Zombie lending, financial reporting opacity and contagion

Using a novel dataset of listed firms in Japan, we find that bank lending to zombie (insolvent) borrowers induces these borrowers to manipulate earnings, resulting in more opaque financial reporting. Such an effect is more pronounced when the lending is from borrowers’ main banks or for longer term loans, suggesting a complicity of informed banks in earnings manipulations. In addition, we find a greater effect on earnings manipulation during the election year when the political incentive is stronger. We overcome the endogeneity concern using an experiment arising from capital injections into banks instituted by the Japanese Government in the late 90’s and find a consistent result. Further, we examine the industry spill-over (contagion) effect stemming from the prevalence of zombie firms and find that profitable firms are associated with more opaque reporting when the industry is dominated by zombie firms. Overall, our results suggest that keeping insolvent borrowers afloat deteriorates the information environment of both zombie firms and their profitable industry peers.