Zombie banks prove to be financial institutions that in reality have literal economic net worths of less than zero. They still keep running because they are able to continue paying their debts using government’s real or implied support for their credit and balance sheet. Although this term has come to be heavily used in the financial crises of 2007 to 2010, it did not originate there.
Instead, Edward Kane coined the phrase Zombie Banks back in 1987. He used it to refer to and relate the perils of allowing a great number of banks that were actually insolvent to continue operating. The phrase came to be utilized for the Japanese banking crisis that began in 1993. It once again arose in popularity during the financial crisis of the last few years where hundreds of banks have failed in single years.
Zombie banks have many problems. Among these are bank runs from frightened depositors who are uninsured for their full account values. They also suffer from margin calls from their counter parties in derivatives contracts.
Zombie banks can be deceptive, as on the surface they may look like they are actually healthy and have the necessary level of capital to run. As investors learn the fair value of their assets, then they are suddenly looked at as insolvent institutions. This is to say that Zombie Banks keep operating in a regular manner as if nothing is wrong with their balance sheets. Yet the truth is that they will likely be seized by the Feds when the word becomes wide spread that they do not have the assets and money that everyone believed.
Healthy banks are able to make loans to new borrowers at the same time that they honor their obligations to lenders and share holders. Insolvent banks, or Zombie Banks, are incapable of generating new loans, since they lack the money and capital to make such loans while still performing on their obligations to lenders and share holders.
Comprehending what constitutes a Zombie bank requires that you know the basics of a bank balance sheet. One side of a balance sheet actually contains a bank’s assets. The other side is comprised of the bank’s liabilities as well as the bank’s equity. The two sides are supposed to equal out, which is expressed in the equation assets equal liabilities plus the bank equity.
Zombie banks manage to hide their problems since no one is able to determine how much their assets are really worth. Asset backed securities and collateralized debt obligations are examples of assets whose values can not clearly be determined at any given moment. They might be worth as much as seventy-five cents for every dollar, or they could be valued as low as twenty-five cents per dollar.
The problem comes when Zombie banks have over valued their assets. If they later are forced to revalue them to correct and more appropriate levels, they quickly discover that they no longer have the assets to cover their future liabilities. Admitting to this causes them to become Zombie banks. At this point, the bank share holders are typically wiped out, while the depositors are given their money back by the Federal Deposit Insurance Corporation.