How Do Non-Performing Loans Evolve along the Economic Cycle? The Role of Macroeconomic Conditions and Legal Efficiency

By | January 19, 2022

The reports about increased insolvency risk during the recent COVID-19 pandemic highlight the importance of banks’ balance sheet resilience. In times of crisis, regulators are most concerned about the build-up of non-performing loans (NPLs) – many historical examples show that excessive levels of NPLs can seriously endanger financial stability (e.g., in JapanItalyMexico, or Asia). Evidence from the high levels of NPLs in Europe during the global financial crisis,and the subsequent sovereign debt crisis, helps understand how regulation can be designed to support a swift resolution of NPLs.

Post-crisis data shows that the resolution of non-performing loans in the recovery period varied substantially across European countries. Diverging macroeconomic conditions account for some of these differences; but it is unclear whether the design of the legal framework contributed to the NPL resolution beyond the macroeconomic trends. We explore this question in our recent study and we examine to what extent the duration and the costs of insolvency and contract enforcement procedures can explain this variation in the post-crisis resolution of non-performing loans. 

What are non-performing loans and how do they affect banks?

Banks record loans as “non-performing” when their borrowers are no longer able to make their contractual payments.[1] The classification of a loan as non-performing is often accompanied by additional loss provisions, which decreases net income. At the same time, higher risk weights for NPLs lower regulatory capital ratios. Consequently, banks with high levels of NPLs have less capital for productive lending and face higher funding costs. The prior literature has documented the severe negative economic consequences of high NPL levels for bank stabilitybank lending, and ultimately, economic activity. Therefore, a quick reduction of banks’ non-performing loans, particularly after an economic downturn, is important to foster lending and maintain bank stability.

How does a country’s legal infrastructure interact with banks’ non-performing loans?

The effect of the legal infrastructure on NPLs is twofold. First, during all states of the economy, an efficient legal system can help reduce moral hazard frictions between banks and borrowers. For example, if a borrower knows that the collateral attached to a loan is quickly realized by the loan-granting bank in the case of default, then the borrower is less likely to apply for high-risk loans ex ante. Therefore, an efficient legal framework can help to reduce information frictions between banks and borrowers regarding the borrower’s credit quality and her willingness to pay. However, even the most optimal incentives ex ante will not entirely preclude actual loan defaults and the corresponding build-up of NPLs during an economic recession. Therefore, we expect that legal efficiency has an even greater impact on banks’ NPL levels during the post-crisis recovery periods when economic growth picks up. At this point during the cycle, efficient insolvency and contract enforcement procedures can help banks to timely seize the collateral attached to the non-performing loan or, in the case of unsecured borrowings, enable the bank to timely write off the proportion of the loan it could not collect. Overall, an efficient legal system likely accelerates NPL reductions by facilitating the workout of the existing NPL stock during the economic recovery after a crisis. 

What are the main findings and policy recommendations?

We employ bank and country-level data from 16 European countries over a period of 10 years around the financial crisis to examine whether a country’s legal infrastructure is associated with NPL levels in its banking sector and whether this association varies along the economic cycle. It is empirically challenging to separate the effect of the legal infrastructure from the effect of a country’s macroeconomic environment; we address this challenge by exploiting local reforms of insolvency laws during our sample period. We examine changes in the resolution of NPL portfolios around five major legal reforms that substantially increased the efficiency of insolvency proceedings in Austria, Belgium, France, Estonia, and Latvia. At least to the extent that these legal reforms do not coincide with other changes in factors that also determine banks’ NPL levels, this difference-in-differences approach then helps attribute differences in NPLs to countries’ legal efficiency.

Our main findings highlight that the choice of a bank’s business model and economic conditions play a role during all stages of the economic cycle. However, the impact of legal efficiency is most pronounced after a crisis, when efficient legal proceedings (e.g., in insolvencies) help resolve NPLs more quickly. Low costs and a high efficiency of insolvency and contract enforcement proceedings are the most important factors of a country’s legal infrastructure and enable banks to swiftly workout their NPL portfolios after a crisis. In contrast, when macroeconomic conditions deteriorate during a downturn, a country’s legal framework does little to avoid the build-up of high NPL levels. 


Our findings can help inform regulators, policymakers, and supervisors when addressing high NPL levels in the future. Policymakers should carefully evaluate the recent insolvency reforms during the pandemic, such as the temporary suspension of the filing obligations (e.g., in Germany, Austria, France, Spain, and the Czech Republic). Such suspensions may lead to an accumulation of insolvency filings after the end of the grace period and then swamp the courts. The resulting inefficiencies will delay the workout of NPLs and present a potential threat to the stability of the banking system that bank supervisors are not equipped to address.  

However, it is important to acknowledge that there are further policy measures that can be taken. Some of these tools have been successfully used by regulators in other countries. One example is the selling of NPL portfolios to external parties (mostly specialized debt servicing companies). These sales are subject to substantial legal restrictions in many countries but might offer potential benefits over other legal reforms. Such a market-based solution may be less costly to implement than comprehensive legal reforms.

Jannis Bischof is a Professor of Accounting at the University of Mannheim.

Nicolas Rudolf is an Assistant Professor at the University of Lausanne.

Wilhelm Schmundt is a Managing Director & Partner at the Boston Consulting Group and a Lecturer at the University of Mannheim.

This post is adapted from their paper, “How Do Non-Performing Loans Evolve along the Economic Cycle? The Role of Macroeconomic Conditions and Legal Efficiency”, TRR 266 Accounting for Transparency Working Paper Series No. 66, available on SSRN.

[1]      While there is no universal definition, the recording of an NPL is usually triggered when the borrower is 90 days late on a payment.

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