After a narrow 5-4 decision in Trump v. Cook, the Supreme Court exercised immense deference to insulate the Federal Reserve from the political whims of the Executive Branch, reinforcing the paradigm of central bank independence and preventing a concerted effort to reshape the Board of Governors in favor of reduced interest rates.^[1] The importance of Federal Reserve independence is best understood vis-à-vis the dual mandate, which guides the pursuit of maximum employment and stable prices in the U.S.^[2]

The implications of Federal Reserve independence often surpass the bounds of its explicit dual mandate. To affect meaningful change concerning inflation and employment, the Federal Reserve leverages the target range for the federal funds rate (the policy rate).^[3] Through this interest rate, monetary policy sets the conditions upon which private markets allocate credit and refinance firms in distress, inadvertently determining which firms are allowed to live and which exit the market. It is precisely in this tension between the dual mandate and capital allocation that zombie firms, or firms that have persistent problems meeting their interest payments, are otherwise kept alive.

The monetary policy of the Federal Reserve does not necessarily hinder the process by which healthy markets facilitate the exit of unviable, outdated firms in favor of growing entrants, but the unintended second-order effects of the dual mandate may perpetuate the continued survival of these zombie firms. Monetary policy is not exclusively responsible for the emergence and persistence of zombie firms, but it certainly shapes the conditions under which zombie firms access credit. Against the backdrop of the private credit boom in the US, comprehending the second-order effects of Federal Reserve policy is a prerequisite to ensuring efficient capital allocation in the long run.

This article will explore the institutional settings that have given rise to zombie firms internationally, using Japan and China as case studies, before indulging in the implications of their presence on economies more broadly. This article will then discuss shifting trends unfolding in the U.S. that may enable the onset of zombie firms while assessing opportunities for the Federal Reserve and other government actors to adapt (through greater oversight of private lending)

The Causes of Zombie Firms

The support of zombie firms through extending credit to distressed borrowers is a recurring phenomenon in advanced and emerging economies alike.^[4] Some firms inherently suffer from weak profitability, but the surrounding institutions that facilitate the flow of credit into these firms are what render them zombies. There is a confluence of institutional forces that give rise to zombie firms in a given economy, but the bulk of the existing literature points to three factors: weak banks, political choices, and monetary policy.^[5]

First, undercapitalized banks, or banks that fail to meet the required minimum capital cushion, maintain an incentive to aid insolvent borrowers to avoid losses on their own balance sheets. A healthy bank is better equipped to write off a loan that was made to a nonviable firm, absorb the loss, and subsequently reallocate capital. In comparison, an undercapitalized bank pulls from a less robust pool of reserves, potentially inviting regulatory intervention if nearing minimum capital levels. The threat of regulatory pressure leads to undercapitalized banks choosing to extend a loan to a nonviable firm to put off the loss, converting that firm into a zombie. This practice of repeated extension of loans by banks to keep borrowers, but also banks, in the game is called evergreening, prolonging the dependency of the borrower in place of liquidation or restructuring.

The notion that corporate lending could be tied to unviable firms by virtue of weak commercial banks was first observed in Japan’s “Lost Decade”, a period of prolonged economic stagnation.^[6] In the wake of crashing asset prices and the slowdown that followed, impaired collateral values were detrimental to bank balance sheets. Japanese banks bordering the minimum capital requirements kept credit flowing to insolvent borrowers via interest concessions and debt forgiveness. The Bank of Japan initially reinforced rather than mitigated evergreening to bolster employment during a recessionary shock.

Second, the financial wellness of banks is inextricably linked with the incentive structure that deploys capital toward weaker firms, but the choices of a country’s policy regime may aid or reduce the misallocation of capital. In the event of a borrower defaulting, under a sufficient insolvency regime, a bank can more easily seize collateral and restructure the firm in an established bankruptcy process. The case of Japan revealed the ramifications of a weak insolvency framework, where lengthy and costly bankruptcy proceedings motivated banks to postpone nonperforming loans.

Additionally, in implementing regulatory backstops intended to preserve employment and financial stability, government bailouts of distressed banks may inadvertently promote persistent refinancing. In the wake of Japan’s real estate bubble, Japanese banks had written off loans equivalent to 16% of its GDP at the time, but nonperforming loans continued to rise concurrently.^[7] Japan also earmarked nearly 25 trillion yen for capital injection into insolvent banks,^[8] while almost 30% of listed firms in specific sectors received subsidized credit at the height of Japan’s zombie crisis.^[9] By aiding banks struggling with deteriorating loan portfolios, the incentive to force borrowers into insolvency or restructuring was reduced, reinforcing continued credit into distressed firms. The zombie lending that unfolded in Japan was thus an unintended consequence of regulatory forbearance that, upon first glance, was aimed at stabilizing its economy.

The events transpiring in China today closely resemble Japan’s experience. By 2016, 6% of China’s total corporate debt was held by nonviable zombie firms.^[10] In 2019, the ratio of nonperforming loans to total gross loans in China peaked at 1.86.^[11] China’s economic policy demonstrates a high preference for industrial policy in preserving capital controls, spearheading subsidized credit, and using state-owned enterprises as policy mechanisms. Implicit government support and preferential financing helped zombified state-owned enterprises to persist. Overall, China has shielded domestic private enterprises from competition with foreign firms.^[12] The diminution of competition weakens market discipline, allowing firms on the verge of exit to receive credit.

Third, more recent analysis has explored the connection between a low-rate environment and the share of zombie firms in a given economy. Downward pressure on interest rates enables otherwise unviable firms to obtain credit at a rate below that of the prime market. Lower interest rates are mutually beneficial for creditors and debtors alike, as a distressed firm becomes empowered to service its debt payments while the bank can subvert realization of the loss by sustaining the loan. Across advanced economies, the Bank for International Settlements notes that lower interest rates are indicative of a higher share of zombie firms, particularly in sectors dependent on external financing, as favorable rates potentially extend the evergreening of loans to lower-productivity firms.^[13] Central banks, including the Federal Reserve, must grapple with the capital misallocation channel of their expansionary monetary policy.

Overall, these three factors work in tandem to produce and sustain zombie firms. Weak banks, particularly those operating under an insolvency regime and lower interest rates, drive credit toward less viable firms, rendering them zombies.

Zombie Firms: How Consequential?

Zombie firms often occur when governments lower interest rates during a recession to boost aggregate demand. This monetary posture of central banks preserves short-term employment in times of crisis. However, an economy comprising a large share of zombie firms causes a decline in productivity over the long-run. The unanchoring of capital from the most efficient firms can be observed through a few channels.

When banks lend to zombie firms, it can lead to credit misallocation and, problematically, deteriorating aggregate productivity. Zombie firms distort the process by which more productive firms attract investment. The already scarce resources of bank credit, private investment, and labor get tied up in firms that offer less economic value.^[14] As the share of zombie firms rises in a sector, or even in the economy more broadly, every additional dollar given to a chronically unprofitable company is another dollar made unavailable to healthier competitors or to the assimilation of new entrants. The result is deleterious: an economy orients itself toward distorted incentives (regulatory forbearance and evergreening) rather than productivity.

Credit misallocation can also drive market congestion, or the crowding out of healthier incumbents and new entrants. The impact of market congestion is particularly acute for entrants, who compete for the same market demand alongside enduring zombie firms.^[15] Healthier incumbents are more likely to survive, but young firms will struggle to garner enough market share to justify the high fixed costs of entry against the backdrop of falling prices. For a new firm to properly compete, it must exceed the requisite productivity threshold to overcome depressed profitability.^[16] The spillover from credit misallocation exceeds the tension between zombie and established firms, inhibiting the introduction of innovative startups (often highly productive). The entrenchment of a higher productivity threshold was found in Japan, where congestion discouraged firm entry and stifled competitive pressures.^[17] The aftermath of a lower rate of firm entry and exit leaves an economy with reduced business dynamism, a phenomenon increasingly associated with slow productivity growth derived from inefficient allocation.

The constraints on the orderly flow of capital are equally accompanied by restrictions on labor mobility. By and large, the adjustment mechanism to a negative recessionary shock is for new productive firms to rehire labor following the exit of more vulnerable firms. Due to lower financing costs stemming from an expansionary environment, zombie firms trap labor and the economy ultimately demands fewer workers. In the long-run, wage growth and the diffusion of technology plateau because labor is ensnared in zombie firms with less incentive to innovate. The impact of zombie firms on labor reallocation is an overlooked channel through which aggregate productivity suffers, since industries with a high share of zombie firms exhibit lower employment growth in healthy firms.^[18]

Taken together, the repercussions of zombie firms on capital and labor allocation underpin a common outcome. The preservation of short-term employment comes at the expense of the equilibrium flow of resources to their most productive uses, culminating in an erosion of economic dynamism upon which growth depends.

Shifts in the U.S.

Fortunately, the Federal Reserve concluded in 2021 that zombie firms were not yet a prominent feature of the U.S. economy. The report highlighted that zombie firms were few in number, concentrated in manufacturing and retail sectors, and tracked closely with cyclical patterns.^[19] As of 2021, their presence was trivial at best from a policy standpoint. The report also established a basic, yet crucial, premise: American banks adequately priced loans to distressed borrowers as risky. However, the Federal Reserve defined zombie firms as weak companies receiving favorable credit from weak banks, raising the question as to what happens when the primary source of investment moves away from banks.

The landscape of corporate debt has changed dramatically in the U.S. due to the meteoric rise of private credit, a segment of nonbank financial intermediaries that allures borrowers with a faster source of financing than banks and public debt markets. The U.S. private credit market has ballooned from $500 billion to $1.3 trillion over the last 5 years, with growth expected to continue in 2026.^[20] The emergence of private credit has been transformative in that most firms’ corporate debt will soon be held by private creditors.^[21] Private credit has the potential to challenge prior conclusions drawn by altering the support structure for zombie firms, and a few already-unfolding trends warrant reexamination of zombie firms in the US.

Since private investment managers are better equipped to take on corporate debt unilaterally, the concentrated lending arising from private credit may reduce coordination costs and decrease bankruptcy episodes in the U.S. Private creditors possess greater risk tolerance compared to traditional banks because of differing payoff structures. Private credit funds may be more willing to inject capital when necessary and take on more equity to try turning a dying firm around.

Private credit firms constantly seek to raise new funds, so their prerogative is to postpone the recognition of a loss via maturity-date extensions, for example.^[22] Private credit firms demonstrate similar behavior to weak banks in this sense, but the privatization of corporate debt means fewer disclosures and less oversight, causing these zombie firms to “go dark.”^[23]

Though the U.S. has maintained a more capable insolvency regime than many of its peers as it pertains to the traditional banking system, the proliferation of private credit may enable greater persistence of zombie firms. Not only will unviable firms lean on private credit more and more as time goes on, but their continued financing will become increasingly difficult to observe and regulate due to their relative opacity.

Conclusion

The Federal Reserve is today confronted by an evolving consideration set. The Federal Reserve’s focus on its dual mandate has precipitated second-order effects on capital allocation. A simplistic, yet misguided, prescription would be for the Federal Reserve to abandon its independence and pursue a mandate with more provisions for capital allocation, but this would result in the politicization of monetary policy while forcing the Federal Reserve to arbitrarily orient capital to business models it sees fit.

Monetary policy should continue to operate within the bounds of the dual mandate, but the U.S. should develop an adept institutional framework around the Federal Reserve to address the capital-allocation consequences of its policy. To broaden the analytical framework, the Federal Reserve should expand its systematic review of key economic indicators by integrating tracking of interest-coverage deterioration and firm bankruptcy and exit rates into the semiannual “Monetary Policy Report.”^[24] This idea is not foreign to the Federal Reserve, as Governor Lisa Cook has already acknowledged the surge in private credit lending.^[25] Though the Federal Reserve’s 2021 finding that zombie firms were not a sufficiently prominent threat was analytically sound, the architecture underlying investment has changed dramatically. The Federal Reserve should consider measures that capture nonbank lending and more obscure flows of credit before delegating the responsibility of addressing reporting on loan extensions and standards for repeated loss deferrals to the relevant institutional authorities (e.g., the Securities and Exchange Commission, the Office of Financial Research, etc.).

The explosion of private credit in the US also warrants regulatory examination, as authorities rely on fragmented datasets and definitions. In addition to adopting metrics able to monitor the sector consistently, one actionable measure would be to reform existing regulatory reporting frameworks to define and identify private credit funds specifically. Private credit funds are subject to the U.S. Securities and Exchange Commission’s Form PF, but they do not yet have a unique private credit section for reporting. Private credit funds file under broad categories, and without a narrow mechanism to track private credit, it becomes difficult to track leverage, credit quality, and loan maturities.^[26]

The independence of the Federal Reserve remains indispensable to insulate prudent policymaking from political pressures, but there is still room for other institutions to provide support. The Federal Reserve should acknowledge and communicate the second-order effects of its monetary policy so the relevant institutional bodies can attempt to course-correct when the dual mandate restricts the Federal Reserve from doing so. As monetary policy continues to clash with an increasingly privatized lending landscape, the U.S. should establish an institutional framework to identify zombie firms and preserve market dynamism.

 

 

 

 

 

^[1] Daniel K. Tarullo, “Fed Independence after Trump v. Cook,” Brookings Institution, July 21, 2026, https://www.brookings.edu/articles/fed-independence-after-trump-v-cook/.

^[2] Board of Governors of the Federal Reserve System, “What Economic Goals Does the Federal Reserve Seek to Achieve through Its Monetary Policy?,” Frequently Asked Questions, last modified August 22, 2025, https://www.federalreserve.gov/faqs/what-economic-goals-does-the-federal-reserve-seek-to-achieve-through-its-monetary-policy.htm.

^[3] Kristie M. Engemann, “How Does the Fed Interpret and Pursue the Dual Mandate?,” Open Vault, Federal Reserve Bank of St. Louis, July 8, 2026, https://www.stlouisfed.org/open-vault/2026/july/how-does-fed-interpret-pursue-dual-mandate.

^[4] Ryan Niladri Banerjee and Boris Hofmann, “The Rise of Zombie Firms: Causes and Consequences,” BIS Quarterly Review, September 2018, Bank for International Settlements, https://www.bis.org/publ/qtrpdf/r_qt1809g.pdf.

^[5] Müge Adalet McGowan, Dan Andrews, and Valentine Millot, The Walking Dead?: Zombie Firms and Productivity Performance in OECD Countries, OECD Economics Department Working Papers, no. 1372 (Paris: OECD Publishing, January 25, 2017), https://doi.org/10.1787/180d80ad-en.

^[6] Ricardo J. Caballero, Takeo Hoshi, and Anil K. Kashyap, “Zombie Lending and Depressed Restructuring in Japan,” American Economic Review 98, no. 5 (December 2008): 1943–77, https://doi.org/10.1257/aer.98.5.1943.

^[7] Tim Callen and Jonathan D. Ostry, eds., Japan’s Lost Decade: Policies for Economic Revival (Washington, DC: International Monetary Fund, 2003), https://doi.org/10.5089/9781589061873.071.

^[8] Udaibir S. Das and Michael M. Kawai, “Japan’s Banking Crisis: Problems and Responses,” in Japan’s Bubble, Deflation, and Long-Term Stagnation, ed. Koichi Hamada, Anil K. Kashyap, and David E. Weinstein (Cambridge, MA: MIT Press; Washington, DC: International Monetary Fund, 2011), chap. 4, https://www.elibrary.imf.org/display/book/9781589068407/ch04.xml.

^[9] Caballero, Hoshi, and Kashyap, Zombie Lending and Depressed Restructuring in Japan.

^[10] W. Raphael Lam, Alfred Schipke, Yuyan Tan, and Zhibo Tan, Resolving China’s Zombies: Tackling Debt and Raising Productivity, IMF Working Paper No. 17/266 (Washington, DC: International Monetary Fund, November 2017), https://doi.org/10.5089/9781484330722.001.

^[11] International Monetary Fund, Financial Soundness Indicators (FSI): Core and Additional Indicators, IMF Data Explorer, indicator AQ12_CFSI_PT (“Nonperforming Loans to Total Gross Loans”), annual data for China, Japan, and the United States, accessed August 3, 2026, https://data.imf.org/en/datasets/IMF.STA:FSIC.

^[12] Scott Davis and Brendan Kelly, “China Debt Overhang Leads to Rising Share of ‘Zombie’ Firms,” Dallas Fed Economics, Federal Reserve Bank of Dallas, December 23, 2025, https://www.dallasfed.org/research/economics/2025/1223.

^[13] Banerjee and Hofmann, “The Rise of Zombie Firms.”

^[14] Giovanni Favara, Camelia Minoiu, and Ander Perez-Orive, Zombie Lending to U.S. Firms, Federal Reserve Bank of Atlanta Working Paper No. 2024-7 (Atlanta: Federal Reserve Bank of Atlanta, August 2024), https://doi.org/10.29338/wp2024-07.

^[15] Adalet McGowan, Andrews, and Millot, The Walking Dead?.

^[16] Banerjee and Hofmann, “The Rise of Zombie Firms.”

^[17] Caballero, Hoshi, and Kashyap, Zombie Lending and Depressed Restructuring in Japan.

^[18] Banerjee and Hofmann, “The Rise of Zombie Firms.”

^[19] Giovanni Favara, Camelia Minoiu, and Ander Perez-Orive, “U.S. Zombie Firms: How Many and How Consequential?,” FEDS Notes (Washington, DC: Board of Governors of the Federal Reserve System, July 30, 2021), https://doi.org/10.17016/2380-7172.2954.

^[20] Peter Ballantyne, Private Credit: Capital Markets Forecast (Seattle: Russell Investments, May 7, 2025), https://russellinvestments.com/content/dam/ri/files/us/en/insights/institutions/alternatives/Private-Credit-Capital-Markets-Forecast.pdf.

^[21] Jared A. Ellias and Elisabeth de Fontenay, “The Credit Markets Go Dark,” Yale Law Journal 134 (2025): 779–857, https://yalelawjournal.org/article/the-credit-markets-go-dark.

^[22] Ellias and de Fontenay, “The Credit Markets Go Dark.”

^[23] Rachel Reed, “Traditional Bank Loans Are Disappearing. Now What?,” Harvard Law Today, Harvard Law School, June 8, 2026, https://hls.harvard.edu/today/traditional-bank-loans-are-disappearing-now-what/.

^[24] Board of Governors of the Federal Reserve System, Monetary Policy Report, submitted to the Congress pursuant to section 2B of the Federal Reserve Act (Washington, DC: Board of Governors of the Federal Reserve System, July 10, 2026), https://www.federalreserve.gov/monetarypolicy/2026-07-mpr-summary.htm.

^[25] Lisa D. Cook, “A Policymaker’s View of Financial Stability,” speech at the Psaros Center for Financial Markets and Policy, Georgetown University McDonough School of Business, Washington, DC, November 20, 2025, Board of Governors of the Federal Reserve System, hFederal Reserve’s 2021 finding that zombie firms were not a sufficiently prominentttps://www.federalreserve.gov/newsevents/speech/cook20251120a.htm.

^[26] Marc Ponchione, Sheena Paul, and Juliet Han, “Form PF Amendments Signal Slimmer Private Fund Reporting,” Harvard Law School Forum on Corporate Governance, June 16, 2026, https://corpgov.law.harvard.edu/2026/06/16/form-pf-amendments-signal-slimmer-private-fund-reporting/.