Do Zombies Rise When Interest Rates Fall? A Relationship Banking Model

A relationship bank or market investors finance an entrepreneur’s risky project. Different from investors, the bank can identify and liquidate bad projects at an interim stage. If the entrepreneur can provide only limited capital, the optimal loan contract induces an inefficient continuation decision, i.e., the bank engages in zombie lending. In the short run – for a given contract – the bank’s incentive to roll over bad loans enhances if the base interest rate drops. In the long run, however, the bank adjusts the contract to a drop in the interest rate and the effect on zombification is reversed