11 October 2017

ECB: Do we want these two to tango? On zombie firms and stressed banks in Europe

This paper investigates the impact of bank stress on the deleveraging process of non-financial small and medium-sized enterprises, with a focus on euro area periphery countries. In particular, authors test whether banks in distress delay the deleveraging of non-viable firms, the so-called zombie firms.

After the financial crisis of 2007/2008 and the subsequent euro area sovereign debt crisis, many banks in euro area periphery countries began to grapple with a wide range of vulnerabilities, stemming above all from high levels of non-performing loans. Simultaneously, economies in the euro area periphery experienced a rise in the share of low-productivity, possibly non-viable, firms with high levels of financial debt.

Authors develop a continuous measure of bank stress, which is based on a principal component analysis of five observable bank traits also employed by microprudential supervisors. They identify zombie firms as those with negative returns and investments, as well as low debt servicing capacity, whereby these criteria have to be met for at least two consecutive years. In a fixed effects regression framework, they find that bank stress does not increase the indebtedness of healthy firms.

However, an increase of bank stress by one standard deviation is associated with an increase in firm leverage of zombie firms by around one percentage point annually. This effect is only present in the five euro area periphery countries, whereas in core countries, they identify no significant effect of bank stress on zombie firm leverage. This suggests that stressed banks in poorly performing economies might be more inclined to conduct risky lending to distressed borrowers, possibly in attempts to gamble for resurrection.

Their findings indicate that the interaction between weak banks and weak non-financial corporations is a possible source of distortion in the  deleveraging efforts of euro area periphery economies. The results are robust to several different methods of identifying ‘zombie firm’ and ‘bank stress’, alternative dependent variables, and different econometric specifications, including a matched sample across euro area periphery and core countries.

Overall, the results suggest that policies aimed at swiftly addressing remaining bank weaknesses and facilitating bank deleveraging, most notably by increasing bank capitalisation or by providing incentives for banks to move more decisively with the workout of bad assets, could support the deleveraging of the corporate sector in general, and SMEs in particular.

Working paper

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