A Theory of Zombie Lending

Abstract

An entrepreneur borrows from a relationship bank or the market. The bank has a higher cost of capital but produces private information over time. While the entrepreneur accumulates reputation as the lending relationship continues, asymmetric information is also developed between the bank/entrepreneur and the market. In this setting, zombie lending is inevitable: Once the entrepreneur becomes sufficiently reputable, the bank will roll over loans even after learning bad news, for the prospect of future market financing. Zombie lending is mitigated when the entrepreneur faces financial constraints. Finally, the bank stops producing information too early if information production is costly.