they are not financed at the expense of future generations. clearly, the crisis makes it even more necessary to undertake reforms that support the level and growth rate of potential output growth. such reforms are diverse and mutually supportive. action can be taken to improve participation in the labour market, to make tax structures supportive of private investment and to make sure that fiscal consolidation plans do not sacrifice socially profitable public investment. total factor productivity can benefit from support to higher education and research and from educating and training the young and low - skilled workers. all of this is essential but it is not in the hands of central banks. the specific factors i wish to explore today are the impact of a delay in the banking sector ’ s balance sheet adjustments on potential growth and what monetary policy can do in this process. following a financial crisis triggered by the bursting of a bubble, which was originally fuelled by a build - up of massive leverage ratios in the banking sector, the lack of balance sheet restructuring can indeed have severe implications for real economic activity. a well - identified danger is the emergence of so - called “ zombie banks ”. these are banks which are undercapitalised but can continue to operate by failing to recognise losses on their loan portfolios. such banks remain weak and, in the short term, overly sensitive to adverse shocks. they are a problem for regulators because they have an incentive to take excessive risks, for example, by extending loans to ex ante risky new customers. a deeper concern, however, is that zombie banks may pose risks for medium to long - term growth if they engage in the so - called “ evergreening ” of loans, which is often discussed with reference to japan. 3 the collapse of the japanese stock and real estate markets in the early 1990s led to severe losses for japan ’ s non - financial corporations, a large number of which became unable to service their bank loans. if banks had decided to call in non - performing loans, they would have been forced to write off existing capital. the fear of falling below the regulatory capital standards gave them the perverse incentive to continue extending credit to insolvent borrowers, gambling on the hope that the firms would recover or that the government would bail them out. this resulted in the evergreening of loans to troubled firms. by keeping the loans current, banks ’ balance sheets also looked healthier because the troubled loans were not reported as non - performing. “ zombie lending ” is dangerous, as it can stifle the physiological progress of creative

requirements incentivised banks to keep lending to non - viable firms in order not to recognise credit losses. in the euro area, bank portfolios may have been rebalanced away from lending to creditworthy firms because high yields have incentivised banks to undertake long sovereign bond positions. this sovereign - bank nexus, whereby domestic banks become the main creditor to national governments, in return increasing the government ’ s incentive to intervene in its banking sector, can become a threat to long - term economic recovery in the euro area. unless both bank balance sheets and public finances are sanitised, and the link between the banks and sovereigns is broken, the euro area may indeed have a long recovery ahead of it, with insufficient loan supply to creditworthy enterprises, depressed productivity and high unemployment rates. policy options and concluding remarks a number of policy actions have to be implemented in order to avert such a scenario. albertazzi, u. and marchetti, d. ( 2010 ), “ credit supply, flight to quality and evergreening : an analysis of bank - firm relationships after lehman ”, banca d ’ italia, working papers, no 756. see ecb financial stability review, may 2013. popov, a. and van horen, n. ( 2012 ), “ the impact of sovereign debt exposure on bank lending : evidence from the european debt crisis ”, ecb mimeo ; bofondi, m., carpinelli, l. and sette, e. ( 2012 ), “ credit supply during a sovereign crisis ”, banca d ’ italia mimeo. acharya, v. and steffen, s. ( 2013 ), “ the ‘ greatest ’ carry trade ever? understanding eurozone bank risks ”, nber working paper series, no 19039. bis central bankers ’ speeches the most important action is to ensure that a broad quality review of banks ’ assets is carried out, so as to ensure that any hidden balance sheet losses are brought to the surface. this is one of the priorities for the new single supervisory mechanism ( ssm ), which is being established as the first pillar of the european banking union. the ssm could start operating in the late summer of 2014 and will directly supervise the euro area ’ s largest and systemically important banks. the banking union in general and the ssm in particular are expected to reduce the risks of regulatory forbearance resulting from closeness between the financial industry and local regulators.