Nothing Stops This Train: The Credit Expansion That Holds Banking Together - Part 2

If you have not read Friday's blog post, please read it first before continuing here.

Zombie banks: the bank that can't lend is already dead

Let's define "zombie bank" without getting too academic. A zombie bank is a bank that is effectively insolvent or impaired, but kept alive (explicitly or implicitly) because letting it fail would trigger broader panic. That's the traditional definition. But functionally, the thing that makes it a zombie is what it can't do anymore:

• It can't extend credit normally.
• It can't take productive risk.
• It can't expand lending without threatening its own survival.
  

So what does it do instead? It "survives" through some mix of:

• government or central-bank support
• cheap liquidity
• accounting flexibility
• rolling bad loans forward (extend and pretend)
• avoiding realizing losses
  

When banks are weak, they often have an incentive to avoid writing down losses and can end up perpetuating weak credit dynamics, including "evergreening" loans rather than dealing with the reality of bad balance sheets. Here's the punchline I like (and you can steal it): A zombie bank isn't dead because it loses money; it's dead because it can't create credit. Because if the system's core function is credit creation, then a bank that can't create credit is basically a museum. It exists, but it's not doing the thing society actually relies on it to do. And when you get enough zombie behavior across the system, you don't get a clean collapse. You often get stagnation, misallocation, and slow decay. That's one reason "keeping the train moving" can turn into "keeping the zombies walking."

When the train slows: what a credit freeze looks like in real life

People hear "credit contraction" and imagine it's just a line on a chart. In real life, it's brutal and surprisingly ordinary. What it looks like for normal people:

• A small business has a line of credit and suddenly the bank won't renew it.
• A buyer who "qualified last year" can't get financing today.
• Mortgage approvals drop, down payments jump, and housing activity seizes.
• Layoffs start not because demand vanished overnight, but because financing did.
  

What it looks like inside the banking system

When stress hits, banks don't just worry about profits. They worry about survival:

• deposit outflows
• rising funding costs
• collateral getting marked down
• non-performing loans rising
• capital ratios getting squeezed
  

And the killer is confidence. A bank can be "fine" on paper with assets that will pay out over time, and still be toast if it faces a liquidity run today. Banking is a leveraged confidence business: long-term assets funded by short-term liabilities. Once confidence cracks, the timeline collapses. This is why credit freezes can feel nonlinear. Everything is "manageable" until suddenly it's not.

Why policymakers keep the train moving (and the tradeoff)

So why does the system keep choosing "don't stop"? Because stopping means letting the contraction loop run all the way through:

• cascading bank failures
• widespread defaults
• collapsing asset prices
• unemployment spikes
• political chaos
  

So when the engine sputters, policymakers typically reach for tools that keep the train rolling:

• liquidity facilities
• deposit guarantees or backstops
• regulatory flexibility
• emergency lending
• sometimes, outright bailouts
  

A key nuance: central banks can provide liquidity, but they cannot magically create creditworthy borrowers or instantly restore collateral values. They can buy time, patch confidence, and encourage lending, but they can't make bad loans good with a speech. And that brings us to the tradeoff that sits under the Lyn Alden "Nothing Stops This Train" theme.

The two doors

Door A: Let the system purge. Defaults happen, weak banks fail, debts get restructured, and the economy takes the pain upfront.

Door B: Backstop and extend. Keep liabilities whole, prevent cascading failures, and push the reckoning forward.

Door B is usually chosen because it's politically survivable in the short term. Door A is often "economically healthy" in the long term, but it can be socially and politically explosive in the short term. This is also why "zombification" is not an accident. It's often a policy outcome. If you are trying to avoid a crash, you tolerate things that look unhealthy on a balance sheet, because the alternative looks worse.

And that's the ending I'd leave the reader with: fractional reserve lending is not a static structure. It's motion. It's expansion. It's confidence. When credit creation slows sharply, the system doesn't gracefully power down. It tightens, it contracts, it breaks weaker institutions, and it forces a response.

The train doesn't keep moving because everyone loves debt. It keeps moving because stopping is the crash.