Zombie Banks, Competition, and the Deterioration of Credit Quality: Evidence from Rural Bank-Level NPL Dynamics in Indonesia

In recent years, the presence of zombie banks has become a significant concern in maintaining the stability of the banking system, particularly within the rural banking sector in Indonesia. This study examines how zombie banks affect credit quality and explores the role of market competition and regional economic growth in shaping this relationship. Using bank-level panel data and a fixed effects approach, this research analyzes the dynamics of non-performing loans (NPLs), both in terms of their levels and growth. The results indicate that zombie banks consistently exhibit higher NPL levels, reflecting weaker credit quality. However, their impact on NPL growth tends to be lower, suggesting a condition of elevated yet relatively stable credit risk. Furthermore, the study does not find strong evidence of risk spillovers from zombie banks to non-zombie banks, implying that credit risk is primarily driven by internal bank-specific conditions. In addition, the relationship between competition and credit risk appears to be non-uniform. Under certain conditions, competition actually amplifies the adverse impact of zombie banks on credit quality. On the other hand, regional economic growth does not mitigate this effect but instead tends to reinforce it, indicating increased risk-taking behavior during periods of economic expansion. These findings provide important implications for policymakers, particularly in designing supervisory frameworks and credit risk management policies. Specifically, the results highlight the importance of strengthening oversight of distressed banks and underscore the need to consider the interaction between bank conditions, market structure, and economic dynamics in maintaining banking system stability.