Credit misallocation during the European financial crisis

Fabiano Schivardi, Enrico Sette, Guido Tabellini 18 July 2017



An important dimension of financial crises is a weakened banking sector. There is a widespread perception in the policy debate that under-capitalised banks can prolong crises by misallocating credit to weaker firms on the verge of bankruptcy and restraining credit to healthy borrowers (‘zombie lending’). This perception is supported by evidence for Japan during the ‘lost decade’ (Peek and Rosengren 2005, Caballero et al. 2008) and, more recently, for the Eurozone during the financial crisis (Acharya et al. 2016).

Due to data and methodological challenges, however, assessing the consequences of a weakened banking sector on credit allocation and real economic activity is difficult. Moreover, during a recession not all economic effects of zombie lending are necessarily bad for the healthy part of the economy. Extending credit to very weak firms keeps them alive and may prevent layoffs, in turn mitigating the adverse aggregate demand externalities that are so important during a recession (Mian et al. 2015). Firms closures can also disrupt input-output relationships that, at least in the short run, can be difficult to substitute for (Barrot and Sauvagnat 2016).

In a recent paper, we explore the extent and consequences of credit misallocation in Italy during and after the Eurozone Crisis (Schivardi et al. 2017). We ask two main questions:

  • What bank characteristics are more conducive to zombie lending?
  • What is the cost of zombie lending in terms of lost economic activity and misallocation of real resources?

Our results show that:

  • Under-capitalised banks were less likely to cut credit to zombie firms;
  • Credit misallocation increased the failure rate of healthy firms and reduced the failure rate of zombie firms;
  • However, the adverse effects of credit misallocation on the growth rate of healthier firms were negligible, and so were the effects on total factor productivity (TFP) dispersion.1

Data and empirical strategy

We use a unique dataset that covers almost all bank-firm relationships in Italy for the period 2004-2013. Italy is an ideal testing ground for these issues, because the financial crisis induced a very deep and long recession, that left a cumulative drop in GDP of almost 10%. This was associated with a prolonged contraction in bank credit (see Figure 1).

Figure 1 Credit growth and GDP growth in Italy

Note: The figure shows the growth of credit by banks to non-financial firms and GDP growth in Italy between 2004 and 2014.
Source: Credit is from Supervisory reports, GDP growth is from National Statistics (ISTAT).

Unlike other Eurozone countries, Italy did not inject public funds to recapitalise its banking system, nor did it create a bad bank to absorb the non-performing loans. As a result, Italian banks remained saddled with a large fraction of bad loans, and several banks struggled to meet the stricter capital requirements imposed by regulators in the aftermath of the crisis. The problem persists today, and it is one of the major current policy challenges in Italy.

We observe all incorporated firms, including small ones, and we focus on the most extreme form of credit misallocation, namely, loans granted to firms that clearly are no longer viable – zombie firms – defined as firms that are highly indebted and for which the returns on assets have been systematically below the cost of capital of the safest firms.

To study what bank characteristics are conducive to zombie lending, we regress the growth rate of granted credit at the firm-bank level on various indicators of banks' solidity, using the regulatory capital ratio as the preferred one. Figure 2 shows that banks with low capital have a substantially higher share of zombies out of total borrowers.

Figure 2 Share of zombie firms by quartile of bank capital

Notes: The figure shows the share of zombie firms by quartiles of bank capital. The share is computed using bank-firm relationships from the Italian Credit Register. Bank capital is the ratio of regulatory capital to risk weighted assets. Data cover the period 2004-2013.

The identification challenge in this type of regressions is that the observed granted credit is the result of both demand and supply of credit. To single out the supply effects, we exploit the fact that Italian firms typically borrow from more than one bank. This enables us to compare banks with different degrees of capitalisation that lend to the same firm, controlling for firm-year fixed effects. As first argued by Khwaja and Mian (2008), this allows us to control for any effect coming from firms' credit demand and to interpret the coefficients in terms of credit supply effects.

Weak banks do engage in zombie lending

We find that, between 2008 and 2013, banks with a capital ratio below the median provide 2 percentage points of additional yearly credit growth to zombie firms compared to stronger banks (a 25% increase relative to the average). The result is robust to the definition of zombie firm and to the measure of bank capital.

Results are similar if we look at the extensive margin: from 2008 onwards, banks with a below the median regulatory capital ratio have a 1 percentage point lower probability of closing a credit relationship with any firm; the probability drops by a further 0.7 percentage point if the firm is a zombie. All these results suggest that weak banks tend to misallocate credit by disproportionately lending to non-viable firms.

Does this matter for the real economy?

We next analyse the consequences of zombie lending on healthy firms. This question is typically addressed regressing indicators of firm performance on the share of zombie firms in the same industry. Following Caballero et al. (2008), industry-year fixed effects are added to account for adverse industry shocks that both increase the share of zombies and affect firms’ outcomes. This approach has two main drawbacks, however. First, it can only identify the impact of zombie lending on healthy firms relative to zombie firms. It is therefore not very informative of what happens to healthy firms in absolute terms. Second, it does not account for the fact that aggregate (industry) shocks may have differential impacts on healthy and unhealthy firms. For example, when performance follows a normal distribution, aggregate shocks that shift the entire distribution to the left mechanically generate a negative correlation between the share of zombies and the relative performance of healthy firms, even in the absence of spillover effects between zombie and healthy firms possibly arising from zombie lending.

To cope with these issues, we use a different measure of the exposure of healthy firms to zombie lending. Since both bank lending and production are geographically concentrated, we take the relevant market to be the province-sector in which a firm is located,2 and study how the average capitalisation of banks active in a given province-sector affects firms performance within the same province-sector, also controlling for sector*year and province*year dummies. Banks are typically active in several province-sectors, and exposure to a single province-sector is very low. Thus, bank capitalisation is unlikely to be correlated with shocks in the province-sector, and we can take it as exogenous with respect to shocks that shift the distribution of firms’ performance.

We find that bank under-capitalisation has only negligible (absolute) effects on the growth of healthy firms during the recession. This holds for several indicators of economic activity, such as the wage bill (a proxy for employment), the capital stock, and revenues. The reason is that, although bank under-capitalisation hurts the relative performance of healthy versus zombie firms, it also improves the growth rate of zombies. As a result, the absolute effect on healthy firms is negligible.

This finding may seem surprising in light of the received wisdom from the previous literature. A priori weak banks that engage in zombie lending should hurt healthy firms in at least two ways: first, by reducing bank credit available to the rest of the economy; second, because lending to non-viable firms hurts their competitors in product and input markets (it is equivalent to a subsidy). However, zombie lending may also have positive economic effects, at least during a deep recession. In particular, by preventing inefficient firms from shrinking or exiting, it could mitigate adverse aggregate demand and input/output externalities. This last mechanism has generally been neglected in the literature, but the data suggest that it may be empirically relevant.

Looking at the extensive margin, the effect of bank capitalisation on survival rates, we find that in province-sectors where lending is predominantly done by banks with a low capital ratio, zombies are more likely to survive and healthy firms are more likely to fail.

Finally, we ask whether bank under-capitalisation is positively correlated with (revenue based) TFP dispersion in the province-sector. The data show that there is a positive association between low bank capitalization and aggregate TFP dispersion, but only in the presence of a large fraction of zombie firms.

Summing up

Overall, our findings show that, during the crisis, weaker banks have kept lending to zombie firms to a greater extent than stronger banks. This has reduced the exit rate of zombie firms, with adverse effects on the survival of healthy firms. The growth chances of healthy survivors, however, were not negatively affected by the presence of zombie lending.

To quantify the aggregate effects, consider an injection of capital of €4 billion in the weaker banks. This is the amount that, as of 2012, would have brought their capital ratio to the median level. Inserting our estimates in a simple evaluation scheme, this injection would increase the yearly output growth by between 0.2% and 0.35% during 2008-13, depending on the relative productivity of zombies versus non-zombies. During this period, output in our sample on average shrank by almost 2% per year. The contribution of zombie lending to this negative performance is therefore between 10% and 20%, and comes almost entirely from the extensive margin and the composition of firms exits.

All in all, this confirms that bank-undercapitalisation may be costly in terms of misallocation of capital and productive efficiency in the medium term, because of the higher exit of healthy firms, but had at best a limited role in aggravating the recession induced by the Eurozone Crisis.

Authors’ note: The views expressed here are those of the authors and do not necessarily reflect those of the Bank of Italy.


Acharya, V V, T Eisert, C Eufinger, and C W Hirsch (2016), “Whatever it takes: The real effects of unconventional monetary policy”, mimeo. 

Barrot, J-N and J Sauvagnat (2016), “Input specificity and the propagation of idiosyncratic shocks in production networks,” The Quarterly Journal of Economics 131(3): 1543-1592.

Caballero, R J, T Hoshi, and A K Kashyap (2008), “Zombie Lending and Depressed Restructuring in Japan,” American Economic Review 98: 1943-77.

Hsieh, C-T and P J Klenow (2009), “Misallocation and manufacturing TFP in China and India,” The Quarterly Journal of Economics 124: 1403-1448.

Khwaja, A I and A Mian (2008), “Tracing the impact of bank liquidity shocks: Evidence from an emerging market,” The American Economic Review 98: 1413-1442.

Mian, A, A Sufi, and F Trebbi (2015), “Foreclosures, house prices, and the real economy,” The Journal of Finance 70: 2587-2634.

Peek, J and E S Rosengren (2005), “Unnatural selection: Perverse incentives and the misallocation of credit in Japan,” The American Economic Review 95: 1144-1166.

Schivardi, Fabiano, Enrico Sette, and Guido Tabellini, “Credit Misallocation During the European Financial Crisis”, CEPR Discussion Paper No. 11901 (also available at SSRN).


[1] As shown by Hsieh and Klenow (2009), in the absence of frictions in the inputs market, the dispersion of TFP can be interpreted as revealing the presence of misallocations in the input markets.

[2] Provinces in Italy are administrative units comparable to counties in the United States.



Topics:  Europe's nations and regions Financial regulation and banking

Tags:  Eurozone crisis, under-capitalisation, zombie lending, misallocation

Rodolfo Debenedetti Chair in Entrepreneurship, Bocconi University and CEPR Research Fellow

Principal Economist, Department of Economics and Statistics, Bank of Italy

Professor of Economics at Bocconi University and CEPR Research Fellow