Source: WDR 2022 team, based on Feyen and Mare (2021).
Note: The figure reports the percentage point increase in the nonperforming loan (NPL) ratio at the country level that wipes out capital buffers for banks representing at least 20 percent of banking system assets (see Feyen and Mare 2021). Higher values denote a higher capacity to absorb NPL increases. The horizontal line subdividing each box is the median value of each group. The height of the box is the interquartile range. The whiskers span all data within the 1.5 interquartile range of the nearer quartile. Panel a shows the distribution of the percentage point increase in the NPL ratio across World Bank regions. Panel b illustrates the distribution of the percentage point increase in the NPL ratio across country income groups. The underlying bank-level data are from up to the third quarter of 2020. EAP = East Asia and Pacific; ECA = Europe and Central Asia; LAC = Latin America and the Caribbean; MENA = Middle East and North Africa; SAR = South Asia Region; SSA = Sub-Saharan Africa.
Although concerns about NPLs often center on formal banks, the microfinance institutions (MFIs) that primarily serve low-income households and micro-, small, and medium enterprises (MSMEs), especially in low-income markets, face similar challenges. MFIs have weathered the pandemic better than first expected as of the end of 2021, but the situation is fluid, and pressures on loan quality may rise as credit moratoria are lifted and restructured loans come due. The strategy outlined here and in chapter 2 to support the timely identification and management of NPLs thus applies, in essence if not in its specific implementation, to MFIs. The key elements of this strategy follow.
Improving transparency and reducing incentives for mismeasurement
An important first step is for regulators and supervisors to establish enforceable rules and effective enforcement mechanisms that support transparency on the health of banks’ balance sheets. This is challenging in the best of times, but it is more difficult in the current crisis because of the uncertainty about economic prospects and the extent and persistence of household and business income losses. The widespread use of debt moratoria and other support measures has reduced the comparability of NPL metrics within and across countries and over time. To facilitate transparency, the use by banks and supervisors of internationally agreed-on definitions of nonperforming and forborne exposures is critical for monitoring and assessing banks’ asset quality in a consistent manner, both within and across jurisdictions, as well as to facilitate timely action to address rising asset quality problems. The easing of regulatory definitions obscures the true asset quality challenges of banks and should be avoided.
Robust regulatory definitions should be underpinned by effective banking supervision. Banking supervisors, responsible for enforcing these regulatory definitions, must also ensure that banks comply with prudential rules. As pressure on banks’ asset quality increases, they have incentives to disguise the extent of their difficulties in an attempt to avoid a supervisory or market response. Faced with these incentives, some banks may exploit regulatory loopholes or engage in questionable practices, such as evergreening loans (that is, rolling over loans to weak businesses to persistently defer repayment), overvaluing collateral, or moving loans off balance sheets to present an overly optimistic picture of asset quality, which can make a supervisor’s job significantly more difficult.
Resolving troubled loans through regulatory interventions
Banks can be encouraged through various public policy interventions to step up their efforts to resolve troubled loans. For example, banking supervisors may require banks to establish dedicated internal workout units aimed at reclaiming past loans. These units would be equipped with the staff and resources needed to apply a standard methodology to assess borrower viability. In this way, a bank can strengthen its capacity to work out NPLs quickly and efficiently, while maintaining bank operations that support new loan origination and dealing with troubled loans.
Public policy interventions, such as national NPL resolution strategies for coordinating NPL resolution efforts across stakeholders in the economy, can also play a role in accelerating the reduction of bad debt. The government of Serbia, for example, established a national NPL working group in May 2015 after the banking system’s NPL ratio rose to 23.5 percent in the aftermath of the global financial crisis. The working group, which included participants from the public and private sectors, developed and implemented a comprehensive strategy for the reduction of NPLs that led to a rapid decline in the NPL ratio to a historic low of 3.4 percent in September 2020.2
Although banks hold primary responsibility for managing distressed loans, more far-reaching public interventions may be necessary if the volume of problem loans jeopardizes the banking system’s capacity to finance the real economy or threatens the stability of the financial system. Some countries with experience in high NPLs have established public asset management companies (AMCs) to manage problem loans removed from bank balance sheets. Such a measure could help restore public confidence in the banking sector and prevent unnecessary fire sales. In Malaysia (Danaharta) and Spain (SAREB), public AMCs were created in conjunction with publicly funded bank recapitalization schemes. The goal was to address constraints the government faced in providing capital, without which the banks would have been unable to transparently recognize the full extent of their exposure to problem loans. The case for and the effectiveness of public AMCs depend, however, on a country’s circumstances and on the soundness of the overall design of the AMCs. This is an area in which emerging economies have often experienced serious challenges.
Dealing with problem banks
Efforts to enforce transparency, combined with measures to strengthen banks’ capital buffers and require banks to develop the capacity to deal operationally with NPLs, can often help to resolve problem banks. In rare cases, however, banks may be unable to manage the financial stress associated with rising NPLs and fail to develop a viable recovery plan. This situation gives a renewed urgency to the need to develop a strong set of early intervention measures to turn around ailing banks and resolve failing ones. The latter would include a legal regime that sets bank failures apart from the country’s general insolvency framework and provides authorities with a wider range of intervention options before banks become insolvent. The toolkit needed should also include powers to allocate losses to shareholders and uninsured liability holders, thereby protecting taxpayers against financial sector losses.
Authorities responsible for handling troubled banks should always prioritize private sector–led and –funded solutions. The use of public money to resolve a crisis should only be considered as a last resort after private sector solutions have been fully exhausted—and only to remedy an acute and demonstrable threat to financial stability.
1 This observation assumes that the definition of an NPL has remained constant throughout the pandemic. NPLs, as defined by the Basel Committee on Banking Supervision, are those loans with lower credit quality in terms of delinquency status (unpaid for a certain period of time) or unlikeliness of repayment. See Basel Committee on Banking Supervision, “Guidelines: Prudential Treatment of Problem Assets; Definitions of Non-Performing Exposures and Forbearance,” Bank for International Settlements, Basel, Switzerland, 2016, https://www.bis.org/bcbs/publ/d403.htm.
2 National Bank of Serbia and Ministry of Finance, Serbia, “NPL Resolution Strategy: Lessons Learned from the NPL Working Group in Serbia,” presentation at FinSAC NPL Resolution Conference, Vienna, May 15–16, 2018, https://thedocs.worldbank.org/en/doc/3c28bd048d78efd27744987253e2c44a-0430012021/original/NPLConferenceDay211MilanKovacMarijaRandelovic.pdf.