Why do NPLs matter?

Policy makers and bank leaders should act with urgency on the advice laid out in this chapter as best fits their capacity—ideally before support measures are lifted and distressed asset levels rise— because developing the systems and capacity needed to deal with NPLs takes time.7 Those who prefer to wait and see risk missing the opportunity to get ahead of the problem. Such a delay not only prevents recovery of viable capital, but also can lead to long-term low investment across an economy.

High NPL levels burden all levels of an economy. For borrowers, failure to repay a debt may lead to the loss of assets and business opportunities and jeopardize future access to credit, which has negative spillover effects on the broader economy. For banks, asset quality problems can lead to capital misallocation, higher funding costs, and lower profitability.8 These issues can drive up the cost of finance for borrowers and impair a bank’s ability to run a viable, sustainable business. Banks may respond by reducing lending volumes, which often leads to the exclusion of underserved, higher-risk groups such as MSMEs, women, and the poor.9

At the aggregate level, high NPLs depress economic growth. Because capital is tied up in underperforming sectors, growing sectors may have limited access to new capital, and so market confidence suffers.10 Banks with high exposure to NPLs and narrow capital buffers may be inclined to reduce the provision of credit11 and continue to finance weak or insolvent borrowers—so-called zombie lending.12 When banks’ capital is locked up in troubled sectors and companies, some second-round business failures may be prevented, but it also diverts funds from more productive sectors of the economy. Inefficient firms could thus have a dominant impact on the functioning of input and output markets, translating into lower economic output, investment, and employment.13

The challenge is particularly acute following financial crises when bank exposure to problem assets often persists at elevated levels because of a lack of incentives and frameworks to resolve them. The ensuing weak growth, in turn, reduces fresh lending and slows the reduction in NPLs.14 The experiences of countries in Central, Eastern, and Southeastern Europe (CESEE)15 in the aftermath of the 2007–09 global financial crisis reveal the long-term problems and severer recessions that can result (see online annex 2A16). The increase in NPLs in the CESEE region was rooted in excess credit growth and lax underwriting practices by banks, whereas in the COVID-19 crisis the pressures on asset quality arise from an unprecedented economic shock and restrictions in economic activity that affect borrowers’ incomes and weaken their debt-weathering capacity. Another difference is that under the current circumstances governments’ ability to contain the impacts of the pandemic on firms and households affects which borrowers remain viable. Weaknesses in the macroeconomic, institutional, corporate, and banking sectors that have driven past crises are a factor as well.

The experiences of the CESEE countries following the global financial crisis nonetheless clearly illustrate the dangers of a delayed initial policy response.17 By allowing the underlying problems to fester, countries compromised the capacity of their banking sector to finance the real economy and ultimately were left trapped in a bad equilibrium of low growth linked to a weak financial system. Avoiding a repeat of this scenario is a priority for policy makers everywhere. Despite important differences in the two crises in the underlying causes and the starting positions of individual countries, the key lesson from the CESEE region, as well as from other regions and at other times, is that rising NPLs require a prompt, comprehensive policy response.

This negative cycle of high NPLs leading to low economic growth is not inevitable. Evidence comparing countries that have proactively pursued strong measures to reduce the stock of NPLs in the wake of an economic crisis with those that have taken a more passive approach reveals that the former approach