVID-19 pandemic, governments worldwide implemented a wide array of measures to ensure that firms could withstand the unprecedented liquidity shock they were facing. Many of these measures work through banks, which are currently lending to a large number of firms in distress, with highly uncertain prospects. While providing this immediate liquidity relieve is crucial, many firms will soon become unviable. Zombie lending is thus likely to reemerge as a concern of policymakers.

This paper analyzes how strong supervision can play a role in changing banks’ behavior, decreasing their willingness to keep rolling over loans to zombie firms. We study “unconventional supervision” stemming from a series of large-scale on-site inspections made on the credit portfolios of several Portuguese banks.

We find that after these intrusive inspections, an inspected bank becomes 20% less likely to refinance a zombie firm, spurring its default. However, banks change their lending decisions only in the inspected sectors.

Our results show that zombie lending is curtailed mainly due to the fact that banks are forced to recognize losses, rather than through a general disciplining effect. Their incentives to keep these firms artificially alive disappear once these losses cannot be avoided. This means that policies that promote an encompassing and prompt recognition of losses can effectively mitigate zombie lending in the aftermath of a crisis.

Click here to go to the paper by Diana Bonfim, Geraldo Cerqueiro, Hans Degryse, and Steven Ongena.