The Covid-19 pandemic has brought an unprecedented decline in national outputs, rising unemployment, higher rates of business distress, and a global contraction in economic activity. Looming within these troubling trends is another potential crisis that could gather momentum in the coming months as payment holidays and various public support schemes come to an end. Many financial institutions are facing a marked rise in non-performing loans (NPLs) that could send shocks across economies and undermine post-pandemic recovery efforts. We explore some of the pressures acutely felt by banks in a crisis context in our new report examining how insolvency and creditor/debtor rights (ICR) systems can help mitigate the rise in NPLs and contribute to their resolution.
Given their role of financing economic activity, financial institutions are in a unique position to mitigate some of the COVID-19 pandemic’s worst financial effects. Banks are essential players in ensuring households and businesses continue to have access to the funding that they need to maintain solvency and endure the crisis. Financial institutions play an even more pivotal role as economic intermediaries in emerging economies and vital sources of capital for micro, small, and medium sized enterprises (MSMEs).
While the volume of NPLs is rising in many countries, the magnitude of this increase remains unclear. Rising NPL rates could undercut economic recovery efforts by weakening banks’ balance sheets, eroding asset quality, decreasing lending capacity, diminishing profitability, and potentially impacting their solvency. When loan default rates rise too steeply, NPLs’ negative impacts can extend beyond the financial sector and credit markets to usher in economy-wide effects such as increased inflation and a reduction in real GDP.
Effective ICR systems achieve this by facilitating debt recovery and loan repayment, resulting in lower NPL occurrence. Strengthened enforcement mechanisms under enhanced ICR frameworks also produce faster and more efficient resolution, thus lowering banks’ cumulative losses and decreasing overall NPL levels. Measures to prevent insolvencies and out-of-court workout tools can speed up adjustment of NPL levels and head off sharp increases. Cumulatively, these helpful developments foster economic and investment growth by both reducing the cost associated with securing credit and increasing access to finance, factors especially important for the success of small entrepreneurs and MSMEs.
ICR reform is an effective tool for reducing NPL levels, and it also brings a catalogue of other progressive effects, including: lower credit costs, increased credit availability, greater returns to creditors, job preservation through reorganization frameworks, and the promotion of entrepreneurship, among others. Strengthened ICR systems offer a solution for policymakers seeking to address high NPL levels and offer a proven pathway to ‘return to normal’ in the aftermath of macroeconomic shock.