Banks have an important role in the allocation of resources in the economy, as they decide which projects should or should not be financed. There is evidence that sometimes this allocation might not be optimal. For instance, when financing costs are especially low, there are several factors that may provide incentives for banks to prefer to finance more vulnerable or riskier firms. These incentives are typically stronger in the aftermath of an economic and financial crisis, given that there are more distressed firms in such periods. This phenomenon was first identified in Japan after the Asian crisis of the 90s and is usually called “zombie lending”. There is ample evidence that this type of financing was present all over Europe in the years following the euro area sovereign debt crisis.

However, there is a question that remains unanswered: what can be done to change the incentives for this kind of lending behavior to occur? Using loan-level data for Portuguese firms, we find that an intrusive supervisory action might significantly change banks’ lending behavior. The on-site inspections carried out during the financial assistance program led to a significant decrease of the refinancing probability of firms close to bankruptcy. It is important to understand what are the mechanisms that explain this change in behavior.  There are at least two mechanisms at play. First, banks’ risk preferences may change (for instance because they fear the consequences of future inspections). Second, the forced recognition of losses may weaken banks’ incentives to engage in evergreening). Our analysis shows that even though both mechanisms are at play, the timely recognition of losses seems to be crucial to improve the allocation of resources in the economy.

For more details see Diana Bonfim, Geraldo Cerqueiro, Hans Degryse and Steven Ongena (2020) “On-site inspecting zombie lending”, Banco de Portugal Working Papers 2020/1.

Prepared by Diana Bonfim. The analyses, opinions, and findings expressed above are those of the authors and do not necessarily coincide with those of Banco de Portugal or the Eurosystem.

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