Unearthing Zombies

Bankruptcy reforms that improve lenders’ ability to recover claims from financially distressed borrowers can mitigate zombie lending. However, we show that after a 2016 bankruptcy reform in India, lenders are reluctant to recognize zombie credit as nonperforming, impeding reform efficacy. A subsequent complementary regulation targeting lender discretion in recognizing nonperforming assets improves zombie recognition fivefold. The lender disincentive to recognize zombies arises from undercapitalized banks’ reluctance to realize loan losses and political economy frictions at state-owned banks. Resolving zombie credit allows lenders to redirect credit to healthy borrowers, but effects are muted at banks more exposed to zombie borrowers. This paper was accepted by Victoria Ivashina, finance. Funding: The authors are grateful for financial support provided by the NSE-NYU Stern Initiative on the Study of Indian Capital Markets. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.01356 .