when an arbitrary threshold is used to tag households as vulnerable and following the combination of shocks described in Figure 5, Panel D. The increase is lower when the financial margin threshold and the same shocks are used—2.1 percent of all banking system assets.

What remains a puzzle is the large share of _risk loans at origination_ ; 8.8 percent of all banking system assets compared to a pre-crisis stock of NPLs among households of only 4.7 percent when an arbitrary threshold is used; and slightly lower when using the financial margin threshold (7.7 percent of banking system assets). Since banks chose to extend loans, the difference between NPLs and these _risk loans at origination_ might reflect something banks know about their borrowers that is not captured in Croatia’s 2008 HBS. In any event, financial distress among households arising from crisis-related economic shocks remains limited at an aggregate level; of course, our analysis precludes any comparison across individual banks.

What can governments do in the presence of over-indebted households? Financial distress not only has a negative social impact, but also overwhelms legal and institutional frameworks for debt restructuring. In this context, governments can help by facilitating private restructuring efforts. In the case of household debt, a tool applied with some success is known as the Bank of England pre-foreclosure protocol. The goal of such interventions is to facilitate out-of-court negotiations between creditors and debtors while avoiding distortions for them to perform in line with their contractual obligations. Discussions between creditors and debtors may include extending the term of debt, changing the type of debt instrument, or capitalizing arrears. Assessing borrowers’ creditworthiness remains paramount and this should be left for banks to decide since they are better placed to judge a household’s debt service capacity. Governments can complement this with consumer protection oversight rules to ensure a fair behavior on the part of creditors. They can also facilitate private debt restructuring efforts that are hampered by institutional arrangements, such as the tax and regulatory treatment of restructured loans.

What about a government program aimed at financially supporting households with debt obligations? As with any subsidy, government financial support should be limited, well-targeted, and adequately assess subsidy incidence. In this regard, government guarantees should be looked at carefully so as to avoid excessive costs and abuse, and fine tuned to a variety of scenarios—as to eligibility—in order to avoid the creation of unsustainable public sector liabilities. More importantly, the assumption that all households need to be compensated for the increase in debt service burden that arises from economic shocks is not justified by the distribution of indebted households across income quintiles. The case for debt relief interventions in Croatia with public financial support is, at this stage, not compelling: fiscal space for public financial support is limited, the social considerations for debt relief interventions funded with scarce public resources are not obvious, and the debtor and creditor moral hazard risks are significant.

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