Bad bank

COVID-19 and non-performing loans: lessons from past crises

Retrieved on: 
Thursday, May 28, 2020

By Anil Ari, Sophia Chen, and Lev Ratnovski[1] During crises, the number of loans that cannot be paid back increases.

Key Points: 
  • By Anil Ari, Sophia Chen, and Lev Ratnovski[1] During crises, the number of loans that cannot be paid back increases.
  • What are the lessons from past crises for non-performing loan resolution after COVID-19?
  • In this article we use a new database covering non-performing loans (NPLs) in 88 banking crises since 1990 to find out.
  • However, other factors could make NPL resolution more challenging: government debt is substantially higher, banks are less profitable, and corporate balance sheets are often weak.

A new dataset on the dynamics of non-performing loans during banking crises

    • This is likely to bring about high levels of non-performing loans (NPLs) i.e.
    • High NPL levels are a common feature of banking crises, and are often studied around such events.
    • Existing Laeven and Valencia (2013) data report peak NPL levels during crises, but more data are needed to understand how NPLs evolve and are resolved.
    • Our recent ECB working paper (Ari et al., 2020) bridges this gap by presenting a new dataset on yearly NPL evolution during 88 banking crises since 1990.
    • The dataset covers major regional and global crises the Nordic crisis, the Asian financial crisis, the global financial crisis and many standalone crises in developing, transition, and low-income economies.

Most banking crises lead to high NPL levels

    • They start at modest levels, rise rapidly around the start of the crisis, and peak some years afterwards, before stabilising and declining.
    • Looking at all crises, we see that NPL levels peak at about 20% of total loans on average, but the variance is large: in developing countries in particular, NPLs can exceed 50% of total loans.
    • Only less than a fifth of banking crises avoid high NPL levels which we define as NPLs exceeding 7% of total loans.
    • It is tempting to use pre-crisis NPL levels to anchor such forecasts.
    • Yet, pre-crisis NPL levels are not a good indicator of post-crisis NPL problems.

Timely NPL resolution is difficult, but essential for economic recovery

  • Countries can facilitate the resolution of high NPLs using a mix of policy measures such as:
    • Asset quality reviews, to identify loans that are non-performing and need restructuring;
    • Separating good and bad assets of banks (known as “good bank”-“bad bank” resolution). This makes the balance sheets of “good banks” more transparent, steadies their market access, and lets them focus on extending new loans. “Bad banks”, often structured as asset management companies, proceed to extracting value from bad assets;
    • Recapitalising “good banks”, to ensure their lending capacity.
    • More details on NPL resolution methods are provided in Balgova et al.
    • (2020), and in ECB Financial Stability Reviews: Grodzicki et al.
    • Despite the economic benefits of NPL reduction and the variety of methods available, the data paint a sobering picture of historic NPL resolution.
    • While some countries resolve NPLs rapidly, a third of countries are saddled with NPLs for over seven years after a crisis.
    • How many years did NPL resolution take?
    • In our paper, we use the local projections method to assess the link between NPL resolution and post-crisis output dynamics, while controlling for their co-dependence.
    • The results underscore that NPL resolution is critical for economic recovery.
    • Six years after the start of a banking crisis, output in countries that experience high NPL levels is 6.5 percentage points lower than in countries that dont.
    • Of the countries that have high NPL levels, output in those that do not resolve NPLs is more than 10 percentage points lower than in those that do (see Chart 3).
    • This means that not resolving high NPL levels reduced output growth by 1.5 percentage points per year at least for the next six years.

What explained slow NPL resolution in Europe after the 2008-2012 crisis?

    • NPL resolution is more protracted in similar circumstances, and in countries with high public debt and more sophisticated banking sectors.
    • Interestingly, these high-level indicators have good predictive power: the average (pseudo) adjusted R-squared across the specifications is 0.24.
    • It turns out that high NPL levels in Europe in the 2010s were hard to anticipate: the crisis was extraordinarily severe for advanced economies.
    • By contrast, protracted NPL resolution was in line with historical patterns: it is common for crises that follow a credit boom (see Chart 4).
    • Chart 4 Actual non-performing loans in Europe versus what could have been predicted

What can we infer for NPL resolution after COVID-19?

    • Our results highlight forces that can make NPL resolution after the COVID-19 events different from that after the 2008-2012 crisis.
    • Some forces are conducive to NPL resolution.
    • Other forces point to challenges in NPL resolution.
    • Moreover, if the economic recovery from the pandemic is slow and protracted, credit losses from corporate distress will rise and could overwhelm banks, further complicating NPL resolution.
    • Given the importance of NPL reduction for economic recovery and many countries historical difficulties in implementing effective NPL-related measures, designing effective NPL resolution policies for the post-COVID-19 world is a key forward-looking financial policy issue for Europe today.

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