How Do Non-Performing Loans Evolve along the Economic Cycle? The Role of Macroeconomic Conditions and Legal Efficiency

Abstract

We investigate the development of non-performing loans (NPLs) held by European banks throughout the economic cycle. During the global financial crisis and the subsequent sovereign debt crisis, banks from all European countries experienced a substantial increase in NPLs. We find that these increases are mainly associated with macroeconomic determinants and characteristics of banks’ business models. Substantial differences across countries exist in the duration and efficiency of NPL resolution after the crisis. We exploit cross-country and time-variant differences in insolvency and contract enforcement procedures to document that the outcome of NPL resolution is associated with the duration and costs of insolvency and contract enforcement during the economic recovery phase. Our findings suggest that the design of a country’s legal regime can ensure swift NPL resolution during the recovery phase, while the build-up of NPLs during a crisis is mainly attributable to economic conditions.