Blog Post

A framework for thinking about bad loans

An important guiding principle in resolving non-performing loans (NPLs) should be to ensure that viable debt remains serviced, while non-viable debt gets resolved. We present here a framework to approach the issue.

By: Date: October 18, 2016 Topic: Finance & Financial Regulation

The attempt to address the problem of non-performing loans in the EU should tackle both sides of credit creation at once.  On the demand side, new credit is not picking up as long as the problem of the debt overhang, namely the disincentive of undertaking new investments and consumption while old debts are prohibitively high, remains.  This, hinders the creation of new productive capacity, necessary to absorb factors formerly misallocated to sectors hit by the crisis. By implication, as long as private debts remain at high levels, economic activity will struggle to pick up. On the supply side of credit, progress has been slow in resolving impaired loans, which persist in banks’ balance sheets. This is problematic for both their overall health but also the creation of new credit.

Figure 1: Gross non-performing debt instruments, % of total gross debt instruments

Source: ECB, Note: peak year to 2016Q1

md-18-10-16

And while a number of countries (namely the Baltics) have managed to decisively resolve bad debts to the benefit of new credit creation, others have made less progress and some have even been unable to make any (Figure 1). The ECB recently issued draft guidelines in an attempt to pool resources and address the issue.

I argue here that an important guiding principle in resolving NPLs should be to ensure that viable debt remains serviced, while non-viable debt gets resolved. But this is not the same as resolving non-performing debt while holding on to performing debt. It helps therefore to categorise loans in two dimensions: viability and ability to service themselves.

Table 1 then provides four possible ways of classifying loans. Performing loans are those that are effectively being serviced and paid back. Viable loans are those for which the underlying assets generate sufficient value to cover funding costs.

Good loans are then, productive loans that are being serviced. This is the only category where debt has a productive role.

Bad loans by contrast are those that do not perform, but also those for which the activities they had financed do not generate enough value.  Aiming to resolve these loans in a swift and timely way should be encouraged, as the only way of identifying losses and reducing uncertainty for creditors but also releasing debtors from unproductive activities (second chance).

Unproductive loans are then those which may actually perform in the sense of servicing payments, but do not themselves generate value. Collateralised loans can provide indicative examples here.

Consider a household in the following situation: the value of its house is smaller than the loan that financed it (negative equity); it is liable by law for that remaining difference, as is the case in European countries (full recourse), and has very little possibility of walking away from such obligation by declaring bankruptcy (say through strict insolvency rules). If the household chooses (or needs) to sell that house, additional resources would be needed to repay the loan in full. Also, since the possibility of walking away from such a liability is effectively not available, the household is left locked into servicing a loan which is economically unattractive, as it is larger than the value of the house.

Protecting creditor rights is of course an important reason why insisting on servicing such debt may be a good idea. But when housing markets have gone through sharp corrections, followed typically by a downturn in the business cycle, such arguably unproductive loans may not be isolated cases, but rather wider spread. From a macroeconomic perspective, one ought to therefore at least consider whether the benefits of “creative destruction” outweigh the costs of violating creditors’ rights. The European Commission alludes to this in its last country report for the Netherlands.

Finally, there is also a category of temporarily distressed loans or strategic defaults. This includes either debts that are temporarily in distress but could return to being performing or loans that are non-performing by choice. The latter are the result of moral hazard where debtors choose not to pay back debt even when economically feasible. Evidence shows that strategic defaults increase as negative equity on mortgages increases, and especially when there is no full recourse. However, households’ likelihood to default strategically is shown to be also associated with perceptions of fairness, but also decreasing with the perceived risk of negative consequences of doing so (stigma, negative credit ratings etc). In this respect, indiscriminate protection of debtors or the less than perfect ability to collect collateral may lead to more strategic defaults.

Resolute action to remove non-performing loans from banks’ balance sheets should address both the supply and demand side of credit. Removing bad loans from bank’s balance sheet is important for their health and financial stability more generally. But removing them also from the debtors’ balance sheet is equally necessary if new credit is to be demanded.

Given the four categories presented above, understanding debtors’ true ability to pay back debts and restructure appropriately is crucial in this process. But aligning incentives between the different parties involved, creditors, debtors and relevant institutions (supervisors, regulators but also tax authorities and courts) is equally important.

The aim is to have as much debt fall in the “good” category. If loans are only temporarily distressed, they need to be identified as such and assisted in becoming productive again. Banks should be incentivized to deal with this in a timely manner.

Unproductive loans could be reduced if, for example, the possibility of walking away from debts through bankruptcy was not protracted and/or unforgiving. But here, while banks do not have an immediate incentive to either identify or deal with such loans, macroeconomic policy makers do, in particular when their size is systemic to the economy. Data on debtors failing to make other payments, like taxes or health insurance contributions, could serve as important indicators of financial distress. Such loans should then be assisted in becoming “bad”, which in turn should be treated swiftly to help redirect resources to productive activities. Enforcement and the rule of law are important in identifying “non-performance”; aligned incentives and bank involvement are important in determining “viability”.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

A tangled tale of bank liquidation in Venice

What can we learn about the Italian banking sector from the decision to liquidate Veneto Banca and Banca Popolare di Vicenza? Silvia Merler sees a tendency for Italy to let politics outweigh economics.

By: Silvia Merler Topic: Finance & Financial Regulation Date: June 26, 2017
Read about event

Upcoming Event

Jul
6
12:30

Is there a way out of non-performing loans in Europe?

At this event we will look at the issue of non-performing loans in Europe. The event will also see the launch of the latest issue of "European Economy – Banks, Regulation and the Real Sector."

Speakers: Emilios Avgouleas, Giorgio Barba Navaretti, Giacomo Calzolari, Maria Demertzis, Martin Hellwig, Helen Louri and Laura von Daniels Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

Raising the inflation target: a question of robustness

In an unexpected move, the Federal Reserve Chair Janet Yellet has recently brought up the issue of raising the inflation target. This blog argues that an increase in inflation targets may prove to be beneficial in achieving price stability in the long run. This would increase the credibility of central banks in achieving inflation goals and stave off the distortionary effects of deflation.

By: Maria Demertzis Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article Download PDF More on this topic

External Publication

A New Liquidity Risk Measure for the Chilean Banking Sector

This paper introduces a new metric for central banks – and in particular for the Central Bank of Chile – to measure liquidity risk in their banking sector using the bidding behavior of commercial banks in their open market operations.

By: Grégory Claeys, Sebastián Becerra and Juan Francisco Martínez Topic: Finance & Financial Regulation Date: June 7, 2017
Read article Download PDF More by this author

Policy Contribution

German Bundestag

Charting the next steps for the EU financial supervisory architecture

The combination of banking union and Brexit justifies a reform of the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) in the near term, in line with the subsidiarity principle and the accountability of EBA and ESMA and their scrutiny by the European Parliament should be enhanced as a key element of their governance reform.

By: Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation, German Bundestag Date: June 7, 2017
Read article Download PDF More by this author

Policy Contribution

The governance and ownership of significant euro-area banks

This Policy Contribution shows that listed banks with dispersed ownership are the exception rather than the rule among the euro area’s significant banks, especially beyond the very largest banking groups. The bulk of these significant banks are government-owned or cooperatives, or influenced by large shareholders, or prone to direct political influence.

By: Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: May 30, 2017
Read article More on this topic

Blog Post

We need a European Monetary Fund, but how should it work?

Many voices are calling for the ESM to be developed into a fully-fledged European Monetary Fund. But what changes would this entail, and how could the new institution be governed? The authors see both need and hope for change.

By: André Sapir and Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: May 29, 2017
Read article Download PDF More on this topic More by this author

External Publication

Les banques européennes se retirent-elles de la scène internationale?

Dirk Schoenmaker conducts a comparative analysis of global systemically important banks (G-SIBs) and examines their evolution (Note: this paper is available only in French).

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: May 23, 2017
Read article More on this topic More by this author

Podcast

Podcast

How will Europe's banking system respond to future challenges?

After the financial crisis, the EU has taken measures to create conditions for a safer banking sector. One of the key measures to do that is the creation of the banking union. How successful has the implementation of the new framework been so far? How will issues in the Italian banking sector be addressed? And how will Brexit change the European banking sector?

By: The Sound of Economics Topic: Finance & Financial Regulation Date: May 5, 2017
Read article More on this topic More by this author

External Publication

The Banking Union: An Overview and Open Issues

Dirk Schoenmaker's chapter in 'The Palgrave Handbook of European Banking', a handbook that collates the expertise and research of leading academic and senior policy makers in the field of European banking

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: May 2, 2017
Read article Download PDF More on this topic

Policy Contribution

Tackling Europe’s crisis legacy: a comprehensive strategy for bad loans and debt restructuring

Years after the start of the financial crisis, non-performing loans and private debt remain obstacles to the recovery of bank credit and investment.

By: Maria Demertzis and Alexander Lehmann Topic: Finance & Financial Regulation Date: April 21, 2017
Read article More on this topic More by this author

Blog Post

Italian banks: not quiet on the eastern front

Italian banks are back in the spotlight. After MPS failed to raise enough capital from private investors earlier this year, Banco Popolare di Vicenza (BPVI) and Veneto Banca take centre stage. The story of these two banks epitomises the strategy of delayed reform that has been so characteristic of the Italian banking crisis.

By: Silvia Merler Topic: Finance & Financial Regulation Date: March 31, 2017
Load more posts