This paper finds evidence that regulatory forbearance toward weakly capitalized banks, which creates “zombie” banks, leads to the creation of “zombie” firms in the Japanese banking crisis of 1997-2003. Capital weak banks bankrupt large borrowers at higher levels of indebtedness than similar firms with better capitalized banks. The average “zombie” entering bankruptcy has an extra 4.7 years of unlife and is 20.8% more indebted than bankrupt firms with better capitalized banks. This is the first direct evidence of bank capitalization being the driving force behind “zombie” firms. I quantify the direct costs of increased bad debts due to forbearance at 4.2% of nominal Japanese GDP in 1997 or US$181 billion. This does not include the indirect costs such as the loss to competitors through lower profitability and employment, nor the foregone profits for banks of not making loans to profitable firms. The results are robust to several alternative measures of indebtedness and are confirmed by robustness checks showing that weakly capitalized banks increase the rate of bad loan disposal and bankruptcies of listed firms after receiving government capital injections. These results are particularly relevant in the aftermath of the global financial crisis of 2008. Regulatory forbearance towards banks remains a politically more palatable option than extensive capital injection in many countries; this study suggests that forbearance may prove to be very costly.