Zombie Prevalence and Bank Health: Exploring Feedback Effects

Abstract

This paper investigates feedback effects between bank health and zombie firms—financially distressed firms receiving subsidized credit. The literature focuses on how banks create zombies, overlooking zombies’ impact on bank health. Using Spanish firm-bank data (2005-2014), we document a vicious cycle: lower bank capital ratios are associated with higher zombie activity in served industries, while higher zombie prevalence is associated with reduced bank capital. We link this to a previously unexplored mechanism where banks respond appropriately to observable financial distress through higher provisioning, but overlook risks from relationship borrowers receiving subsidized rates. Our findings suggest that this feedback stems not from financial distress alone, but from the combination of distress with interest rate subsidies.