ECB Financial Stability Review Article: Pandemic May Have Contributed to Zombification

18 May 2021

By David Barwick – FRANKFURT (Econostream) – The pandemic and in particular policy measures to mitigate its economic fallout may have led to an increase in the prevalence of so-called zombie firms in the euro area, according to an article from the ECB financial stability review published Tuesday.

The article considered the question of whether ‘failing firms that continue operating on the back of cheap credit and debt forbearance’ may have benefitted from the pandemic and avoided going under, a development that in turn could hamper economic recovery and ultimately weigh on the balance sheets of banks.

‘The economic impact of the pandemic and the policy response may have, at least temporarily, contributed to some degree of zombification’, the article said.

Liquidity-providing measures to back up loans or allow companies to defer their obligations to repay may have helped zombie firms, while favourable financing conditions may have also assisted, it said.

With respect to loan guarantee schemes, national eligibility criteria granted access to all but 1% of viable firms, but ‘may have also been unable to prevent as many as 90% of firms identified as zombies from becoming eligible for public support’, according to the article.

Eligibility does not imply use, the article noted, but the correlation between use and the prevalence of zombie firms by sector across the euro area ‘may indeed suggest zombies might have accessed such schemes’.

With respect to loan moratorium schemes covering almost €1 trillion in loans, the moratoria tended to be short, so that ‘by and large, any benefit to a zombie firm’s individual financial position may have been modest at most’, the article said.

Besides loan guarantee and moratorium schemes, zombies stood to benefit from favourable financing conditions, as their higher credit risk does not imply systematically higher lending rates. However, banks’ strong capital positions going into the pandemic ‘might have averted some risk of excessively lenient lending to zombie firms’, the article said, as weak banks are more likely to be lenient towards failing companies.

‘With most banks having entered the crisis well capitalised and therefore being able to sustain larger losses from the pandemic, incentives for forbearance should be lower’, the article said. However, ‘it will be necessary to continue ensuring that banks maintain sound capital positions, while taking a forward-looking stance on loan loss provisioning.’

Even if zombie firms did benefit from the pandemic, the short-term effect boosted aggregate demand and helped prevent more joblessness as well as other side effects of insolvency, the article noted. In the medium term, however, it poses risks to the financial system, given the exposure of banks, sovereigns and investors, it said.

These risks could come into sharper relief under scenarios including unexpected shocks, weak economic developments or policy support withdrawal, when ‘the existence of a sizeable cohort of firms with zombie characteristics may lead to sell-offs, large-scale downgrades or “catch-up defaults”’, it said.

The actual losses potentially associated with these events would weaken balance sheets and possibly threaten systemic financial stability, the article said.

‘Additionally, the existence of a wider tail of overindebted corporates could be a drag on growth, as debt overhang can affect firms’ investment and employment’, it said. ‘Such macro risks could in turn feed back into the banking sector and the financial system.’