CAFRAL-SRU Brown Bag Seminar - Unearthing Zombies
Speaker(s) Dr. Nirupama Kulkarni, Research Director, CAFRAL Publication Online
ABSTRACT

"Zombie" borrowers, which are 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. 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 regulation is able to nullify the influence of capital but not ownership. Post-reform, credit reallocates to young and healthy borrowers. Zombie borrowers then cut investment, whereas healthy borrowers expand it. Overall, our results suggest that regulatory action toward zombies might be necessary in weakly capitalized banking systems, but governance frictions can limit the efficacy of even the strongest regulation.