Non-performing loans (NPLs) or bad loans--where borrowers fail to meet their repayment obligations--have long been a concern for banking regulators due to their impact on financial stability and economic growth. Economists Alessandra Donini, Giulia Fusi and Mattia Picarelli from the European Stability Mechanism--a “financial backstop” for euro area countries facing financial or sovereign debt crises that is based in Kirchberg--analysed the evolving risks surrounding NPLs, highlighting recent trends and potential vulnerabilities. Their findings, published in an ESM blog post on 21 February 2025, underscored the need for continued monitoring and forward-looking assessments.
Euro area banks classify a loan as non-performing when principal or interest payments are overdue for at least 90 days.
Euro area NPLs
Following the 2007-2009 global financial crisis and the European sovereign debt crisis of 2010-2012, euro area banks saw a sharp rise in NPLs, which peaked at €1trn in 2014, accounting for 8.1% of total gross loans. High NPL levels weakened banks’ profitability, increased risk-weighted assets and constrained their ability to extend credit to businesses and households. Regulatory measures and banks’ efforts to clean up their balance sheets significantly reduced NPL levels, bringing them down to 2.3% of total loans by the third quarter of 2024.
Despite these improvements, recent data indicates a decline in asset quality. The ESM economists observed that banks with historically low NPL levels are now experiencing a rise in bad loans, particularly in sectors such as commercial real estate. In contrast, banks in countries that previously grappled with high NPL levels, including Portugal, Italy and Slovenia, have shown resilience, continuing to reduce their stock of bad loans. At the other end of the spectrum, few countries are seeing rising NPL ratios, with Luxembourg experiencing the most pronounced deterioration.
Credit risk assessment
Given the increasing complexity of the macrofinancial environment, the ESM economists proposed a new asset-quality-at-risk framework to assess credit risks proactively. This framework is based on the growth-at-risk approach, which estimates future NPL distributions under various economic conditions. Using quantile regressions, the model provides a more detailed analysis of how macroeconomic factors influence NPL ratios across different segments of the banking sector.
The economists found that GDP growth and house price growth were key predictors of NPL levels, with their influence becoming more pronounced at higher levels of NPL distribution. Conversely, the yield on government bonds had a stronger impact on banks with relatively low NPL levels. Among bank-specific factors, only loan book growth showed a significant correlation with changes in NPLs.
Asset quality deterioration
The new framework also provided insights into the likelihood of NPL increases for banks with different risk exposures. For instance, a bank with significant exposure to vulnerable economic sectors saw its NPL ratio rise from 0.7% in the third quarter of 2019 to 3.8% in the second quarter of 2024. The probability density function indicated a growing risk of further short-term deterioration, with increasing uncertainty in future estimates.
By contrast, another bank that had successfully cleaned up its balance sheet saw its NPL ratio decline from 11.3% in the third quarter of 2019 to 4% in the first half of 2024. The framework suggested that this institution faced a lower risk of future deterioration, as projections became more stable over time. Although both banks reported similar NPL ratios in 2024, the model showed different probabilities of future asset quality deterioration, depending on macrofinancial conditions and business models.
Policy implications
The three economists emphasised that while euro area banks have significantly reduced their NPL levels, rising geoeconomic fragmentation, sectoral downturns and long-term structural challenges could create renewed risks. Although systemic risks remain contained, they stressed the need for continuous forward-looking risk assessments to safeguard financial stability.
They highlight that their asset-quality-at-risk model provides policymakers with a flexible tool to detect vulnerabilities in banks’ loan books and argue that as economic conditions evolve, this approach will support the early identification of institutions at risk of credit quality deterioration, allowing for timely interventions to protect financial stability in the euro area.