Undercapitalization and “Zombie” Lending

Undercapitalization and “Zombie” Lending

One of the many symptoms (or, in some views, causes) of a general slowdown of dynamism and growth in developed economies is the prevalence of lending to “zombie firms,” where banks will lend to low-productivity firms that would be underwater if their lenders didn’t roll over their credit.

A new paper from the European Central Bank finds that the imposition of additional capital requirements that would have recognized losses from struggling firms led to banks increasing their lending to such “zombie firms” at the expense of lending to more productive enterprises:

We provide evidence that a weak banking sector contributed to low productivity following the European debt crisis. An unexpected increase in capital requirements provides a natural experiment to study the effects of reduced capital adequacy on productivity. Affected banks respond by cutting lending but also by reallocating credit to distressed firms with underreported loan losses. We develop a method to detect underreported losses using loan-level data. We show that the credit reallocation leads to a reallocation of production factors across firms. We find that the resulting factor misallocation accounts for 20% of the decline in productivity in Portugal in 2012. [Emphasis added].

The policy change in question was a set of new supervisory rules imposed during the 2011-2012 sovereign debt crisis, which required banks to deduct from their available capital the difference between the sum of provisions (money set aside to cover potential losses) and  impairments (the loss of the value of an asset), which had been previously underreported.

To avoid falling below the regulatory minimum due to this change in accounting and supervision during a credit crunch, banks would “roll over” loans to at-risk “zombie” firms to prevent them from going into default (and reducing their regulatory capital). This lending came at the expense of lending to more productive firms.

The paper recommends raising regulatory capital requirements and supervision during good times to avoid such a state of affairs during bad times. One tool that would do so in a way that encourages lending during downturns could be the countercyclical capital buffer, which increases in boom times but is reduced during a downturn.

I didn't find this helpful.This was helpful. Please let us know if you found this article helpful.
By |2019-02-15T11:40:38-08:00February 15th, 2019|Blog, Financial Regulation|