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How to tackle Europe’s non-performing loan problem

European banks are struggling with high levels of non-performing loans. This column explores the channels through which persistently high non-performing loans hold down credit growth and economic activity. A survey of EU authorities and banks reveals that the loans are not written-off for a variety of deep-seated reasons, including legal and tax code issues. An agenda is proposed comprising tightened bank supervision, structural bankruptcy reforms, and the development of markets for distressed assets.

European banks are struggling with high levels of non-performing loans (NPLs). The Global Crisis and subsequent recession have left businesses and households in many countries with debts that they cannot repay. For the EU as a whole, NPLs stood at over 9% of GDP at the end of 2014, more than double the level in 2009. NPLs are particularly elevated in some southern countries, such as Cyprus, Greece, Italy, and Portugal. And they are generally concentrated in the corporate sector, most notably among small and medium-sized enterprises (SMEs), which contribute almost two-thirds of Europe’s output and employment, and tend to be more reliant on bank financing than large firms.

Figure 1. Europe: NPLs after the Global Crisis

Note: FSIs are computed using consolidated bank data and therefore do not reflect only domestic NPLs.
Sources: IMF Financial Sector Indicators (FSIs) and country authorities.

Why are high non-performing loans a problem?

Weak bank balance sheets have long been known to act as a drag on economic activity, especially in economies that rely mainly on bank financing. The literature on financial dependence and growth is well-established (Rajan and Zingales 1998, Kashyap et al 1994). Several recent studies have looked specifically at the feedback effects from NPLs to macroeconomic performance. Using different country samples, Klein (2013), Nkusu (2011), and Espinoza and Prasad (2010) all find that higher NPLs tend to reduce the credit-to-GDP ratio and GDP growth, while increasing unemployment. This is consistent with data for EZ banks over the last five years. Banks with higher NPLs – which tend to be less profitable, have relatively weaker capital buffers, and have higher funding costs – tend to lend less (see Figure 2).

Figure 2. Eurozone: Implications of high NPLs for bank performance  (Percentages)

Notes: CET1= common equity tier 1 capital ratio. 1/ The graph shows the annual interest income to gross loans, for over 100 euro area banks, relative to the annual average for banks with the same nationality, over the period 2009–13. 2/ The graph shows the average funding cost for each bank, which was defined as: [interest expenses/(financial liabilities-retail deposits)]-sovereign government bond yield (5-year rolling avg). 3/ The graph shows annualised lending growth relative to average lending growth in the same country, using data from the European Banking Authority for a sample of more than 60 banks over the period 2010–13. Outliers have been excluded, based on extreme values for lending growth, NPLs and interest margins.
Sources: Bloomberg L.P.; European Banking Authority; SNL Financial; Amadeus database; national central banks; Haver Analytics; Bankscope; and IMF staff calculations.

In recent work, we examine the channels through which persistently high NPLs hold down credit growth and economic activity in Europe (Aiyar et al. 2015). High NPLs tie up bank capital that could otherwise be used to increase lending, reduce bank profitability, and raise funding costs – thereby dampening credit supply. Reducing NPLs expeditiously will therefore be crucial to supporting credit growth, especially to SMEs that are more reliant on bank financing. Further, ‘unclogging’ the bank lending channel would enhance the transmission of monetary policy to the real economy. Resolving impaired loans would also stimulate demand for new loans, as it would facilitate debt restructuring for viable firms, while promoting the winding-down of unviable firms.

Why are NPLs so persistent?

Given the many virtues of timely NPL resolution, what is holding it back in Europe? Write-off rates for European banks remain much lower than those of US and Japanese banks, despite a much higher stock of NPLs. We conduct a new survey of European country authorities and banks to understand why this is the case. The reasons range far beyond weak cyclical conditions, and are often deep-seated. Some features of the tax regime, such as the limited tax deductibility of provisions, can discourage write-offs. Weak debt enforcement and ineffective bankruptcy procedures increase the cost of recovering assets provided as collateral for loans. Accounting rules hinder timely loss recognition and inflate provisions. And markets for distressed debt in Europe, with some notable exceptions, are small or non-existent. Based on the survey, deficiencies in the legal system and distressed debt markets are viewed as larger challenges for NPL resolution than other structural and institutional obstacles (Figure 3). We also find that different obstacles are interlinked, with difficulties in one area compounding challenges in others. And the challenges are generally more daunting for countries outside the Eurozone.

Figure 3. IMF survey-based scores on obstacles to NPL resolution: Eurozone vs. non-Eurozone

Notes: The figure shows average obstacle scores based on the survey responses of EZ and non-EZ countries with high NPLs. For each country, the final obstacle score in each area is a maximum of the two scores, based on the responses of the authorities and banks operating in these countries.  The scores take values ranging from 1 to 3, where 3 = High degree of concern, 2 = Medium degree of concern; and 1 = no concern.
Source: IMF surveys of country authorities and banks.

We also find that greater reported severity of obstacles to NPL resolution is associated with worse NPL outcomes (Figure 4). This suggests that the survey does capture the relevant structural and institutional constraints on NPL resolution that are likely to be binding in the high NPL countries surveyed.

Figure 4. Survey-based country obstacles score vs. NPL outcomes

Notes: The survey–based country obstacles index takes values between 1 and 3 (3 = High degree of concern about institutional obstacles to NPL resolution, 2 = Medium degree of concern; 1 = no concern); the survey-based obstacles score shown in the charts is max (country, bank).
Source: IMF surveys of country authorities and banks.

What should be done to reduce NPLs?

A comprehensive approach to accelerating NPL resolution by European banks is needed. Such a strategy would have three main pillars:

  1. First, the ECB and national regulators should tighten bank supervision.

Decades of international experience shows that swift recognition of loan losses is crucial to incentivising NPL resolution and corporate restructuring. More conservative provisioning and collateral valuation would encourage banks to resolve NPLs quickly. Banks should be required to set aside more capital for NPLs that remain on their books for too long, and to meet loan restructuring targets within a reasonable period of time. In systemic cases where SME loans dominate, supervisors could agree with banks on standardised criteria to distinguish nonviable firms (for quick liquidation) from viable ones (for restructuring) – the so-called ‘triage approach’. This would avoid overwhelming the judicial system (Bergthaler and others 2015).

  1. Second, structural reforms are needed to make bankruptcy more efficient and make it easier to collect debts.

There is currently enormous variation in legal frameworks between countries. For example, the average length of foreclosure proceedings in Italy is almost five years, compared to less than one year in Germany and Spain.  Lengthy court procedures should be shortened, and out-of-court arrangements encouraged as an alternative. Such reforms would increase the value of collateral provided by borrowers, and therefore make it easier for banks to write off bad loans.

  1. Third, active markets in distressed assets need to be developed.

A liquid market connects banks (sellers) with specialist investors (buyers) experienced in managing impaired assets. In some cases, a publically supported asset management company (AMC) can help kick-start such a market. In the wake of the Asian financial crisis, Korea’s state-owned AMC KAMCO was instrumental in developing uniform pricing criteria for bad loans. Spain’s SAREB provides an example closer to home. Its entry into the market led Spanish banks – anticipating upcoming asset sales – to adjust their asset valuations and start selling NPLs. This in turn attracted more investors and third-party loan servicers, creating a virtuous cycle.

These three pillars of reform are complementary and should be implemented simultaneously for maximum effect. For example, more assertive supervision may increase the incentives of banks to sell NPLs at the margin, but may not suffice without a well-developed market for distressed debt. In turn, creating such markets would be greatly facilitated by bankruptcy reforms that increase collateral values and therefore attract willing buyers.

Finally, a host of supporting reforms would enhance the effectiveness of a comprehensive push to reduce NPLs. Improving the quality of debtor information available at credit bureaus, linking credit bureaus with asset registers, and making these repositories accessible to private sector agents across national borders, would help develop the market for distressed debt. Ensuring that public creditors participate fully in debt restructuring would remove an important source of delay in many jurisdictions. And amending some tax rules might be necessary to remove disincentives to provision or write off loans.

Implementing this challenging agenda will require sustained policy effort. The longer it is delayed, the greater the risk of anaemic credit growth and a sputtering recovery.

Authors’ note: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.


Aiyar, S, W Bergthaler, J Garrido, A Ilyina, A  Jobst, K Kang, D Kovtun, Y Liu, D Monaghan and M Moretti (2015) “A strategy for resolving Europe’s problem loans”, IMF Staff Discussion Note No 15/19, Washington, DC, International Monetary Fund.

Bergthaler, K, Y Liu and D Monaghan (2015) “Tackling small and medium sized enterprise problem loans in Europe”, IMF Staff Discussion Note No 15/04, Washington, DC, International Monetary Fund.

Espinoza, R and A Prasad (2010) “Nonperforming loans in the GCC banking system and their macroeconomic effects”, IMF Working Paper No 10/244, Washington, DC, International Monetary Fund.

Kashyap, A, O Lamont and J Stein (1994) “Credit conditions and the cyclical behavior of inventories”, Quarterly Journal of Economics, 109(3): 565-92.

Klein, N (2013) “Non-performing loans in CESEE: Determinants and impact on macroeconomic performance”, IMF Working Paper No 13/72, Washington, DC, International Monetary Fund.

Nkusu, M (2011) “Nonperforming loans and macrofinancial vulnerabilities in advanced economies”, IMF Working Paper No 11/161, Washington, DC, International Monetary Fund.

Rajan, R and L Zingales (1998) “Financial dependence and growth”, American Economic Review, 88: 559-86.

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