Credit market conditions have been identified as a key driver of the prevalence of zombie firms. This column studies the relationship between credit conditions and zombie firms using a new theoretical framework. It highlights that credit market tightness creates opposing incentives for banks and firms. Increases in credit market tightness first lead to a higher share of zombie firms, but the share begins to decline at higher levels of tightness. The theoretical predictions are supported by industry-level data from Japan, which furthermore shows that the ability of capital injections to reduce zombie lending increases with credit market tightness.
Zombie firms are a significant concern for policymakers, as they are unproductive entities that inefficiently allocate resources and hinder economic growth. The share of zombie firms has been increasing over time in both advanced and emerging economies (Albuquerque and Iyer 2023). Credit market conditions have long been identified as a key driver of the prevalence of zombie firms, particularly for their role in Japan’s economic stagnation (Caballero et al. 2008). A growing body of research links the increasing share of zombie firms to the abundance of available credit, which incentivises banks to continue lending to unprofitable firms (Acharya et al. 2022, 2024, Andrews and Petroulakis 2019, Favara et al. 2024, Hamano and Zanetti 2017, 2022, and Tracey 2025).
Despite the well-documented relationship between credit conditions and the prevalence of zombie firms, the theoretical foundations of this connection have received limited attention. Why do banks choose to forbear on firm credit payments when credit supply is abundant, and why do firm owners persist in operating loss-making enterprises? In our new paper (Hamano et al. 2025), we tackle this question by developing the first theoretical model linking the supply and demand for credit in a frictional credit market with the share of zombie firms. Our framework introduces a novel measure of credit market tightness representing the abundance of credit that underpins opposing forces that generate zombie firms in frictional financial markets. The theory allows us to test and empirically validate the link between credit abundance and zombie firms using industry-level data from Japan. We find that during the Japanese banking crisis of the early 2000s, credit injections into industries with tight credit markets — by banks with excess liquidity — led to a reduction in the share of zombie firms.
Costs of credit intermediation, abundance of credit, and zombie firms
Our study explores the notion that the costs associated with credit intermediation play a fundamental role in determining the prevalence of zombie firms. The costs we consider extend beyond contractual arrangements and regulatory compliance to include the search and opportunity costs involved in establishing credit relationships. Our framework formalises the idea that the avoidance of search costs incentivises lending to unprofitable firms (zombies), as both banks and firms lower lending standards to bypass the expenses associated with finding suitable credit counterparts.
The abundance of credit generates distinct opportunity costs of forming credit relationships between bank and firm. Specifically, for a bank, credit abundance decreases the likelihood of finding borrowing firms and increases the opportunity costs of forgoing credit relationships, thus inducing the bank to lower lending standards. For a firm, the incentives are reversed. This is because credit abundance increases the likelihood of finding lending banks, thereby reducing a firm’s opportunity costs of forming a new credit relationship and providing incentives to the firm’s ownership to exit lending relations to avoid losses.
Thus, while search costs unambiguously increase zombie lending, credit abundance creates opposing incentives for banks and firms, ultimately fostering the formation of weak credit relationships and contributing to the proliferation of zombie firms.
A theory of zombie firms and credit market tightness
We formalise these ideas in a parsimonious model of frictional financial intermediation between banks and firms. We assume that the costs of financial intermediation arise from search and matching frictions that obstruct the costless meeting between banks and firms with heterogeneous productivity in the credit market. Search frictions entail two distinct forces on the proliferation of zombie firms.
First, they lower the threshold of idiosyncratic productivity required for a firm to secure credit. Banks, seeking to avoid the costs of searching for new borrowers, optimally maintain lending relationships with low-productivity firms with negative profits, thereby increasing the equilibrium share of zombie firms.
Second, search frictions make the opportunity costs of financial intermediation endogenous to the degree of abundance of credit in financial markets. Credit availability exerts two opposing forces on the creation of zombie firms. On one hand, an increase in credit supply intensifies competition among banks and raises credit market tightness — captured by the ratio of loan supply to demand. The rise in credit market tightness and the resulting increase in competition across banks generate countervailing opportunity costs for the bank and the firm. In a tight financial market with abundant credit, the bank encounters elevated search and opportunity costs and optimally lends to low-productivity firms to avoid such costs, thus stimulating the proliferation of zombie firms. On the other hand, when credit is abundant and the credit market is tight, firm owners face lower opportunity costs for staying in a credit relationship. They can terminate the relationship and find with low search costs a new lending bank upon receiving a new draw of productivity, hence discouraging the proliferation of zombie firms. Thus, the increase in credit market tightness incentivises bank lenders and disincentivises firm equity holders from maintaining a weak credit relationship.
These two opposing forces create an inverted U-shaped relationship between credit market tightness and the prevalence of zombie firms, as illustrated in our theoretical model (Figure 1). An increase in credit market tightness raises the bank’s opportunity cost of foregoing a credit relationship, prompting banks to lower the productivity threshold required for firms to secure and maintain credit. Consequently, low-productivity firms are more likely to remain in the market, leading to a higher share of zombie firms. However, as credit market tightness continues to rise, low-productivity firm owners become increasingly incentivised to terminate unprofitable credit relationships to avoid sustained losses. This effect is amplified by lower search costs for finding alternative lenders and the possibility of securing better outcomes through a new productivity draw. As a result, the share of zombie firms begins to decline. The model demonstrates that beyond a sufficiently high level of credit market tightness, the firm owner’s incentive to exit the credit relationship outweighs the bank’s incentive to sustain it, leading to a reduction in the share of zombie firms. Similarly, capital injections into banks decrease lending to zombie firms, as an exogenous increase in abundance of credit — leading to an increase in credit market tightness — encourages firms to abandon unprofitable credit arrangements.
Figure 1 Theoretical relationship between the share of zombie firms and credit market tightness
Our model predicts that for sufficiently large credit injections, credit abundance and high tightness in the financial market strengthen the firm’s incentive to forgo unprofitable credit relationships relative to the bank’s incentive to maintain unprofitable relationships to avoid high search costs, reducing the share of zombie firms on balance.
The theory posits the following two empirical predictions:
- Inverted U-shaped relationship: The share of zombie firms follows an inverted U-shaped pattern in relation to credit market tightness.
- Capital injection effectiveness: The ability of capital injections to reduce zombie lending strengthens as credit market tightness increases and as firms gain greater bargaining power.
Evidence of zombie firms and credit market tightness
We empirically validate our theoretical predictions using industry-level data from 31 sectors in Japan over the period 2000–2019. Zombie firms are those that receive subsidised credit, indicated by interest payments that are lower than the hypothetical risk-free interest payments, as originally defined in Caballero et al. (2008). Using this definition, we compute the share of zombie firms from the Nikkei Financial Quest database. To construct measures of credit market tightness consistent with our theoretical framework, we leverage data on loan supply and demand from the Loan Officer Opinion Survey on Bank Lending Practices at Large Japanese Banks and the Tankan Survey, conducted by the Bank of Japan. As shown in Figure 2, the share of zombie firms exhibits an upward trend over the sample period and displays cyclical variation.
Figure 2 Time series showing the aggregate and sectoral dynamics of credit market tightness and the share of zombie firms
Figure 3 illustrates an inverted U-shaped relationship between credit market tightness — encapsulating credit abundance — and the share of zombie firms that is consistent with the theory. This pattern is further validated by the empirical test for non-linearity in Lind and Mehlum (2010). The evidence supports the first prediction of our theory.
Figure 3 Empirical relation between credit market tightness and the zombie ratio and fitted estimates
We test the second theoretical prediction regarding the effectiveness of capital injections in reducing zombie lending by developing a novel index that measures firms’ exposure to such injections. This index is constructed based on exogenous capital injections and their impact on the share of zombie firms during Japan’s late-1990s banking crisis, following the methodology of Giannetti and Simonov (2013). Consistent with our theory, we find that the effectiveness of capital injections in reducing the proportion of zombie firms increases with credit market tightness and hence the abundance of credit in an industry.
Overall, both the theoretical and empirical evidence consistently demonstrate a robust non-linear, inverted-U-shaped relationship between credit abundance and the prevalence of zombie firms in the economy. Our results highlight the need for further research on the broader implications of credit market frictions on economic growth and the optimal design of policy interventions to address financial frictions for the allocation of credit.
Source : VOXeu
