Zombie firms drag down healthy rivals — bottom-quartile borrowers hit hardest

When so-called "zombie firms" — chronically insolvent companies that survive only by rolling over debt — take on more liabilities, borrowing costs rise for healthy companies in the same sector, a new analysis has found. The negative spillover is especially severe for viable firms in the bottom 25 percent of credit ratings, which face both higher interest rates and restricted access to credit because of the zombie firms operating alongside them. Experts say financial institutions should track sector-level zombie firm exposure as a core risk indicator while assessing individual company risk separately.

Toss Insight published the findings Monday in a report titled "The Dual Challenge of Domestic Bank Financial Intermediation: Conditions for Productive Credit Allocation and Stable Deposit Funding." The report said sector-level risk management is necessary because distress within an industry can worsen lending conditions for healthy firms, but warned that blanket classification of low-rated yet viable companies as high-risk borrowers could seriously distort credit allocation.

According to the researchers, when the share of debt held by zombie firms — defined as companies whose interest coverage ratio (operating profit divided by interest expenses) has remained below 1 for three consecutive years — rises by 10 percentage points, the average borrowing rate for healthy firms in the same sector increases by about 0.10 percentage point.

The blow falls hardest on healthy firms in the bottom quartile of credit ratings. For those companies, a 10-percentage-point increase in the zombie firm debt share pushes borrowing rates up by 17 basis points (one basis point equals 0.01 percentage point) and slows loan growth by 2.3 percentage points.

By industry, the negative spillover from zombie firm proliferation was more pronounced in the service sector than in manufacturing. The report attributed this to banks' tendency to price interest rates based on broad industry-wide risk rather than the capabilities of individual firms.

The report recommended that financial institutions separate sector-level risk assessments from individual company risk assessments, so that capital tied up in distressed firms can flow toward viable companies with stronger growth potential — improving the efficiency of productive finance.

Specifically, the report said lenders should differentiate interest rate, credit limit and maturity terms based on operating cash flow, sales continuity and the recoverability of interest coverage capacity, and should distinguish between viable but vulnerable firms and those with structurally low prospects for rehabilitation. For sectors such as services, where collateral-based evaluation is difficult, the report called for credit assessment frameworks that reflect operational sustainability — including cash flow, sales resilience, customer base and accounts receivable collectability.

The report also urged policymakers not to respond to the zombie firm problem by broadly cutting support for distressed sectors, but instead to identify viable firms within those sectors and ensure their access to financing does not become unduly constrained.

Meanwhile, zombie firms accounted for 17.1 percent of domestically audited companies as of end-2024, the highest share since 2010. Beyond simple mismanagement, zombie firms are increasingly seen as a structural problem that causes inefficient allocation of labor and capital, depresses total factor productivity and undermines the overall efficiency of the economy.