Our goal is to quantify the macroeconomic consequences of credit misallocation resulting from forbearance incentives in Japan. Forbearance is a practice whereby banks accommodate bad borrowers struggling to meet their obligations. It results in loan relationships being kept alive, which would otherwise be terminated in the absence of incentives to forbear. The phenomenon was pervasive during Japan’s “Lost Decade” but has resurged in the aftermath of the Great Financial Crisis (GFC).

Indeed, the “Moratorium Law” of 2009 encouraged banks to extend loans to distressed SMEs. Forbearance generates credit misallocation, which the literature has shown can result in substantial output and productivity losses. The existing literature on forbearance is extensive, but it has focussed on firm-level, bank-level, or industry-level regressions, showing e.g. that zombies depress the employment growth of healthy firms. Importantly, it lacks an assessment of the aggregate impact of forbearance on economic performance. Our approach enables us to perform such a quantitative assessment. We design a search theoretic model of credit markets with heterogeneous firms and firmbank specific frictions that capture forbearance. Using the model as a guide, we develop a methodology to recover empirical estimates of these firm-bank relationship specific frictions. With these estimates in hand, we can perform counterfactual exercises that deliver estimates of the aggregate impact of those frictions, e.g. on aggregate productivity. Finally, we provide regressionbased evidence in support of our channel. First, we relate our estimates of forbearance frictions to measures of zombieness and show that higher frictions are associated with a higher probability that a firm is classified as a zombie. Second, we exploit geographical variation in search frictions across Japanese prefectures to show that forbearance frictions are more significant when search frictions are more stringent.

The project is consistent with the objectives of the Keynes Fund as it studies a specific cause for the failure of market efficiency in credit allocation, and its consequences for the real economy. Numerous countries are currently experiencing a productivity slowdown and it is important to understand to what extent dysfunctional credit markets contribute to this phenomenon. Forbearance has been a concern in many countries following the GFC. The main challenge with evaluating the extent of forbearance and its aggregate consequences is that it is mostly a hidden phenomenon. Our theoretical-empirical approach is meant to retrieve estimates of forbearance frictions in the absence of direct observational data.