The ECB’s Comprehensive Assessment has gone a long way towards ensuring adequate recognition and provisioning of NPLs, but there is still a legacy stock of NPLs on many  3  For a discussion of the “switching costs” created by relationship lending see Kim, M., D. Kliger, and B. Vale (2003), “Estimating Switching Costs: The Case of Banking”, Journal of Financial Intermediation Vol. 12, Issue 1. 4  Brunnermeier, M. (2009), “Deciphering the Liquidity and Credit Crunch 2007–2008”, Journal of Economic Perspectives, Vol. 23, No. 1. BIS central bankers’ speeches  3  banks’ balance sheets. This affects incentives to lend because, although some tolerance by banks towards NPLs can act as a shock-absorber, when NPL ratios exceed a critical level slow and inefficient resolution becomes a major impediment to both banks and the economy at large. From the bank side, it undermines the payment culture, as it rewards strategic defaulters while discouraging performing debtors from continuing to repay their debt. The process of handling and supervising NPLs also often raises operating costs. 5 And in the wider economy, it prevents creative destruction in the form of resolving non-viable companies, as well as swift restructuring of viable but over-indebted firms. All this perpetuates the macroeconomic effects of the debt overhang and retards the economic recovery, which in turn slows down the recovery in credit demand. Critical to addressing this problem is a legal and operating environment that encourages both banks and firms to accelerate NPL resolution.

And this depends in turn on several factors at the national level including the efficiency of insolvency regimes, out-of-court restructuring frameworks and judicial systems. For example, differences between countries in the speed of insolvency proceedings can affect the ability of banks to seize collateral, and hence influence their incentives and ability to resolve NPLs. To illustrate, according to the World Bank, to resolve insolvency in Italy takes 1.8 years, compared with just 0.4 years in Ireland. 6 Ineffective insolvency systems also render out-of-court restructuring frameworks less operable, as they fail to act as a credible threat, thereby dissuading creditors and debtors from agreeing on a restructuring. This latter point may be particularly important because, in a debt overhang environment, the overall efficiency of NPL resolution and the cost for society hinges crucially on the ease with which debt can be restructured outside of the insolvency framework. For firms whose business models remain fundamentally viable, liquidation may be economically inefficient and some form of voluntary debt restructuring could be essential to restore their viability and allow them to borrow and invest again. Several countries have already made progress in reforming their national legislation. To give just one example, in Portugal the government introduced new regimes for fast-track in-court and formalised out-of-court restructuring in 2011 and 2012. Experience has shown, however, that the effectiveness of an improved legal framework depends on various accompanying factors, such as improving debtor-creditor coordination and building sufficient administrative and judicial capacity to successfully mediate restructuring.