Zombies, Insolvency Reform, and Misallocation of Capital

Distressed and zombie firms are widespread in economies with weak insolvency regimes. This study investigates whether reforming insolvency laws can reduce capital misallocation. We introduce a framework for decomposing financial misallocation and derive metrics adequate to capture two conceptually distinct sources of inefficiency. The first refers to composition misallocation from inefficient leverage distribution, while the second refers to scale misallocation from suboptimal capital allocation among firms. Using firm-level data from 22 economies between 2003 and 2024, we find that effective reforms significantly reduce scale misallocation, especially in sectors with a high concentration of distressed and zombie firms. Event studies reveal a steady decline in scale misallocation following reform, mirroring higher recovery rates and shorter insolvency durations, leading to a 3.5% productivity gain over 5 years. We present additional firm-level evidence substantiating these gains: reforms reduce debt among distressed and zombie firms, increase their borrowing costs, and enable previously credit-constrained firms to access greater funding for investment, thereby improving overall capital allocation.