Non Performing Credit Causes Healthy Credit to Vanish

One of the most debated topics in the banking sector in recent years has been that of non-performing loans (NPLs). At the center of the institutional debate is the question of how to dispose of the enormous amount of NPLs accumulated by European banks since the global financial crisis of 2008. To get an idea of ​​the extent of the phenomenon, in September 2016 the stock of NPLs in large European banks exceeded € 900 billion, equal to over 9% of euro area GDP. One third of this amount was held by Italian banks. The pandemic and the ensuing economic recession has made the problem even more urgent, as operators and regulators expect an increase in the volumes of problem loans in the coming months.
The extent of the phenomenon, current and prospective, has transformed a typically micro-economic issue (managing credit risk is, so to speak, in the DNA of each bank) into an important topic from a macro-economic perspective. In other words, what worried the European central authorities (legislative and banking supervisory bodies) were the potential negative externalities of an excess of NPLs, primarily the threat to the ability of banks to provide credit to the economy. This fear has given rise to a series of different types of measures aimed both at "disposing" of impaired loans already present in the balance sheets of banks, and at reducing the accumulation of new NPLs. The results have so far been encouraging, since the stock of NPLs, in June 2019, was reduced to less than 600 billion euros. However, the forecasts for the near future, marked by the results of the restrictions imposed by Covid-19, have made the picture decidedly bleaker.

Despite the considerable number of institutional studies on the issue of deterioration in credit quality and its effects, it is still not clear whether there really is a causal relationship (and therefore not just a simple correlation) between NPLs and credit supply. To what extent, that is, does an increase in non-performing loans cause a reduction in credit? For example, some argue that only the weakest banks (the least capitalized or the least profitable) would contract credit if they had a bad loan portfolio. What if, on the other hand, larger NPLs favored an increase in credit, but in the perverse mode of zombie lending? This possibility contemplates that some banks (again, the more fragile ones) may react to higher NPLs by increasing the supply of credit to unprofitable and highly indebted companies, with a view to keeping them alive in order to avoid further erosions of their assets.

My work with Immacolata Marino contributes to the debate on NPLs by trying to answer these questions. To this end, we compare the reaction of a sample of banks that had a sudden increase in NPLs with the behavior of a control sample, made up of banks as similar as possible to those belonging to the first group. The sudden increase in NPLs in the first group compared to the second resulted from the application of a more stringent criterion for the classification of non-performing loans and a stricter scrutiny that the European Central Bank imposed, in 2014, only against a hundred of European banks (precisely those which, at the end of 2014, would have been subject to the single supervision mechanism for the first time). Our main result is that, compared to the control sample, the sudden increase in NPLs led the "treated" banks to reduce the size of their balance sheets to the detriment of the loan portfolio. The reduction was more marked for banks that belonged to countries characterized by higher average levels of non-performing loans (and this regardless of "country factors" such as the trend of the economic cycle or aggregate credit demand), especially if less capitalized and less profitable.
In light of our results, for the future we expect that the foreseeable increase in the flow of new bad debts induced by the difficult economic situation could translate into a credit crunch. However, this tightening should be contained for more solid (more capitalized) banks or for those that have in the meantime managed to set aside reserves to cover probable higher credit losses.