The long and deep recession after the financial and foreign debt crisis has left a legacy of non-performing loans on Italian banks’ balance sheets. In December of 2015, bad loans summed to about €200 billion, a large figure that represents approximately 11.0% of the total amount of loans given (18% including other troubled loans not written off).1 Unlike other recent banking problems, where losses were concentrated in real estate or sovereign debt exposure, close to 80% of these bad debts came from bank lending to non-financial businesses (Bank of Italy 2016a). Credit quality has recently seemed to be improving, and much of the existing stock of impaired loans is backed by collateral.2 However, as we discuss below, recovery times for collateral are long, so the quality of loans continues to be a problem to be taken seriously.
Healthy banks as a policy objective
Policymakers in Italy, from the government to the Italian central bank, understand well the importance of correcting their banks’ problems, as do economists. Much research has established the importance of a healthy banking system in providing the lubricant to grease the wheels of the economy. When banks become distressed, they usually reduce origination of new loans to borrowers, which in turn slows the economy.3 And, in fact, this unhealthy dynamic has been shown to be playing out now in Italy.4
Moreover, the burden of non-performing loans has also contributed to the decline in share prices observed in recent years for the major banks in Italy (Bank of Italy 2016a).
Judicial inefficiency in Italy exacerbates the well-known problems posed by bad loans and has prompted recent reforms aimed at streamlining insolvency proceedings and speeding the process by which lenders can repossess collateral on defaulted loans, a reform welcome by monetary authorities (Bank of Italy 2016b). According to our research, legal reforms to improve the efficiency of the courts, and in particular to speed up the judicial and extrajudicial recovery of collateral, offer the potential of substantial benefits for Italy’s banks (and, by extension, the economy itself), without any moral hazard downside.
Credit risk as a source of bank fragility
In a new paper, we analyse the empirical frequency with which borrowers delay repayment to their lenders (Schiantarelli et al. 2016). To do so, we use the detailed information on bank loans to firms in the Italian Credit Register. Our data allow us to capture a firm's decision to delay repayments of term loans as well as draw-downs of lines of credit in excess of the maximum borrowing limit for more than 90 days at the level of the bank-borrower. We exploit the fact that many Italian firms borrow from multiple banks to test how the same firm behaves with respect to different banks, depending upon the strength of the bank’s balance sheet, the local judicial environment, and the nature of the past bank-firm relationship. We find very strong evidence that borrowers ‘behave badly’ when their lender has faced large losses in the past, meaning that the likelihood of delaying loan repayments increases significantly with the lender’s distress. As many of these loans eventually become permanently impaired, some banks find themselves caught in a vicious cycle of past losses encouraging future losses and distress.
Why would a borrower’s decision to delay repayments depend on its lender’s financial condition? Obviously, there can be multiple causes for a delay in loan repayments, ranging from firm financial distress to strategic considerations by firms about how such behaviour may affect their ongoing or future relationship with lenders. With regard to the latter, a firm will be trading off the short-term gain of keeping control of financial resources (i.e. by not paying now), against the potential future loss of impairing their relationship with the current lender(s) or with potential future lender(s).
The balance of this trade-off may depend on the financial health of the lender, on the bargaining power of the borrower, and on the institutional environment that affects the ex post ability to recover collateral or otherwise force repayment through the judicial process. Everything else equal, one would expect a firm to be more likely to delay re-payment to weaker banks because the expected value of the continuation of the relationship is smaller. Firms with greater bargaining power – which we proxy by firm size – also ought to be more willing to default when lenders are weak, either because lenders will be reluctant to cut off a large customer or because large firms have better ability to switch lenders. Our evidence supports these predictions.
This research shows that banks face a source of vulnerability stemming from borrowers’ self-reinforcing tendency to default – one that is distinct from the vulnerabilities related to banks’ use of short-term debt, which was at the heart of problems in the US banking sector that then became global during the 2007-2009 financial crisis. More precisely, we highlight this new channel through which credit risk can enhance bank fragility by showing that borrowers in Italy selectively delay repayments to banks already weakened by past bad loans; borrowers thus seem to take a step towards possible default because they observe other borrowers doing so.
Legal reform could improve borrower behaviour
What about the role of slow recovery time for collateral and, hence, the potential effects of legal reform? We find that the impact of bad loans on repayment delays depends upon the efficiency of the local courts. While the average estimated duration of property execution proceedings was more than three years in 2007, significant disparities persist across the country. The duration ranges from under one year in Crema (Lombardy) to almost seven years in Cosenza (Calabria). As Figure 1 shows, there is a marked contrast between northern and southern Italy, with the south characterised by longer proceedings, yet there is also substantial heterogeneity within these two broad areas. We find that borrowers’ tendency to delay payments to distressed banks only occurs in parts of Italy where legal enforcement is poorer (approximately those with a recovery time of more than the median value of three years).
Figure 1 Judicial inefficiency in Italy, 2007: Average number of days necessary to resolve property recovery proceedings in Italian courts
We also stratify our data by firm quality (e.g. access to cash flow or profits) to test whether or not the behaviour we document truly reflects strategic behaviour. That is, are distressed borrowers merely selecting which banks to pay by allocating a fixed but limited cash-flow budget across lenders? Or, are borrowers paying less than they otherwise would because lenders are weak? In fact, we show that even the safest firms exhibit this behaviour. Even firms that could pay – those with high credit quality – sometimes choose not to pay because of the confluence of weak banks and weak legal enforcement.
Reforming the recovery process for collateral thus offers the potential to improve banks’ balance sheets and enhance financial stability, not only by increasing loan collections directly, but by improving borrowers’ incentive to service their existing debt. The extent of any improvement will depend upon the degree to which the new forms of out-of-court assignment of collateralised goods and other legal innovations will be incorporated into new loans contracts and in renegotiated ones. When the reforms will be fully implemented, it is likely that the price of bad loans will increase and make it easier for banks to dispose of them in the market. In the transition period, the effect on the market price of existing bad loans will be more limited and its estimates subject to a degree of uncertainty (Bank of Italy 2016c). Our research suggests that transferring loans from distressed banks to stronger ones may improve incentives to debt repayment.
Fragility from bank vulnerability to illiquidity in debt markets has traditionally been the main focus of regulators and central bankers. This liquidity risk – which became manifest for banks during the 2008 crisis – has been addressed with mechanisms like deposit insurance, liquidity requirements (called for by the Basel III reform package), and lender of last resort facilities operated by central banks. It seems likely that better legal enforcement, such as improving the speed and certainty with which creditors can take possession of collateral, could reduce the fragility stemming from credit risks that we have observed. We hope that that Italy’s ongoing efforts at real reform succeed.
Balduzzi, P., Brancati, E. and Schiantarelli, F. (2014) ‘Financial markets, banks' cost of funding, and firms' decisions: Lessons from Two crises’, Boston College working paper No. 824,
Bank of Italy (2016a) Financial stability report, number 1. Available at: https://www.bancaditalia.it/pubblicazioni/rapporto-stabilita/2016-1/en-FSR-1-2016.pdf?language_id=1
Bank of Italy (2016b) Governor’s concluding remarks. Available at: https://www.bancaditalia.it/pubblicazioni/interventi-governatore/integov2016/en-cf-2015.pdf?language_id=1
Bank of Italy (2016c) Relazione annuale. Available at: https://www.bancaditalia.it/pubblicazioni/relazione-annuale/2015/index.html
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Bonaccorsi di Patti, E. and Sette, E. (2012) ‘Bank balance sheets and the transmission of financial shocks to borrowers: Evidence from the 2007-2008 crisis’, Bank of Italy Working Paper, No. 848.
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Cingano, F., Manaresi, F. and Sette, E. (2013) ‘Does credit crunch investments down? New evidence on the real effects of the bank-lending channel’, Mo.Fi. R. Working paper No. 337.
Cornett, M.M., McNutt, J.J., Strahan, P.E. and Tehranian, H. (2011) ‘Liquidity risk management and credit supply in the financial crisis’, Journal of Financial Economics, 101(2), pp. 297–312.
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Schiantarelli, F., Stacchini, M. and Strahan, P.E. (2016) ‘Bank quality, judicial efficiency and borrower runs: Loan repayment delays in Italy’, NBER Working paper No. 22034.
 They include loans for which borrowers are late in their repayments (or are overdrawn) for more than 90 days, restructured loans and other forms of impaired loans.
 The flow of new non-performing loans in proportion to total loans fell to 3.3 per cent in the fourth quarter of 2015, the lowest level recorded since the third quarter of 2008.
 Early studies in macroeconomics emphasized the impact of a financial accelerator, whereby an economic slowdown, whatever the source, is accelerated because banks and other credit providers experience losses, which in turn lead them to reduce credit (e.g., Bernanke (1983), Bernanke and Blinder (1988), Peek and Rosengren (1997)). A similar dynamic played out during the financial crisis, when housing declines hampered bank balance sheets and led to credit tightening and adverse real effects (e.g., Cornett et al. (2011), Chodorow-Reich (2014)). Evidence on the effect on Italian firms’ real outcomes of the negative shock to banks, following the financial crisis or both the financial crisis and the sovereign debt crisis, is contained in Cingano et al (2013) and in Balduzzi et al. (2016), respectively.
 While not the main focus of their study, Bonaccorsi di Patti and Sette (2012) use post financial crisis data from Italy to show that banks with more loans written off the previous period have expanded credit more slowly than healthier banks.