Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan

We examine the misallocation of credit in Japan associated with the perverse incentives faced by banks to provide additional credit to the weakest firms. Firms are more likely to receive additional bank credit if they are in poor financial condition, because troubled Japanese banks have an incentive to allocate credit to severely impaired borrowers in order to avoid the realization of losses on their own balance sheets. This "evergreening" behavior is more prevalent among banks that have reported capital ratios close to the required minimum, and is compounded by the incentives arising from extensive corporate affiliations.