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Do zombies rise when interest rates fall: A relationship banking model

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  • Herweg, Fabian
  • Kähny, Maximilian

Abstract

A relationship bank or market investors finance an entrepreneur’s risky project. Unlike investors, the bank can identify and liquidate bad projects at an interim stage. If the entrepreneur can provide only limited capital, the optimal loan contract induces an inefficient continuation decision, i.e., the bank engages in zombie lending. In the short run – for a given contract – the bank’s incentive to roll over bad loans is enhanced if the base interest rate drops. In the long run, however, the bank adjusts the contract to a drop in the interest rate, and the effect on zombification is reversed.

Suggested Citation

  • Herweg, Fabian & Kähny, Maximilian, 2026. "Do zombies rise when interest rates fall: A relationship banking model," European Economic Review, Elsevier, vol. 182(C).
    • Handle: RePEc:eee:eecrev:v:182:y:2026:i:c:s0014292125002685
    DOI: 10.1016/j.euroecorev.2025.105218
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    Keywords

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    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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