25 Mar 2021

Resolve non-performing loans with more liability for banks

Researchers around SAFE recommend realistic assessment of loan losses in bank balance sheets and a resolution strategy in line with the EU Bank Recovery and Resolution Directive

In times of crisis, banks tend not to report non-performing loans (NPLs) correctly on their balance sheets. This leads to the continued financing of non-viable firms so-called zombie firms, which can have negative consequences for economic growth. Public recapitalizations of banks, relaxed depreciation rules and capital requirements in the wake of the Corona crisis, and a suspension of insolvency obligations, further exacerbate the problem. To avoid this, European regulators and supervisors should provide incentives for banks to identify and recognize NPLs in a timely and accurate manner, which can be achieved, for example, through effective asset quality reviews, stress tests and adequate accounting rules.

These are the recommendations of financial economists around the Leibniz Institute for Financial Research SAFE in an empirical analysis commissioned by the European Parliament.

“In recent decades, banks have had little incentives to identify loan losses on their balance sheets early and effectively,” says SAFE Director Jan Pieter Krahnen, who contributed to the study. “A realistic valuation of loans would give banks an incentive to identify NPLs in a timely manner and resolve them efficiently, for example through bank mergers or secondary market sales,” Krahnen adds.

Leverage the European secondary loan market for NPL resolution

An active secondary loan market would be helpful for NPL recognition and resolution and could thus contribute to the stability of the banking sector in Europe. “The higher the selling price of NPLs on the secondary market, the lower the capital loss for the bank selling these NPLs,” explains Loriana Pelizzon, director of SAFE’s Financial Markets department at SAFE and also author of the analysis. “A strong and well-developed secondary loan market therefore also facilitates bank resolution under the EU Bank Recovery and Resolution Directive (BRRD).”

Even though aggregated bank capital in Europe seems to be large enough to absorb potential NPL losses, there is considerable uncertainty about future developments. A comparison between 17 European countries further suggests strong cross-country differences. Assuming different negative scenarios, NPLs account for a larger share, relative to banks’ equity, in European countries with lower GDP per capita. Accordingly, weaker countries are most vulnerable to additional NPLs due to thin capitalization in their respective banking systems.

An extremely negative scenario with high systemic risks can therefore not be completely ruled out. In such cases, direct government intervention to stabilize the banking system may be justified. However, even in this case, the researchers recommend not to channel rescue money directly to banks, but rather to firms and households, in order to maintain the functioning of the BRRD and prevent adverse risk incentives for banks.

Download the SAFE White Paper No. 84

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