Non-performing loans and euro area bank lending behaviour after the crisis

Abstract

Non-performing loans (NPLs) remain high on the policy agenda in Europe. Their persistence at elevated levels after the financial crisis gave rise to financial stability concerns – including possible adverse impacts on financial intermediation. A commonly-held view is that NPLs impair the credit allocation mechanism. However, the literature has not so far offered a theoretical framework to support this view. This paper argues that loan demand and supply dynamics may vary over the economic cycle and that banks that are burdened with high NPLs may discriminate between households and firms in their credit allocation decisions in the recovery phase. Using a novel bank-level dataset for large euro area banks covering the period of the recent economic upswing, we find robust evidence that the stock of NPLs relative to banks’ shock-absorbing capacity, measured by bank capital, has been a significant factor in explaining bank-specific loan origination. The effect is found to be more significant for corporate than for household lending. since high NPL stocks do indeed appear to impair credit allocation, dedicated policies aimed at bringing NPL stocks down are required to avoid adverse impacts on the real economy. Our findings support the aims of the guidance that the single supervisory mechanism has given to banks on their NPL strategies. Additionally, the linkages between high NPL stocks and credit flows motivate the need for complementary measures to address impediments to NPL resolution, such as weaknesses in judicial and insolvency frameworks.