In policy paper, Mark Hallerberg and Christopher Gandrud examine the cautionary tale of Japan.
There is a growing consensus that Italy is finally taking the necessary steps to deal with its banking problems. European Union and Italian regulators have increased pressure on the country's most troubled large bank, Monte dei Paschi di Siena, to improve its balance sheet, and the government issued an emergency decree on 23 December 2016 with measures to clean up the industry. The Italian Parliament approved up to 20 billion euros for 2017 for this government programme. While there is some scepticism that 20 billion euros will be enough, given that one bank alone might need almost half of the fund, the expectation is that it will help the economy - banks will begin to lend again, and this will boost investment and spending in a country that has had essentially no economic growth since the early 2000s. Will the steps Italy is planning really transform these zombie banks into healthy ones?
To understand the question and the possible answers to it, consider the root problem. Zombie banks are banks whose stocks of non-performing loans (NPLs) are not large enough to make them insolvent, but are large enough to leave the banks with a very limited capacity to make new loans to productive economic enterprises. Managing these loans can divert considerable personnel resources away from profitable lending. Zombie banks thus do not contribute positively to the wider economy. Instead they are a drag on the economy as they allocate capital to inefficient activities that created non-performing loans. Once burdened with these loans, they are less likely to lend capital (European Central Bank, 2016). This can cause an 'adverse feedback loop' between the banking sector and the economy (Fujii and Kawai, 2010), as zombie banks slow economic growth and low economic growth increases the volume of non-performing loans.
In our policy paper, How not to create zombie banks: lessons for Italy from Japan, for the Brussels-based institute Bruegel, we compare the situation in Italy with that in Japan almost two decades ago to illuminate the causes and effects of, and the possible solutions to, the zombie bank problem.
Both the Italian and Japanese banking systems were hobbled by NPLs. Though it is difficult to compare directly NPLs in different countries at different times because of the use of different definitions and varying supervisory stringency in enforcing those definitions, Japan's NPLs peaked at over eight percent of gross loans in 2001. Italy's are currently over 16 percent.
The Japanese experience suggests that three elements are necessary to tackle zombie banks. First, there needs to be a recapitalisation of key banks that have been identified as viable so that they can take losses from balance sheet restructuring. Just because a bank has more capital does not mean that its management will have incentives to actually undertake restructuring. Second, an independent supervisor needs to diagnose the problem and force banks to act. Third, there needs to be a way to effectively dispose of NPLs. The public sector can play a crucial role in this respect in terms of setting up a secondary market for NPLs and managing their orderly disposal at non-fire sale prices.
These steps are well understood. Crucially, however, all three are necessary and bank management and policymakers need incentives to implement them in combination. In both Japan and Italy, efforts stalled at the recapitalisation stage because policymakers and most banks had few incentives to take losses from balance sheet restructuring. In the Japanese case, significant NPL restructuring did not begin until a tough independent regulator stepped in. Italy is arguably at the stage where it has the first two components in place, with recent measures to recapitalise the sector and with the European Central Bank, with no financial stake in the banks, becoming the key independent supervisor. There have been efforts to dispose of NPLs in Italy, but these have largely stalled because of weak incentives.
 Data from FRED, fred.stlouisfed.org. Accessed January 2017.
 If one sticks with the 'zombie' analogy, another option would be to 'kill' the zombie if there is little hope of reviving its business. In many European countries there has been great political reluctance to do this however (Gandrud and Hallerberg, 2015)
Read the full paper, How not to create zombie banks: lessons for Italy from Japan, published on 8 March on the Bruegel website.