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. We establish a causal link between banks? lending incentives and accrual manipulation using a natural experiment arising from capital injections into banks instituted by the Japanese Government in the late 90?s. Further, we examine the industry spillover (contagion) effect of such accounting manipulation and find that profitable firms adopt more opaque reporting when its industry is dominated by zombie firms. Finally, we find that banks with greater incentives to inflate capital ratios lend more to zombie firms. Overall, our results suggest that keeping insolvent borrowers afloat deteriorates the information environment of both zombie firms and their profitable industry peers.