ESM: Asset-Quality-at-Risk

?This ESM working paper introduces a new forward-looking framework to assess potential asset quality deterioration in euro area banks.

?Drivers of Asset Quality Deterioration - The study examines non-performing loans (NPLs), which have been a key focus for policymakers since the Global Financial Crisis (2007-2009) and European Sovereign Debt Crisis (2010-2012); The research identifies non-linear relationships between NPL ratios and macro-financial factors, such as GDP growth, inflation, unemployment, house price dynamics, and government bond yields; Using dynamic fixed-effects panel quantile regression, the study finds that different macroeconomic and bank-specific variables have varying impacts across the distribution of NPLs, particularly at the upper tail (high-risk banks).

?Introduction of "Asset-Quality-at-Risk" (AQaR) - AQaR is based on the Growth-at-Risk (GaR) framework, which assesses economic risks based on current financial conditions; This model predicts the probability distribution of future NPL ratios, allowing supervisors to anticipate potential asset quality deterioration rather than react to past data;

The framework enables forward-looking risk monitoring, helping authorities set risk thresholds for banks and assess whether their NPLs are increasing in risk severity.

?Empirical Results - The research finds that GDP growth and house price growth significantly reduce NPL ratios, while higher government bond yields and inflation are linked to higher NPLs; Bank-specific variables like loan growth and capital ratios show mixed effects, with loan growth becoming a significant risk factor at higher quantiles; The analysis shows that traditional linear models underestimate credit risk, especially in crisis scenarios, making quantile regression a more effective tool for risk assessment.

?Policy Implications - For Microprudential Authorities: The AQaR framework provides an early warning indicator of asset quality risks at the bank level, allowing targeted supervisory interventions; For Macroprudential Authorities: By aggregating risk assessments, policymakers can track systemic financial stability trends, particularly in times of economic downturn; For Bank Risk Management: Banks can use AQaR to assess their own exposure to rising NPL risks and adjust risk buffers accordingly.

Original source: https://www.esm.europa.eu/system/files/document/2025-02/WP%2069.pdf