The treatment of defaulting loans has become a major concern for supervisory authorities and bank regulators. During the global financial crisis (GFC), the growth of nonperforming loans (NPLs) was a consequence, amongst other factors, of poor bank corporate governance and lack of effective managerial oversight. A loan is generally considered nonperforming when a debtor has not made scheduled payments for at least 90 days, although there is no consensus among regulators and policymakers about the definition of a NPL (Bholat et al, 2019). Defaulting loans play a central role in the linkages between faulty lending practices and credit risk. This has implications for the management of asset quality and for the stability of firms and the banking sector.

NPLs tend to have their root causes in poor loan origination at times of expansion while they only become visible at times of distress. This can be observed in the experience of the current pandemic crisis which is markedly different from the GFC as regulators appear to be much more willing to suspend the application of microprudential rules in order to facilitate the provision of credit. The pandemic-caused recession is viewed as exogenous to the financial system, and hence regulatory suspension appears reasonable and legitimate, as banks are not seen as carrying any of the blame for the present crisis (Chiu et al, 2020).

NPLs require intrusive monitoring tools: effective corporate governance performs a fundamental role in evaluating the riskiness of banks’ assets and monitoring the deterioration of loans. Mismanagement of the processes of assessing NPLs can lead to a lack of recognition of impaired loans in banks’ balance sheets or delay in the classification of loans as NPLs. In our recent article, published in the Journal of Financial Regulation, we argue that senior management has perverse incentives to hide NPLs to avoid negative signalling effects, as a high stock of defaulting loans is typically perceived as weakness of the economic conditions of a bank.

Managers prefer to hide these exposures although this can exacerbate information asymmetries on asset quality. This is mainly due to the fact that disclosing NPLs and setting aside loan loss reserves reduces the short-term profits of a bank, and, as a result, leads to a reduction in performance-based remuneration for executive directors and senior managers. In that sense, a bank with a high stock of concealed poor quality loans confronts the serious agency problems faced by any corporation with overvalued equity (Jensen, 2005).  Managers’ tendency to delay the recognition of NPLs can decrease the value of assets and prevent the development of the market for NPLs. Such problems emerged in several cases of European banks that faced financial difficulties in the last few years (eg Banco Santander, Piraeus Bank and Alpha Bank).

The EU adopted a set of regulatory measures to monitor and resolve nonperforming exposures (NPEs) such as Regulation 630/2019 and Directive 1023/2019. The new supervisory toolkit implemented in the European Banking Union aims to improve the classification of asset quality and establish common practices to prevent a high ratio of NPEs to total loans.

However, managerial involvement in the assessment of asset quality presents concerns in terms of resolution tools for NPL recovery. The main mechanism through which bank senior management can prevent the classification of defaulting loans as NPLs is forbearance (eg by granting payment holidays and extending the duration of loans). Forbearance can be legitimate but may also be unviable, in which case it is a manifestation of the managerial agency problem and harms the long-term interests of bank shareholders as well as financial stability. As it is impossible for regulators to distinguish ex ante between legitimate and unviable forbearance, corporate governance mechanisms setting appropriate procedures and incentives are essential.

We suggest that there is an incumbent need for the relevant ECB guidance to encourage effective internal control mechanisms within the banking industry, which in turn would make it more manageable to address the NPL problem. Drawing from the concept of a polycentric regulatory space that acknowledges the significance of enrolling banks’ internal functions and entrusting them with a quasi-regulatory role, we advance a range of reforms in senior executive remuneration that would be applicable only to high-NPL banks with a view to creating financial incentives to safeguard asset quality at the origination stage.

Further, our findings suggest that NPL workout units should be part of the general risk management function of each bank and should be led by the chief risk officer who should sit on the board, supervised by the board risk committee. In banks with high NPLs, the ECB, guidance should strengthen the role of the chief risk officer (CRO), by requiring that the CRO sits on the board, and clarify the role of risk committees, which should have a special responsibility to develop a comprehensive NPL strategy. 

Andreas Kokkinis is Senior Lecturer at the University of Birmingham, School of Law.

Andrea Miglionico is Lecturer at the University of Reading, School of Law.