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

Posted by ARC Commitee - Jun 24, 2022


In many countries, the recent crises like the COVID-19 pandemic or the war in the Ukraine also led to an increase in the level of insolvency risk. In such a situation, regulators and policymakers are most concerned about the build-up of non-performing loans (NPLs) and the resilience of bank balance sheets – many historical examples show that excessive levels of NPLs can seriously endanger financial stability (e.g., in Japan, Italy, Mexico, or Asia). Our paper examines the high levels of NPLs in Europe during the global financial crisis, and the subsequent sovereign debt crisis, and present evidence that 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 only account for some of these differences and can only indirectly be addressed through regulation. It is more important to understand whether the design of the legal framework contributes to the efficiency of NPL resolution beyond the macroeconomic trends. To explore this question ,we examine to what extent the duration and the costs of insolvency and contract enforcement procedures can explain the variation in the post-crisis resolution of non-performing loans.

We employ bank and country-level data from 16 European countries over a period of 10 years around the financial crisis. 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 show that general macroeconomic conditions as well as the choice of a bank’s business model play a role during all stages of the economic cycle. 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 results underscore the concerns about the temporary suspension of the insolvency filing obligations during the pandemic (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.

However, while legal reforms that increase the efficiency of insolvency proceedings appear like a first-best solution, their implementation takes time and is part of a political process. Therefore, it is important to emphasize that there are further policy measures available. One example is the sale of NPL portfolios to external parties (mostly specialized debt servicing companies). This market-based solution is subject to substantial legal restrictions in many countries but might 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”, European Accounting Review (forthcoming), available here.





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