Note on Financial Stability and Supervision No. 12 - Do high levels of NPLs impair banks' credit allocation?

The Bank of Italy released one new Note on Financial Stability and Supervision (Note No. 12).

Recently, various commentators have argued that high NPL stocks can limit banks’ lending ability, impairing the monetary policy transmission mechanism.
This note looks at some facts on the relationship between NPLs and credit growth, and summarizes some recent empirical results, casting doubts on this thesis. In a nutshell, it seems to have no strong foundation, either on theoretical or on empirical grounds.
NPLs are relatively opaque, difficult to value, and therefore illiquid; also, they typically do not yield a steady return; thus, other things equal, banks with large NPL holdings are less profitable, and pay a risk premium on capital and liquidity markets. Indeed, the Single Supervisory Mechanism has taken various steps to foster a reduction of NPLs, with very good results. This note argues that the current debate on NPLs features many reasons to reduce the stock of NPLs in banks’ balance sheets, but that not all of them are well-grounded ones.