55 Pages Posted: 16 Dec 2019 Last revised: 12 Oct 2020
Date Written: November 29, 2019
"Zombie" borrowers - insolvent firms sustained by continued extension of credit by complicit banks - can prevent the efficient allocation of resources. We use supervisory data on the universe of large bank-borrower relationships in India to examine two key reforms aimed at tackling zombie lending: an overhaul of the bankruptcy law, and a subsequent regulation that removed lender discretion in recognizing bad loans. Using a novel method to identify zombies, we show that the latter reform is more effective in forcing banks to recognize zombie loans as non-performing. While the effect of the bankruptcy law is muted in weakly capitalized and government-owned banks, the regulatory action is able to nullify the influence of capital but not ownership. Post-intervention credit reallocates to young and healthy borrowers. Zombie borrowers then cut investment, whereas healthy borrowers expand it. Overall, our results suggest that regulatory action might be necessary, above and beyond bankruptcy reform, to target zombie lending in weakly capitalized banking systems, but governance frictions can limit the efficacy of even the strongest regulation.
Keywords: NPA, Zombie, Bankruptcy, Bank Regulation, India, Creative Destruction
JEL Classification: F34, G23, G28, G33, K42, O53
Suggested Citation: Suggested Citation