Unearthing Zombies

Since ineffective debt resolution perpetuates zombie lending, bankruptcy reform has emerged as a solution. We show, however, that lender-based frictions can limit reform impact. Exploiting a unique empirical setting and novel supervisory data from India, we document that a new bankruptcy law had muted effects on lenders recognizing zombie borrowers as non-performing. A subsequent unexpected regulation, targeting perverse lender incentives to continue concealing zombies, increased zombie recognition particularly for undercapitalized and government-owned banks, highlighting the role of bank capital and political frictions in sustaining zombie lending. Resolving zombie loans allowed lenders to reallocate credit to healthier borrowers who increased investment.