Author: Nicolas Aragon (National Bank of Ukraineб Universidad Carlos III de Madrid, Universidad Carlos III de Madrid and Kyiv School of Economics).
Abstract: After bubbles collapse, banks have often rolled-over debt at subsidized rates to insolvent borrowers or "zombie firms." This paper explores the incentives to restructure debt in a game with risk shifting under debt overhang. We provide conditions under which it is privately optimal to zombielend even when it is socially ineffcient. When a farm becomes insolvent, the firm loses access to competitive funding and its bank can exert monopoly power. The bank prefers to zombie-lend given that owing funds for investment is not profitable due to risk shifting and liquidation entails costs. The model explains the inefficiency of traditional policies in the presence of zombies such as bank recapitalization and monetary policy and highlights the necessity of debt haircuts.
Cite as: Aragon, N (2022). Debt overhang, risk shifting and zombie lending. NBU Working Papers, 1/2022. Kyiv: National Bank of Ukraine. Retrieved from https://bank.gov.ua/admin_uploads/article/WP_2022-01_Aragon_eng.pdf.