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Debt Overhang, Risk Shifting and Zombie Lending

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Listed:
  • Nicolas Aragon

    (National Bank of Ukraine
    Universidad Carlos III de Madrid
    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.

Suggested Citation

  • Nicolas Aragon, 2022. "Debt Overhang, Risk Shifting and Zombie Lending," Working Papers 01/2022, National Bank of Ukraine.
    • Handle: RePEc:ukb:wpaper:01/2022
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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