(May 2023)
By Stephen Ptohopoulos ACIB, CCBI*
Disclaimer: Views and opinions expressed are my own and are not necessarily those of my employer.
In this article I give a brief overview on the topic of zombie firms. When researching about this subject matter my principal source / reference was a paper published by the Bank of International Settlements (BIS) titled The rise of zombie firms: causes and consequences (Banerjee and Hofmann, 2018)¹.
A zombie firm denotes a company that is unprofitable over a lengthy period combined with an inability to service its debts. A characteristic typically used to define or identify a zombie firm is a company with weak debt to profitability ratios, most notably an interest coverage ratio (ICR) below 1.
Several hypotheses have been put forward about the cause of zombie firms. The predominant hypothesis is the role played by ‘weak’ banks. For the purposes of this statement, a ‘weak’ bank is defined as a lender which holds assets (i.e., loans / advances) that have fallen in value, resulting in (to use accounting parlance) an impaired balance sheet. It is argued that such banks are inclined to roll over loans extended to companies having difficulty servicing their debt rather than writing them off i.e., ‘extend and pretend.’
The prolonged period of low interest rates ceteris paribus improved the ICRs of poorly performing companies, easing financial pressures. This may have resulted in less deleveraging. Through the transmission mechanisms of the financial system, lower policy rates lead to lower yields across the spectrum of financial assets. The theory is that as interest rates on risk-free investments (short term government treasury bills) and minimal risk assets (like government bonds and bank deposits) plummet, many investors seek improved (higher) returns from alternative investments – which have higher credit risks. It is argued that in these circumstances financial pressure on zombie companies (which are risky investments) can ease because there are investors with a risk appetite hunting for investments with higher yields.
Another probable cause is jurisdictions/states with poorly designed corporate insolvency regimes. I would add to us jurisdictions with deficiencies in their legal frameworks, with the weak enforcement of contracts, which results in difficulties and/or a lengthy process for foreclosures of land and real estate assets pledged as collaterals to the banks.
I suspect the problem and incidence of zombie firms is likely to be bigger in the case of small and medium enterprises (SMEs), which are typically private, unlisted companies. In contrast, mid-market corporates (MMCs) and multinational corporations (MNCs) have better access to, and thus often raise, external financing from capital markets. These companies are therefore often subject to greater scrutiny and market discipline. I would speculate that the incidence of zombie firms is larger if the companies in question are resident in countries in which the main or only source of external financing is bank lending. Such countries usually also tend to have underdeveloped capital markets and less sophisticated financial systems.
I would argue that the situation with respect to zombie firms was also exasperated by the COVID-19 pandemic. Because it was not possible to segregate zombie firms from viable firms the support given to companies by governments and banks in the form of rent and V.A.T. deferrals, government guaranteed loans, payment holidays (moratoriums), extending working capital, rescheduling of loan payments, favourable interest rates, etc., probably simply stored up problems for the future. Zombie firms which might otherwise have been forced to cease operating and face insolvency were able to live on, thanks to ‘life support’ received during the COVID-19 pandemic.
The advent of zombie firms has consequences at the macro-economic level. If the lending portfolios of the banks comprise of many zombie firms ultimately this will undermine one of the key objectives of central banks, which is financial stability. Having unhealthy banks does not reconcile with the objective of a stable and resilient financial system.
The advent of zombie firms would indicate, at best, a sub-optimal, and at worst, a dysfunctional, banking system in which the banks are underperforming in terms of their core economic function – that is, to convert ‘savings’ (deposits) from the public into [productive] ‘investments’ (loans to firms).
Economic theory would suggest – backed up by empirical studies – that zombie firms tend to be less productive than healthy firms. It is further argued that zombie firms ‘crowd out’ investment (including bank lending) and employment in more healthy/viable firms, lowering aggregate productivity (in terms of labour productivity and total factor productivity). In other words, there is a less efficient allocation of resources. Resources, including bank loans, become tied up in zombie firms. Zombie firms compete with more viable firms for economic resources such as capital expenditure (capex), bank loans, staff/labour, etc.,
I thought the conclusion of the authors of the cited BIS paper (Banerjee and Hofmann 2018)¹ was interesting. They argued (to paraphrase the authors) that in a low interest rate environment, central banks face a difficult trade-off between the upsides of benign economic conditions conducive to higher aggregate demand with the downside of the misallocation of resources constraining productivity due to a higher incidence of zombie firms.
A zombie firm is a company that over an extended period is unable to cover its debt servicing costs from current profits. The prolonged period of low interest rates in the recent past appears to have given a new impetus to zombie firms. There is empirical evidence that zombie firms result in sub-optimal (economic) outcomes in product markets (industries), individual banks and banking / financial systems. At the macro level they can impact productivity. It seems axiomatic that beyond researchers in the academic world, policymakers, regulators and banks devote time and effort to address this phenomenon. The increases in interest rates and the ongoing challenges banks face in terms of managing their capital will put the incidence of zombie firms into sharp relief. Most likely there are things that policymakers, regulators and individual banks can do to prevent or at the very least minimise the advent of zombie firms.
¹Banerjee, R and Hofmann, B (2018). ‘The rise of zombie firms: causes and consequences’, BIS Quarterly Review, September 2018
*Associate member of the London Institute of Banking & Finance, holder of the Certificate in Bank Strategy, Operations and Technology (Certificated member) of the Chartered Banker Institute.
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