The Walking Dead of the Banking Sector

Imagine you are walking down the street and you see a bank that looks like it has been abandoned for years. The windows are boarded up, the sign is faded, and the door is locked. You wonder how this bank is still in business, and why no one has shut it down or taken it over.

This bank is what economists call a zombie bank. A zombie bank is a technically insolvent bank, meaning it has more liabilities than assets, but it continues to operate thanks to external support or regulatory forbearance. In other words, it is a bank that should be dead but is somehow still alive.

Zombie banks are not just a fictional scenario. They are a real phenomenon that has been observed in many countries around the world, especially in the aftermath of financial crises. In this blog post, we will explain what causes zombie banks, what are their consequences, and what can be done to deal with them based on the publication from IMF titled "Determinants of Zombie Banks in Emerging Markets and Developing Economies" by Hannah Sheldon, Torsten Wezel, and Zhengwei Fu.

Read my other posts here: Conventional Finance - FinFormed, Islamic Finance - FinFormed, Takaful - FinFormed, Career - FinFormed and Randow Writings - FinFormed

Signup to FinFormed here

What Causes Zombie Banks?

Zombie banks can emerge for various reasons, but they usually have two common factors: hidden losses and lack of action.

Hidden losses refer to the fact that zombie banks tend to conceal the true extent of their bad loans or non-performing assets. They do this by engaging in evergreening, which is a practice of providing new loans to their troubled borrowers to help them repay old loans, or by delaying the recognition of losses on their balance sheets. By doing so, zombie banks avoid falling below the minimum capital requirements imposed by regulators, and they hope to buy time until the economy recovers or their borrowers improve their performance.

Lack of action refers to the fact that zombie banks are not adequately addressed by their owners or by the authorities. Owners of zombie banks may be reluctant to inject new capital or restructure the bank because they fear losing control, diluting their stake, or admitting failure. Authorities may be unwilling or unable to intervene and resolve the bank, because they lack the legal framework, the political will, or the fiscal resources to do so. They may also fear triggering a systemic crisis, a public backlash, or a legal challenge.

What Are the Consequences of Zombie Banks?

Zombie banks are harmful to the economy, because they misallocate credit, distort competition, and hinder growth.

Misallocation of credit means that zombie banks divert scarce financial resources away from productive and efficient firms and towards unproductive and inefficient ones. Zombie banks have an incentive to lend to their zombie clients, who are also insolvent but still operating, in order to avoid realizing losses and gamble for resurrection. By doing so, zombie banks crowd out lending to healthy firms, who could use the funds to invest, innovate, and create jobs.

Distortion of competition means that zombie banks create an uneven playing field in the banking sector, and undermine market discipline and incentives. Zombie banks can offer lower interest rates and more lenient terms to their borrowers because they are not concerned about profitability or risk. This gives them an unfair advantage over their competitors, who have to charge higher rates and impose stricter conditions to maintain their soundness. Zombie banks also reduce the pressure on their borrowers to improve their performance, because they do not enforce repayment or impose sanctions.

Hindrance of growth means that zombie banks slow down the recovery and the potential of the economy, by holding back the necessary restructuring and reallocation of resources. Zombie banks prevent the exit of insolvent firms, which occupy valuable assets, labor, and market share, and prevent the entry of new and more efficient firms, which could bring innovation and dynamism^labour. Zombie banks also reduce the confidence and the stability of the financial system, which are essential for the smooth functioning and ^{Three main steps can}development of the economy.

What Can Be Done to Deal with Zombie Banks?

Zombie banks are a serious problem that requires urgent and comprehensive action. Three main steps can^{By using sound and sustainable policies and practices, prevention means that zombie banks need to be avoided and discouraged} be taken to deal with zombie banks: identification, resolution, and prevention.

Identification means that zombie banks need to be detected and exposed, by using reliable and consistent methods and data. This requires enhancing the transparency and the quality of bank financial statements, conducting regular and rigorous stress tests, and applying uniform and prudent accounting and prudential standards. Identification also requires strengthening the independence and the capacity of bank supervisors, auditors, and rating agencies, who are responsible for monitoring and assessing bank performance and risk.

Resolution means that zombie banks need to be treated and eliminated, by using effective and efficient tools and procedures. This requires establishing a clear and credible resolution framework, that defines the roles and the responsibilities of the authorities, the triggers and the criteria for intervention, and the resolution options and the instruments available. Resolution also requires mobilizing sufficient fiscal and financial resources, that can be used to recapitalize, restructure, merge, or liquidate zombie banks, while protecting depositors and minimizing the cost for taxpayers.

By using sound and sustainable policies and practices, prevention means that zombie banks need to be avoided and discouraged^which. This requires improving the macroeconomic and the institutional environment, that can foster growth, stability, and governance in the economy. Prevention also requires enhancing the market discipline and the incentives, that can encourage bank owners, managers, and creditors to maintain adequate capital, manage risk, and monitor performance.

Conclusion

Zombie banks are a menace for the economy, that can cause serious and lasting damage. They are the result of hidden losses and lack of action, and they lead to misallocation of credit, distortion of competition, and hindrance of growth. They need to be identified, resolved, and prevented, by using a combination of methods, tools, and policies.

To summarize, here are the main points of this blog post:

Zombie banks are insolvent banks that continue to operate thanks to external support or regulatory forbearance.
Zombie banks hide their losses by evergreening their loans, and avoid being treated by their owners or the authorities^{economic growth}.
Zombie banks misallocate credit to unproductive firms, distort competition in the banking sector, and hinder economic growth.
Zombie banks need to be detected and exposed, treated and eliminated, and avoided and discouraged, by using reliable data, effective tools, and sound policies.

P.S. If you are interested in learning more about the topic of zombie banks and their determinants, I recommend reading the full working paper by Sheldon, Wezel, and Fu (2024). It is available for free on the IMF website here.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

Subscribe on LinkedIn

If you found this blog post insightful, don’t forget to subscribe to our website for more updates on Finance. Your subscription will help us continue to bring you the latest insights into the world of finance. And if you think this post could benefit others, please feel free to share it. Let’s spread the knowledge together!