Credit Market Tightness and Zombie Firms: Theory and Evidence

We develop a framework of financial intermediation with search and matching frictions between banks and firms which explains the co-existence of bank lending to unprofitable firms with low productivity (zombie firms). The incidence of zombie firms depends on credit market tightness that encapsulates the abundance of credit provision in financial markets. An increase in credit market tightness initially increases the share of zombie firms due to the bank's incentive to forgo costly separation. In contrast, the firm's incentive to terminate an unprofitable relationship rises with an increase in credit market tightness, which decreases the share of zombie firms. These countervailing forces generate an inverted U-shaped relationship between credit market tightness and the share of zombie firms. A high firm bargaining power magnifies the firm's incentive to terminate unprofitable relationships and decreases the share of zombie firms. We test our theory by constructing measures of credit market tightness and bargaining power for 31 industries in Japan. We find that capital injections during the Japanese banking crisis of the early 2000s had stronger efficacy in reducing the share of zombie firms in sectors with high firms' bargaining power, consistent with the predictions of our theoretical framework.