DP16658 Zombie Lending and Policy Traps
We build a model with heterogeneous firms and banks to analyze how policy can affect
the efficiency of credit allocation and long-term economic outcomes. When transitory
demand or productivity shocks are small, conventional monetary policy can restore
efficient bank lending and production by lowering interest rates. For moderately large
shocks, however, conventional policy may hit the effective lower bound, necessitating
unconventional policy such as regulatory forbearance towards banks to stabilize the
economy. Aggressive unconventional policy runs the risk of introducing zombie lending and a “diabolical sorting”, whereby low-capitalization banks extend new credit or
evergreen existing loans to low-productivity firms. In a dynamic setting, policy aimed
at avoiding short-term recessions can be trapped into protracted excessive forbearance due to congestion externalities imposed by zombie lending on healthier firms.
The resulting economic sclerosis transforms transitory shocks into phases of delayed
recovery and potentially permanent output losses. Our model highlights the importance of maintaining a well-capitalized banking system to avoid such policy traps as
not raising capital requirements upfront but raising them significantly upon the arrival
of shocks can also backfire by encouraging zombie lending.