Non-technical summary of ESM Working Paper 69: Asset-Quality-at-Risk

Non-performing loans (NPLs) have been a point of attention for financial sector policymakers since the Great Financial Crisis. Although NPL levels are currently low, they reached a peak of €1 trillion in the euro area in 2014. High levels of NPLs can create a vicious cycle, affecting banks' profitability, capital, and lending capacity to the real economy, ultimately threatening the financial stability of the system.

The paper introduces a new approach, called "asset-quality-at-risk" to predict future NPL ratios based on current macro-financial conditions and bank-specific characteristics. First, we find that the drivers of NPLs identified in the literature affect them differently depending on their levels, which highlights that relationships between various factors become more complex (non-linear) in crisis situations. Then, we introduce a new forward-looking indicator of potential asset quality deterioration called "asset-quality-at-risk," linking the factors that cause NPLs to the likelihood of future NPLs. 

Our findings are relevant for micro- and macroprudential authorities. First, the results show that failing to account for complex relationships (non-linearities) can lead to a misrepresentation of the relation between credit risk and macro-financial conditions. Additionally, the proposed "asset-quality-at-risk" framework can help inform authorities about bank-specific risks that may arise during adverse economic developments, providing a measure of the likelihood of certain NPL ratios materialising in certain banks. Finally, the proposed framework can provide insights about the system-wide distribution of future realisations of NPL ratios, thus supporting authorities in monitoring the build-up of risk at the aggregate level.