Unintended Consequences of Specialized Bankruptcy Courts: Evidence from Zombie Lending

Abstract

Using a sample of listed zombie firms in China over the period 2016-2021, we examine the economic consequences of the introduction of specialized bankruptcy courts (SBCs) from the perspective of zombie lending. We find that the introduction of the SBCs unexpectedly and significantly increases the size of zombie lending, given the intervention of local governments and the perverse incentives of banks. The mechanism is that introduction of the SBCs improves the efficiency of corporate bankruptcy hearings, increasing the exposure probability of banks’ bad loans and regional unemployment. And in order to cover up bad loans and unemployment, banks and governments have increased their demand for zombie firms and thus have to continue lending to them. We also find that the introduction of the SBCs significantly increased the crowding out effect of zombie credit on non-zombie credit. And banks changed their lending strategies to zombie firms in order to avoid the risks associated with the increase in zombie lending, using more short-term loans and mortgage-backed loans. We show that the formal system of bankruptcy courts fails to constrain zombie lending, given the intervention of local governments and the perverse incentives of banks. This suggests that regulators should reduce government intervention in credit market and establish effective regulatory policies other than capital adequacy.

Keywords: Specialized bankruptcy courts, Zombie lending, Bank perverse incentives, Government intervention