Lending quality and contracts enforcement reforms

• Published date: 01 January 2024
• Author: Vincenzo D'Apice,Franco Fiordelisi,Giovanni W. Puopolo
• Date: 01 January 2024
• DOI: http://doi.org/10.1111/eufm.12422

DOI: 10.1111/eufm.12422

ORIGINAL ARTICLE

Lending quality and contracts enforcement

reforms

Vincenzo D'Apice

1

|Franco Fiordelisi

2,3

|Giovanni W. Puopolo

4

1

Center for Relationship Banking and

Economics (CERBE), Rome, Italy

2

Essex Business School, Colchester, UK

3

University of Rome III, Rome, Italy

4

University of Naples Federico II and

CSEF, Naples, Italy

Correspondence

Giovanni W. Puopolo, University of

Naples Federico II and CSEF, Cintia 21,

80026 Naples, Italy.

Email: giovanniwalter.puopolo@unina.it

Abstract

We investigate the causal relationship between the

efficiency of country's judicial system and the quality of

bank lending, using the contracts enforcement reforms

implemented in four European countries as a quasi‐

natural experiment. We find that strengthening con-

tracts enforcement determines large, significant and

persistent reductions in banks' nonperforming loans.

Our results have important policy implications: they

point at judicial efficiency as a critical determinant of

the stability of the banking sector and its resilience to

adverse shocks such as the recent Covid‐19 pandemic.

KEYWORDS

banking stability, judicial systems, nonperforming loans

JEL CLASSIFICATION

G21, G28

The problem of Non‐Performing Loans (NPLs) is not solving itself—and it has not yet been

resolved. While it is true that the amount of NPLs has fallen significantly—by almost 50% since

2014—the stock of NPLs is still very high. It is also very old. Many of the NPLs that we see on

banks' balance sheets have been there for years. […] We have to get a handle on this problem. We

have to solve the issue of NPLs while the economy is still resilient. If banks have to sail into the next

Eur Financ Manag. 2024;30:440–464.wileyonlinelibrary.com/journal/eufm440

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© 2023 John Wiley & Sons Ltd.

EUROPEAN

FINANCIAL MANAGEMENT

We would like to thank John Doukas (the editor) and an anonymous referee for their thoughtful suggestions and

comments. Moreover, we are grateful to Luisa Carpinelli, Christa Bowman, Giovanni Cerulli, Nicola Cetorelli, Ralph de

Haas, Radha Gopalan, Iftekhar Hasan, David Marques Ibanez, Bill Megginson, Tommaso Oliviero, Lorenzo Pandolfi,

Gordon Phillips, Alexander Plekhanov, Klaus Schaeck and Anjan Thakor for very useful comments. We also thank the

participants at conferences: American Economic Association 2018, Financial Intermediation Network of European

Studies 2018, and at seminars held at the European Banking Authorities, and Universities of Essex, Luiss, and Rome

III, for their very valuable insights.

storm with too many NPLs on their balance sheets, they will be less able to weather it and come out

safely on the other side.

[Andrea Enria, 14 June 2019]

1

1|INTRODUCTION

One of the most important legacies of the Global Financial Crisis (GFC) of 2008 and the

subsequent Euro Sovereign Crises of 2011–2012 has been the sharp and widespread increase in

the stock of nonperforming loans (NPLs) held by European banks.

2

In turn, such an increase in

NPLs worsened the downturn. Moreover, it slowed down the recovery in several countries

(ESRB, 2017). NPLs, in fact, represent a burden for both the borrower and the lender. On the

one hand, the former cannot use trapped valuable collateral for different purposes and its credit

history worsens, negatively impacting her future financing needs (see, for instance, Bernanke

et al., 1999). Conversely, the latter sees its profitability and liquidity reduced by NPLs (Casu

et al., 2015). However, while small amounts of NPLs do not represent much of a concern,

especially in the case of profitable banks with sufficiently large loan portfolios, large amounts of

NPLs can undermine banks' capital adequacy, constrain their lending activity,

3

and even lead

to default.

4

At an aggregate level, this may impair the transmission of monetary policy and

undermine the financial stability of the overall banking system, with severe consequences for

economic development (Barseghyan, 2010; Bernanke & Gertler, 1995; Iannotta et al., 2019;

Tarazi et al., 2018).

Despite in recent years banks and regulators have made a significant effort to reduce the

stock of NPLs held by European banks, it is essential to understand how it is possible to reduce

NPLs without imposing stricter rules and capital requirements on the banking system which

may further depress the economy. Economic theory and policy papers (Avramidis,

Mylonopoulos, & Pennacchi, 2021; Baudino & Yun, 2017; ECB, 2017a,2107b; Jappelli

et al., 2005; Jassaud & Kang, 2015; North, 1990) suggest that the efficiency of judicial system

plays a vital role in determining how NPLs are handled.

5

Judicial systems that become more

efficient imply an improvement in settlement of the contract enforcement and ensure a better

framework for collateral repossession.

6

In turn, this increases NPLs' recovery rates, reduces the

time of their disposal and enhances the development of a secondary market for bad loans, thus

reducing the amount of existing NPLs held by banks.

7

Similarly, more efficient judicial systems

1

Speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the Conference ‘EDIS, NPLs, Sovereign Debt and Safe Assets’

organized by the Institute for Law and Finance, Frankfurt, 14 June 2019.

2

By contrast, before the start of the GFC, nonperforming loans were relatively low and stable across most EU countries.

3

Losses stemming from NPLs also lead to banks capital reduction, and, as highlighted by Peek and Rosengren (1997), Gambacorta and

Mistrulli (2004), Watanabe (2007), Berrospide and Rochelle (2010), Michelangeli and Sette (2016), and Gambacorta and Shin (2018),

capital‐restricted banks are even more reluctant to grant new loans.

4

Banks' portfolio quality also influences risk‐taking behavior. While prudential banks are typically more cautious when facing increasing

levels of NPLs, banks characterized by large amounts of NPLs are more likely to assume higher risks in the future (Bowman &

Malmendier, 2015; Eisdorfer, 2008; Koudstaal & Wijnbergen, 2012).

5

In his speech at the European Parliament's Economic and Monetary Affairs Committee on 19 June 2017, the Chair of the Supervisory

Board of the ECB, Danièle Nouy, has further reiterated this view ‘I would also like to stress that addressing NPLs requires determined

action from all stakeholders, not only supervisors. In addition to our work, legal and institutional measures are required, notably in the

areas of insolvency and judicial processes’.

6

The majority of bank lending is linked to some type of collateral, such as real estate, whereas only a small part consists of non

collateralised or unsecured loans.

7

In Europe, low transparency surrounding bad loans, differences in national legislation and inadequate write‐downs have strongly

contributed to the underdevelopment of a secondary market of NPLs.

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