In spite of growing regulatory pressure in most developed economies, bank lending to zombie firms remains a pressing issue in the world of finance. The concept of zombie firms describes companies that are unable to cover their debt servicing costs with operating profits, becoming unviable and in financial distress. One factor that has been identified as contributing to the persistence of these firms is the willingness of banks to continue lending to them, despite their poor financial health. These firms are artificially kept alive by banks.
“In the 1990s, during Japan's lost decade, a phenomenon was observed where many financially unstable firms were kept afloat due to bank lending instead of being allowed to exit the market. The banks had invested a significant amount of money in these firms, and they preferred to continue lending money to avoid the firm’s bankruptcy instead of lending to new firms. This practice of "zombie lending" has become increasingly prevalent, especially after the global financial crisis and the European sovereign debt crisis. A low interest rate environment, together with low levels of bank capital, creates the ideal environment for zombie lending. It became apparent that zombie lending was also occurring in India and China, making it a global phenomenon. In Portugal, with its slow economic growth, all the conditions were set to create a phenomenon similar to that seen decades earlier in Japan.” – Geraldo Cerqueiro Professor at CATÓLICA-LISBON
At its core, zombie lending is a form of "extend and pretend" banking. Instead of addressing the underlying problems of a struggling borrower, banks continue to lend in the hopes that the borrower will be able to repay the debt in the future. This approach can have disastrous consequences for both the borrower and the lender, as it allows underlying problems to fester and grow. It also has negative consequences on the economy, as more creditworthy firms may have difficulties in having access to credit. Competitors of zombie firms may suffer as well from the distortions they create.
Banks engage in zombie lending in part due to the short-term incentives that drive many bankers. By continuing to lend to struggling companies, bankers can continue to generate fees and commissions, even if the loans ultimately turn sour. With this behavior, banks also avoid the recognition of losses.
“In the event of a company defaulting on a large loan from a bank, the bank is faced with a significant problem. This is because it is required to set aside funds, or "provision", to cover the potential loss. When a bank must provision, it uses its own capital to offset the declared loss. However, if the bank's capital is already low, it will be hesitant to declare losses, as doing so could lead to the bank falling below the legal minimum capital requirement, consequently facing regulatory interventions.
Historically, it was widely believed that providing banks with more capital was the most effective way to address the problem of zombie lending, where banks continue to lend to companies that are unlikely to be able to repay their debts. It was assumed that banks were hesitant to declare losses because they lacked sufficient equity to absorb them. However, following the European sovereign debt crisis, attempts were made to regulate the industry and increase banks' capital levels, yet the problem persisted. Another reason why banks are reluctant to declare losses is that their CEOs are under pressure to please shareholders and maintain their own careers. This is a challenge faced by banks of all sizes. The only way to stop zombie lending is to compel banks to recognize losses, rather than providing them with more capital.” – Geraldo Cerqueiro
So, what could force the banks to avoid this distorting behavior?
On-site inspecting zombie lending
Diana Bonfim and Geraldo Cerqueiro Professors at CATÓLICA-LISBON and their co-authors, Hans Degryse and Steven Ongena, analyzed credit portfolios of various Portuguese banks that underwent large-scale on-site inspections. They discovered that inspections can greatly affect banks' future lending choices. The intrusive inspections carried out on banks allowed supervisors to analyze all the information on borrowers and evaluate if the banks were giving favorable lending conditions to firms who are in bad financial health, hence scrutinizing if the banks were assessing the credits risks properly.
The authors show that after the inspections, inspected banks became less likely to finance zombie companies. Inspected banks became 20% less likely to refinance unviable zombie firms. Once banks were forced to recognize losses on existing exposures, they had less incentives to continue to support these ailing firms.
In the realm of banking, it was once assumed that extending loans to struggling firms would prevent them from declaring losses, thus perpetuating their status as zombie firms and delaying the inevitable default. Yet, a shift in perspective has occurred, with banks now recognizing that regulators are expected to scrutinize their loan books in a timely and intrusive manner, thereby making them less willing to try to postpone the recognition of inevitable losses. In other words, the prevailing sentiment among financial institutions is that it might be more prudent to cease lending now to unviable firms than to postpone the unavoidable. – Geraldo Cerqueiro
The study also investigated the impact of these inspections on loan default rates. It was found that when a bank refinances a zombie borrower, it prevents the firm from defaulting on its outstanding debt. However, within a year of their bank being inspected, zombie companies were 1 to 2 percentage points more likely to default. This helps to confirm the hypothesis that banks were keeping these firms artificially alive.
The inspections also had aggregate effects. By analyzing industry-level data, the results revealed that industries with higher exposure to these inspections experienced a higher rate of firm creation and increased average productivity, suggesting that the inspections had a cleansing effect on the economy. However, banks tend to change their lending decisions only in sectors that are being inspected, rather than across all sectors. The behavior changes only when banks were forced to fully recognize potential losses. As such, the inspections changed bank behavior mostly through a mechanism that forces the recognition of losses, rather than through a more general discipling mechanism.
Overall, these results highlight the importance of recognizing losses promptly and comprehensively. This can help to mitigate the likelihood of zombie firms being refinanced and can contribute to a more efficient allocation of resources in the economy.
How can policies encourage banks to promptly recognize their losses and stop zombie lending?
Policies Implications
These intrusive inspections are difficult to implement because they are costly, very intensive in human capital and cannot not be done frequently. However, policies that promote prompt and comprehensive recognition of losses can be effective in mitigating zombie lending. Further, enhancing transparency and information sharing is a crucial step in addressing zombie lending and promoting a healthy financial system.
You can read more about Diana’s and Geraldo’s work on the Management Science article “On-Site Inspecting Zombie Lending”, or on the Banco de Portugal Working Papers.
Written by Daniela Guerra, Science Communicator at CUBE