A year ago our research showed Europe had an €800 billion stock of bad loans. In our latest Global Financial Stability Report we show that the problem has now grown to more than €900 billion. This stock of nonperforming loans is concentrated in the hardest hit economies, with two-thirds located in just six euro area economies. The European Central Bank’s Asset Quality Review confirmed this picture, which revealed that the majority of banks in many of these economies had high levels of nonperforming assets (see chart 1).
In January, the European Central Bank announced its expanded asset purchase program to address the risks of persistently low inflation. This has already delivered measurable signs of success: financing costs have fallen, equity prices are higher and the euro has depreciated, helping to support inflation expectations.
But other policies must complement this central bank action—aimed at unclogging bank lending channels—to maximize the effectiveness of monetary policies.
Bad loans hinder lending
Banks need to tackle their bad loans, which are a burden on bank balance sheets and a drag on credit. As the diagram below shows, they reduce profitability as banks have to set aside funds to cover the losses, they generate less interest income, and they have associated operational costs (such as administrative expenses and legal fees).
Less profitable banks have lower retained earnings and so generate less capital for new lending. These loans (net of provisions) also use scarce balance sheet resources as banks need to fund them and they tend to have high risk weights for regulatory capital ratios—leaving less room to provide new loans. Banks with high levels of these loans may also be less willing to lend to borderline borrowers as they want to avoid future bad assets, leaving many banks chasing the same good-quality companies.
At the same time, these loans are the flip-side of the corporate sector debt overhang, which acts as a brake on lending growth from the demand side as highly indebted borrowers are less likely to want more credit.
What should be done? Regulators should provide strong incentives for banks to maintain adequate provisioning to help reduce the gap between bank and market valuations for nonperforming loans. They should ensure that provisions reflect forward-looking expected credit losses and that banks use prudent approaches to collateral valuation, recovery rates and resolution time. Banks should also develop and use specialized capacity for handling these loans. Country officials should continue to review and reform legal frameworks for bankruptcy, where necessary.
A second way to help unclog bank credit is for regulators to provide greater clarity about bank regulatory and supervisory standards. Banks are making lending decisions at a time when they are adapting business models to new regulatory and economic realities. In this environment, banks are likely to be unwilling to lend more by running down buffers of capital or liquidity—in excess of regulatory minima—in the absence of clarity about medium-term regulatory requirements.
If policymakers and bankers do not act to support bank lending, simulations in the Global Financial Stability Report suggest that credit growth could be limited to a meager 1-3 percent on average per year.