The extent to which banks in Europe have accumulated provisions against future non-performing loans – their ‘coverage ratios’ – is a central concern for financial stability. New research by Lucia Alessi (European Commission, Joint Research Centre), Brunella Bruno (Bocconi University), Elena Carletti (Bocconi University), Katja Neugebauer (Bank of Portugal) and Isabella Wolfskeil (Bocconi University) examines the wide variation in banks’ coverage ratios across European countries, what drives them and what policies can be most effective in increasing them.

The study finds that coverage ratios are mostly driven by bank-specific characteristics, such as reserve policies, the level and change of non-performing loans, credit growth, as well as forward-looking measures of credit risk. The implication is that microprudential supervision can be potentially more effective than macro policies in affecting them. But more stringent macroprudential policies, especially those affecting bank provisioning, also turn out to be associated with higher coverage ratios.

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One of the most debated issues in Europe since the global financial crisis concerns the accumulation of large stocks of non-performing loans (NPLs) – bank loans that are either more than 90 days past due or that are unlikely to be repaid in full. Because of the Covid-19 pandemic and the associated economic recession, the issue of surging NPL stocks is bound to be a policy priority once again with potential implications including increased systemic risk and impairment of the credit supply to the real economy.

This study takes a different angle, arguing that the real threat for banks and thus, financial stability is not the amount of NPLs per se, but rather the ‘uncovered’ portion of NPLs, as the larger this share the larger the impact on banks’ capital. Banks prepare themselves for future loan deterioration by accumulating provisions, which amass into loan loss reserves (LLRs).

The coverage ratio, which is defined as the ratio between LLRs and NPLs, measures how much of the expected losses associated with NPLs have been already covered by banks through the accumulation of loan loss reserves. It follows that the higher coverage ratios are, the more banks have already internalised the future deterioration of their loans.

Interestingly, however, loan loss coverage policies still vary largely across banks and countries in Europe, with many of the countries with the highest level of NPLs reporting below-average coverage ratios. This observation triggers the new study: what drives banks’ coverage ratios? And what policies can be most effective in increasing them?

The main result is that coverage ratios are mostly driven by bank-specific characteristics, and to a less extent by macro factors. The implication is that microprudential supervision can be potentially more effective than macro policies in affecting them.

Among the bank-specific characteristics, coverage ratios depend mostly on credit risk-related factors such as reserve policies, (the level and change of) NPLs, credit growth, as well as forward-looking measures of credit risk. Banks tend to increase their coverage level when NPLs and credit supply increase, but the relation is not linear, as banks are not able to increase their reserves at the same pace as NPLs increase. It follows that banks with higher NPLs levels tend to have lower coverage ratios than banks with lower NPL levels.

Taken together, these results suggest that coverage ratios tend to work more as a prudential (forward-looking) buffer than a mere (backward-looking) booking account, even before the introduction of a new, forward-looking accounting standard known as IFRS 9.

Looking at macro determinants of banks’ coverage ratios, the study finds that specific macroprudential measures, as well as the presence of developed markets for NPLs, have been successful in increasing coverage ratios. For example, more stringent macroprudential policies (especially those affecting bank provisioning) turn out to be associated with higher coverage ratios.

The researchers also observe different reactions of banks from high-NPL countries, pointing to the need for specific actions in these jurisdictions. In particular, banks from these countries are especially sensitive to changes in the rule of law, as stronger contract enforcement or more efficient courts may help banks to resolve NPLs and thus reduce the need for large coverage. Moreover, only in these countries are tighter capital rules associated with lower NPLs and coverage ratios.

Finally, high-NPL countries are those that most benefit from the development of a secondary market for NPLs. To make loan disposals more likely, banks seem to increase coverage ratios, which helps to reduce the bid-ask spread and the loss the bank takes as a consequence of the NPL sale.

‘Cover your assets: non-performing loans and coverage ratios in Europe’

Authors:

Lucia Alessi (European Commission, Joint Research Centre)

Brunella Bruno (Bocconi University)

Elena Carletti (Bocconi University)

Katja Neugebauer (Bank of Portugal)

Isabella Wolfskeil (Bocconi University)