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Following the actions of the ECB, the amount of Non-Performing Loans held by banks in the eurozone has fallen from an average of 6% in 2016 to less than 2% in 2023. However, credit risk management will remain a priority for supervisory purposes in the years to come, which is why a prudent approach and a functioning ecosystem are needed

Ten years ago, in October 2014, the European Central Bank (ECB) became the single supervisor of all significant financial institutions in the eurozone. Since then, one of the ECB’s main achievements has been dealing successfully with non-performing loans (NPLs)—i.e., past-due, unlikely-to-pay (UTP), or defaulted loans—that constituted a major threat to the health of European banks.

In the aftermath of the global financial and euro sovereign debt crises, European banks found themselves with an unprecedented amount of NPLs. By 2016, NPLs in the eurozone amounted to over €1 trillion, representing 6% of total loans in the region, with significant differences across banks and countries. One-third of European NPLs were held by Italian banks, where the average NPL ratio was 20%, compared to a 6% average in the eurozone.

The scale of the problem required targeted action from the ECB, whose main concern was that an excess of NPLs could impair bank lending and reignite the so-called bank-sovereign risk "doom loop", where credit losses might lead to bank distress at the local level, threatening national government solvency. Spillover effects across regions were also possible, endangering the stability of the entire banking system.

Focusing on the potential effects of a high level of NPLs on the credit supply, impaired loans negatively affect bank profitability and capital. In turn, low profitability and low capitalization weaken the banks' ability to extend credit. It's not just a question of how much credit is provided, but also which borrowers receive the resources. Unprofitable and undercapitalized banks face distorted incentives, often being tempted to lend more to weaker firms in an effort to delay their insolvency. Economists refer to these phenomena as "evergreen" and "zombie lending," where "weak" banks continue to finance unhealthy firms (zombie firms), artificially keeping them alive to avoid further negative repercussions on their profits and capital.

To prevent the accumulation of NPLs on the banks’ balance sheets, the ECB introduced guidelines on how banks should classify, manage, and provision for NPLs. As a result of these and other measures, within a few years, the stock of impaired loans in the euro area halved, falling to less than 2% of total loans. For Italian banks, this meant NPLs for €56 billion, i.e. less than 2.5% of their total loan portfolio (PwC data as of December 2023).

Are NPLs no longer a priority? While the data are encouraging, a prudent approach remains necessary for several reasons. First and foremost, the credit risk once borne by the banking sector has not been eliminated but merely transferred to specialized investors. In Italy alone, non-banking institutions still hold around €250 billion in NPLs that need to be recovered or actively managed. Second, banks themselves may hold large amounts of loans in sub-performing status (the so-called Stage 2 of the impairment process), which, along with UTP exposures, require sophisticated management approaches that entail "back-to-bonis" strategies as contract restructuring and the provision of new financing. Third, emerging risks—such as climate-related risks—reverberate on banks’ balance sheets in the form of increased credit risk. As such, credit risk will continue to be a supervisory priority in the years to come.

To efficiently handle problem loans, a well-functioning ecosystem is needed. This includes committed banks, non-banking financial institutions, supervisory authorities, and governments. In this regard, the quality of the institutional framework is a key factor affecting NPL management. Restructuring and insolvency regimes still vary across jurisdictions in Europe. Italy, for example, lags behind other EU countries, resulting not only in lengthy and costly recovery processes but also in more cumbersome corporate debt restructuring procedures. Advancement and greater harmonization in this area are much needed. Progress is especially desirable concerning UTP and Stage-2 loans to small and medium-sized enterprises, given the implications of risk management for small firms in the real economy, particularly in our country.

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