Should zombie lending always be prevented?

It has been argued that zombie lending might have been one of the main culprits behind the sluggish Japanese recovery in the so-called “lost decade”. Among others, zombie lending may lead to misallocation of capital, reduction of profits for healthy firms, and lower employment. The only remaining question is: Why do banks engage in zombie lending practices? Is it due to wrong incentives for bank managers, or perhaps misguided government policies? Using a simple model, the paper exposes a strong link between collateral value and the strategic importance of zombie lending. The author shows that zombie lending may be an optimal strategy for a bank in some cases as it leads to greater lending ex-ante and prevents further losses from fire sales. Consequently, it can be argued that zombie lending is a side effect of market incompleteness and is ex ante welfare improving, so that it may not be possible or even desirable to prevent its occurrence. Another policy implication is that capital injection into the banks would not solve any problem. However, direct purchase of the collateral on the market would certainly alleviate the problem of zombie lending.