A bank loan is considered non-performing when more than 90 days pass without the borrower paying the agreed instalments or interest. Non-performing loans are also called “bad debt”.
Why are NPLs an issue for banks?
A performing loan will provide a bank with the interest income it needs to make a profit and extend new loans. When customers do not meet their agreed repayment arrangements for 90 days or more, the bank must set aside more capital on the assumption that the loan will not be paid back. This reduces its capacity to provide new loans.
To be successful in the long run, banks needs to keep the level of bad loans at a minimum so they can still earn a profit from extending new loans to customers.
If a bank has too many bad loans on its balance sheet, its profitability will suffer because it will no longer earn enough money from its credit business. In addition, it will need to put money aside as a safety net in case it needs to write off the full amount of the loan at some point in time.
What does this have to do with monetary policy?
The euro area economy is heavily dependent on banks providing credit.
The tools of monetary policy make use of this fact. The ECB can raise or cut the rates banks have to pay to borrow money from it. This enables it to influence the cost of credit in the private sector and thus make sure inflation stays at levels below but close to 2% over the medium term.
However, if banks are overburdened with NPLs they will not be able to provide as much credit, making this mechanism for influencing rates in the private sector less effective.
Source: European Central Bank
Published: 12 September 2016
The above presentation was created for educational purposes.