25 Jan 2021

NPLs need tailored policy solutions

International team of financial economists around SAFE compares and evaluates policy measures to make Europe's banks more crisis-proof in times of Corona

To overcome the Corona crisis, Europe's economies depend on a healthy and resilient banking sector. To achieve this, however, a significant rise in non-performing loans (NPLs) must be tackled somehow. In a recent SAFE White Paper, the SAFE Pandemic Policy Team scrutinizes which policy options safeguard the integrity and functionality of the banking system and which criteria are defining the desired policy response.

The team of international financial economists around the Leibniz Institute for Financial Research SAFE distills the requirements that a desirable policy response preferably would meet: (1) effectiveness, (2) feasibility, (3) credibility, (4) alignment of incentives and (5) structural impact to the banking system. Subsequently, the team applies the criteria to a list of several concrete options for action that are open to policymakers to address the NPL problem: a private issue of equity capital by individual banks; the temporary forbearance of capital requirements in the banking sector; a synchronized recapitalization of all credit institutions with public money; the reduction of risks by selling assets to third parties or by setting up a bad bank; and the restructuring of assets and liabilities of affected banks using development institutions (e.g. KfW in Germany).

“A bank that manages to strengthen its capital base on its own would also be able to restructure NPLs itself – in this much preferred case additional help would not be needed,” says SAFE Director Jan Pieter Krahnen, a member of the SAFE Pandemic Policy Team and one of the paper's authors. “However, if help is required, the borrower-specific information available at the level of housebanks should be relied on when making investment decisions. The private information advantage of on-balance sheet solutions renders any non-recourse transfer of loan portfolios to outside institutions much less attractive.”

Regulatory leniency changes incentives for banks

Regarding forbearance in the banking sector, the team believes caution is warranted as this could spur the suspension of key elements of the banking union, putting a subsequent reintroduction of regulation rules in doubt due to credibility concerns. “Regulatory leniency changes the incentives for banks, which can and will also jeopardize financial stability in Europe in the longer term,” Krahnen explains.

“A one size fits all policy measure is wishful thinking,” adds Loriana Pelizzon, director of SAFE’s Financial Markets department and also a member of the SAFE Pandemic Policy Team. However, creating an EU-owned bad bank could put greater pressure on banks: “An EU-wide bad bank that absorbs NPLs from across the European single market could potentially work more efficiently than member states alone when it comes to the liquidation of collateral and should be less prone to capture than national vehicles. It would also improve the development of an European secondary financial market for these loans”.

“All the measures we have evaluated are not necessarily mutually exclusive,” Pelizzon continues, “but in terms of effectiveness and feasibility, political credibility, potential disincentives, and consequences for businesses and consumers, there are significant differences to keep in mind.”

Download the SAFE White Paper No. 79

Scientific contact

Prof. Loriana Pelizzon, Ph.D
Director of the SAFE research department Financial Markets
Email: pelizzonwhatever@safe-frankfurt.de
Phone: +49 69 798 30047