Home Banking Tackling Non-Performing Loans in a Performing Economy

Tackling Non-Performing Loans in a Performing Economy

by internationalbanker

By Gonzalo Gasós, Senior Director Prudential Policy and Supervision, European Banking Federation




When the economic recovery from a crisis begins, we should always put over the bedside table the masterpiece of Carmen M. Reinhart and Kenneth S. Rogoff1 to prevent dreams of overoptimism from allowing us to lower our guard. Nevertheless, I dare say that this time is different. At least, there are fundamental differences between the current crisis and others regarding the causes and the banking sector’s degree of preparation. Banks were part of the problem in previous crises, notably in the financial crisis of 2008 but also indirectly in the real-estate bubble of the early ‘90s, the emerging-markets shock of the same decade and the euro area plight of 10 years ago. But this time around, banks are part of the solution to the COVID-19 crisis.

This time is different, isn’t it?

Firstly, the current crisis did not originate in the financial sector but resulted from a health calamity. Many of the bank clients of concern are citizens and businesses with clean payment records—until the outbreak of the pandemic. Their difficulties are not directly related to financial mismanagement, but they have been casualties of an external shock. Secondly, many of the past crises started with a severe correction in the valuation of assets—either stocks, real estate or sovereign bonds. However, this is not the case today. The real problem is the temporary or permanent reductions of income for various groups of bank clients. Thirdly, the type of nonperforming loans (NPLs) that might arise on banks’ balance sheets is also different; hence, the strategies to tackle them should be adjusted accordingly. Before, it was all about extinguishing legacy distressed debts stemming from reckless credit expansion, with collateral liquidation as the main recovery option. This time, it will be more about dealing with unlikely-to-pay (UTP) exposures from clients who may in the future be able to generate sufficient resources to pay back their debts.

Another relevant difference is the collaboration between public authorities and the private sector to overcome the economic consequences of the virus. The combined policy response to the health crisis has been swift, substantial and effective. Monetary-policy support quelled market volatility, supervisory policy granted some degree of temporary flexibility, moratoria prevented the spread of systemic risk, and recovery funds rounded off the multi-pronged policy reaction, instilling stability. For their part, banks have committed to continue lending as part of the solution.

NPL tsunami or just a wave?

In the summer of 2020, even the most optimistic predictions forecast a severe rise of NPLs in the European banking system during 2021 as support measures waned. Indeed, a crisis is typically followed by a surge in corporate bankruptcies and a sharp increase in NPLs, which can impair the financial situations of individual banks and eventually cause systemic risk in the entire banking system. It is no surprise that regulators and supervisors are carefully monitoring bank portfolios.

In the summer of 2021, nevertheless, the latest NPL ratio of the European banking sector published by the European Banking Authority (EBA)2 stands at 2.5 percent, the lowest level in the last decade, continuing a longstanding downward trend. However, there are hidden signs of credit-quality deterioration. The European Central Bank (ECB)3 indicates that the share of IFRS 9 (International Financial Reporting Standards 9) stage 2 loans reached 13 percent at the end of 2020, the biggest ratio observed in years, and it is estimated to rise to 17 percent throughout the remainder of 2021.

Whether this is the preamble of an NPL tsunami is the topical question these days. It remains to be seen, but it will not catch banks unprepared. Capital ratios are at their highest levels since the beginning of the regulatory reform, and extraordinary provisions were accumulated by the end of 2020, mostly due to overlays to cover the presumed sprout of NPL cases expected to arise in 2021. But the advent of COVID-19 NPLs might be delayed at least to 2022; hence, banks may have to readjust or roll over excess provisions until then.

How much is too much?

Supervisors have warned about the magnitude of the expected COVID-19 NPLs. Some argue that the peak could be as high as in the past NPL crisis, exceeding one trillion euros. But the problem of the upcoming wave of NPLs is not just a matter of volume but the pace at which it will emerge. If a significant number of NPLs arise in a short period of time, it could wipe out the provisions of some banks, forcing them to sell too many loans in too short times, thus triggering fire sales and incurring big write-offs. It is, therefore, essential not only to anticipate the height of the next NPL peak but also understand how short the build-up period will be. 

International Monetary Fund (IMF) research on banking crises since 19904 shows the typical NPL trajectory [Figure 1]. The mean time from the start of the crisis to the peak of the NPL ratio is 3.3 years. If the current crisis were to follow the same pattern, the NPL peak could be reached in the first half of 2023. However, it can be argued that the unusual, enormous public support could change the shape of the NPL appearance in three ways: delaying the NPL growth at the beginning, subsequently “bursting” a steep increase in a short period and reducing the overall level at the peak. 

Against this background, the main aspect to watch is the potential concentration of the NPL upsurge in a short period of time. In anticipation, public and private institutions are widening and sharpening their tools for NPL management. The European Commission (EC) has put an NPL Action Plan5 on the table to improve the functioning of NPL secondary markets. The plan aims at creating the conditions for a more liquid NPL market and contemplates several options for NPL transfers out of banks’ balance sheets.

A greater role for market-based instruments

Between 2015 and 2020, the European banking system transferred out around 700 billion euros of NPLs6 [Figure 2], of which an amount of more than 450 billion euros was absorbed by national asset management companies (AMCs). Direct sales of large portfolios represented the bulk of the rest. The usual profile was that of legacy NPLs that had been sticking to the balance sheets of banks for too long. The most common strategy of purchasers was based on liquidation and collateral realisation. The composition of the nonperforming exposure (NPE) trading since 20147 indicates a predominance of 90-days-past-due NPLs, while UTP exposures represented just a small fraction [Figure 3].

However, UTP might be the most common type of tradable deteriorated asset in the first stage of the next NPE wave. The support measures, especially the long moratoria period, have sustained viable clients and zombiecompanies alike. The European Systemic Risk Board (ESRB)8 highlighted the importance of the trade-off between limiting the inefficient liquidation of viable businesses and minimising the continuation of zombie firms. Indeed, banks are currently classifying their portfolios and assessing the viability of individual firms. They will have to select which loans are worth staying on their balance sheets and which ones should be transferred out. The transfer options are the same as in past years, but there is an opportunity to make more intensive use of market alternatives.

The results of a poll with bank experts and risk managers from a webinar of S&P Global Market Intelligence (GMI) and European Banking Federation (EBF)9 revealed a general expectation that securitisation could gain ground from AMCs as a tool to transfer NPE risk out of banks [Figure 4]. If the prospects prove right, AMCs will reduce their predominance from the 64 percent of the last NPL market to only 36 percent in the next NPL market. Direct NPE sales would remain as in the past, while electronic trading platforms are expected to grow but still represent a niche of the total market.

There is an opportunity to further use the potential of NPE securitisations in the coming years. An enhanced securitisation market would permit banks to mobilise the COVID-19 NPLs  rapidly, making room on balance sheets for new, fresh lending. The experiences in Italy and Greece with the La Garanzia sulla Cartolarizzazione delle Sofferenze (GACS)10 and the Hercules Asset Protection Scheme (HAPS)11, respectively, are promising and could be replicated for the COVID-19 NPL vintage in a broader set of countries.

Direct sales to the market have been widely used so far; however, this time, prices could be depressed if a huge supply of NPLs—in a short time—does not meet sufficient market demand. In these conditions, estimated spot market values of many loans could sit far away from net book values, thus damaging fair prices. 

Electronic trading platforms could be an interesting outlet for multiple portfolios of smaller loans. Regulators are designing standard data templates, which could be very helpful if defined pragmatically and efficiently.

Asset management companies with public intervention were the most important vehicles in the past NPL wave. However, this time their roles should be limited as a last resort for NPLs that cannot be resolved by a liquid and properly functioning market.

Can a performing economy solve the NPL problem?

The ECB’s response to the coronavirus pandemic12 combined with an ambitious European Union (EU) Next Generation program13 have significantly contributed to propping up the European economy with fresh money and an ambitious investment plan. This is another difference from the past crises, at least in Europe. As a result, European economic indicators are taking off.

The latest European Commission’s (EC’s) economic forecast14 anticipates that the euro area’s gross domestic product (GDP) will come back to pre-crisis levels in the last quarter of 2021. Hence, less than two years have been necessary to recover the level of economic activity seen right before the COVID-19 outbreak. The strong rebound will continue in 2022, with a projected 4.5-percent GDP growth rate. The model and duration of the economic recession and ensuing recovery was largely debated in 2020. At this point, with better visibility, the V-shape pattern is becoming apparent.

Nonetheless, the rising macroeconomic figures of the economy during the recovery phase could hide a large degree of distress due to sectoral reallocation of economic activity. Technology and freight have expanded, while contact-intensive service sectors such as leisure, hospitality and transport have suffered. Banks are analysing the viability of every client within each sector.

The management of this crisis from the standpoint of the banking sector has been commendable so far. It is necessary to round it off well. The size of the COVID-19 NPL pile remains uncertain, but one thing is clear: The banking system should not be carrying it for too long. It is time to create the conditions for more liquid NPL trading and let the market do the rest. 


Gonzalo Gasós is Senior Director of Prudential Policy and Supervision at the European Banking Federation, driving the prudential advocacy in Brussels and the supervisory collaboration in Frankfurt since 2015. Previously, he developed positions on risk management and prudential standards at Santander Group and financial-services consultancy at Accenture.



1 Carmen M. Reinhart and Kenneth S. Rogoff: “This time is different: Eight Centuries of Financial Folly”, 2009.
2 European Banking Authority: “Risk Dashboard”, June 30, 2021.
3 European Central Bank: “Financial Stability Report”, May 2021.
4 International Monetary Fund Working Paper No. 19/272: “The dynamics of non-performing loans during banking crises”, December 2019.
5 European Commission: “NPL Action Plan“, December 2020.
6 White & Case LLP: “COVID-19 and the state of the European NPL market”, Debashis Dey, Dr. Dennis Heuer, Victoria Landsbert, Jeffrey Rubinoff andLisa Seifman, April 12, 2021.
7 Deloitte: “Deleveraging Europe, October 2019.
8 European Systemic Risk Board: “Preparing for the post-pandemic rise in corporate insolvencies”, Bo Becker and Martin Oehmke, January 2021.
9 European Banking Federation and S&P Global Market Intelligence: “Managing Credit Risk during the COVID-19 Crisis & Recovery Phase in Europe”, May 25, 2021.
10 Ministry of Finance of Italy: Press release on the GACS scheme, January 27, 2016.
11 Bank of Greece Deputy Governor’s Speech: “The pandemic crisis as a challenge: Greece the day after”, September 9, 2020.
12 European Central Bank: “Our response to the coronavirus pandemic”, 2020-2021.
13 European Commission: “Recovery plan for Europe”, 2020-2021.
14 European Commission: “Summer 2021 Economic Forecast: Reopening fuels recovery”, July 7, 2021.


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