Deteriorating Bank Health and Lending in Japan: Evidence from Unlisted Companies Undergoing Financial Distress

When a borrower faces an informational hold-up problem, deteriorating bank health might reduce a borrower's credit availability. However, a bank with an impaired balance sheet might attempt to "gamble for resurrection" and hence increase risky lending to "zombie" firms. The purpose of this paper is to investigate what impacts the weakened financial conditions of banks had on loans outstanding to medium-size firms in Japan. Estimating lending functions, we examine the determinants of lending to unlisted Japanese companies in the late 1990s and early 2000s. We find that two alternative measures of bank health -regulatory capital adequacy ratios and ratios of non-performing loans (NPLs)- had opposite impacts on lending. In the case of regulatory capital adequacy ratios, its deterioration had a perverse impact on lending. The deteriorating NPL ratios, however, increased lending to troubled firms to keep otherwise economically bankrupt firms alive.