Don't Fear Zombies. At Least, Not Yet

As the economic consequences of the lockdown became apparent in the spring of 2020, governments rushed to provide financial support in the form of lending guarantees to shuttered businesses. The need to act fast to avoid a wave of bankruptcies created a potential increase of funds flowing to weak or "zombie" firms.

Previous research has argued that lending to weak firms delays economic recovery because it slows the reallocation of assets from low productivity uses (the zombies) to productive ones, hurting healthy firms in two ways: reducing the flow of bank credit that is available, and creating a sort of hidden subsidy for uncompetitive firms. Assessing the potential impact of zombie lending during the COVID-19 crisis is important for future economic recovery.

The paper "Identifying the Real Effects of Zombie Lending" in the Oxford Review of Corporate Finance Studies, by Fabiano Schivardi (Luiss University), Guido Tabellini (Bocconi University), and Enrico Sette (Bank of Italy) contributes to an important academic and policy debate by arguing that "there is no solid support for the assertion that government policies to sustain corporate lending will have negative consequences due to zombie lending."

The trio of authors builds on their previous research about zombie lending in "Credit Misallocation During the European Financial Crisis" (IGIER working paper 2020) exploring the extent and consequences of credit misallocation in Italy during and after the Eurozone Crisis. In fact, while keeping zombies alive increases credit misallocation in the long run, doing so during downturns may have short term beneficial effects such as avoiding bankruptcies and preventing layoffs. The authors cite evidence using Italian data that the bulk of loan requests during the crisis will come from firms that were financially sound before the start of the pandemic.

Secondly, and perhaps more crucially, the authors show that the framework used in past literature to identify the negative effects of zombie lending on the real economy suffers from a serious identification problem. The paper concludes that "the risk that government credit guaranteed schemes create an incentive for zombie lending should not hold back governments and banks from providing firms with credit during the COVID-19 pandemic: it is essential to avoid that the liquidity crisis pushes many solvent firms out of the market."

There's a lesson here for regulators, according to Professor Tabellini. "After the financial crisis, policy makers forced banks to reduce credit to zombie firms. Instead, there are benefits to letting bank credit flow to the economy without worrying too much about being selective as to where the credit goes. Forcing banks to recognize their bad loans is important in a second phase," he said.

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