World Development Report 2022

Introduction The pandemic and the associated policy responses have significantly affected the financial position of households, firms, and governments. The payment and enforcement moratoria described in chapter 1 have supported borrowers by allowing a temporary halt in their bank repayment obligations. In applying these moratoria, banks have been able to help mitigate the economic fallout from COVID-19 (coronavirus). It is not yet clear which borrowers will be permanently affected by the pandemic and how debtors will adjust to the structural changes in the economy. It is evident, however, that many borrowers are facing financial difficulties that go beyond liquidity stress. This situation is an unprecedented challenge for banks and bank supervisors because the magnitude of the ongoing shock, the uncertainty of the impact, as well as the ensuing government support have made the screening, monitoring, and management of risk extremely difficult. Rising borrower distress is widely expected to translate into increases in nonperforming loans (NPLs) in the banking sector, although this is not yet clearly evident in reported NPL ratios. Data suggest that as of August 2021 the ratio of reported NPLs to total loans in most countries was broadly stable (figure 2.1).1 However, for several reasons the data may not reflect the full reality of NPL levels: • Moratoria and other borrower support measures were still in place in many countries in the second quarter of 2021,2 as were fiscal and monetary interventions aimed at cushioning the impact of the pandemic on households and firms (chapter 1). • Relatively tranquil global financial markets have also influenced countries’ domestic financing conditions, especially by easing pressure on government debt refinancing. • NPL data are often made available with a significant time lag. • Many countries continue to apply regulatory definitions of NPLs that are predominantly based on payment arrears (and are therefore backward-looking). Notwithstanding the seemingly positive data, bankers and policy makers anticipate that NPLs will increase significantly when governments lift moratoria and borrowers become obligated to repay their loans according to their original repayment schedules. Some countries are already reporting significant increases in special-mention loans (loans with potential weaknesses in repayment prospects, but not yet considered nonperforming) and an acceleration of preemptive loan restructuring that may delay the recognition of credit losses. These developments suggest that rising pressures on asset quality are forthcoming. Banks have processes to manage NPLs in the normal course of business, but the scale and complexity of the expected increase in NPLs could overwhelm the capacity of the banking system, creating pressures that affect the broader economy. For example, when dealing with large and rising volumes of NPLs, banks often stop financing both the supply side of the economy by denying lending to viable firms for investment and working capital and the demand side by declining to finance consumption and household credit. For banks highly exposed to slow-growing, low-productivity firms, capital can become tied up in low-performing sectors at the expense of high-growth ones. Looking ahead, then, a rise in NPLs could affect the banking sector’s capacity to support the economic recovery with fresh lending, while increasing the risk of bank failures. The concern is greater for emerging economies that are heavily exposed to credit risk and that tend to rely on bank credit to finance the real economy.3 If unaddressed, high NPL levels may thus severely dampen recovery from the pandemic. To preserve capital and manage uncertainty in periods of economic and financial distress, credit intermediaries are incentivized to ration credit extended to higher-risk borrowers such as micro-, small, and medium enterprises (MSMEs) and underserved, vulnerable households. Similarly, international credit for low-income frontier markets, which have been especially hard-hit by the pandemic, may also dry up 80 | WORLD DE VELOPMENT REPORT 2022