The effect of regulatory and risk management advancement on non-performing loans in Europe

We study whether the implementation of advanced risk management techniques to manage credit quality has a significant impact in controlling credit risk and hence, reducing the level of non-performing loans (NPLs) across banks from both emerging and advanced European economies for the period of 2000-2011. The analysis reveals that there exists a wide variation in terms of the adoption of such advanced techniques internal rating-based (IRB) across European banks, and that emerging Europe, which suffered the most from the surge in NPLs in the post-crisis period, lags significantly behind the Eurozone economies in terms of the intensity of IRB adoption rates. We use a panel of European banking sector data and test for the effect of a newly introduced IRB-variable on NPLs, while controlling for the macroeconomic, and bank-specific determinants as discussed in the existing literature. We employ dynamic generalized method of moments (GMM) estimation methods in our panel regressions to investigate the effect of different IRB implementation regimes on the level of NPLs on a country level. Our findings confirm that the intensity of IRB usage within a banking system leads to a statistically significant decrease in the aggregate amount of NPLs, especially in the post-crisis period, after controlling for macroeconomic and bank-specific characteristics of the individual economies. This result is consistent with the view that the efficiency of credit risk management may turn out to be critical for avoiding widespread distress and for improving the profitability and solvency of banking systems as a whole, which in turn leads to a better allocation of resources and faster economic growth.