Publication - 27 May 2020 - RESEARCH BULLETIN NO.71 - COVID-19 and non-performing loans: lessons from past crises - 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. The data show that dealing with NPLs is critical to economic recovery.
Compared with the 2008 crisis, some factors are conducive to NPL resolution this time: banks have higher capital, the forward-looking IFRS 9 accounting standards can help NPL recognition, and the COVID-19 crisis was not preceded by a credit boom. 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
As a result of the coronavirus (COVID-19) pandemic, the economy has come to a sudden halt. This is likely to bring about high levels of non-performing loans (NPLs)¬ – i.e. loans that are in or close to default. High levels of NPLs are problematic because they impair bank balance sheets, depress credit growth, and delay economic recovery (Aiyar et al., 2015; Kalemli-Ozcan et al., 2015). Persistently high NPL ratios were a concern in several European countries after the 2008-2012 crisis, and the COVID-19 pandemic can cause a re-emergence of the NPL problem.
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. For each crisis, we report NPLs over an 11-year window around the crisis.
What do we learn from these data?
Most banking crises lead to high NPL levels
During crises, NPLs typically follow an inverse U-shaped pattern. 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.
Anticipating future levels of NPLs is key for formulating NPL resolution strategies. 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. After a crisis, NPLs increase to three times their pre-crisis values on average, and over ten times in extreme cases (see Chart 1).
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. (2016), Beck (2017), Brei et al. (2020), and in ECB Financial Stability Reviews: Grodzicki et al. (2015) and Fell et al. (2016 and 2017).
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. The NPL reduction outcomes after the global financial crisis are direr yet: two-thirds of the countries that experienced high NPL levels could not resolve those within seven years after the crisis (see Chart 2). Strikingly, this also implies that while advanced economies tend to have lower post-crisis NPLs, these take longer on average to resolve.
Copyright: European Central Bank
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