major legal impediments and taxation obstacles. In countries with a long history of unresolved asset quality problems, the establishment of a coordination body could signal authorities’ newfound determination to clean up bank balance sheets and gain public and financial industry support for critical legal and regulatory reforms. Such a body could also help to prioritize policy actions, sustain momentum over a likely multiyear process, and ensure that reforms remain on track. Where helpful, IMF and the World Bank could provide assistance and advice on strengthening financial supervision, including on NPL identification and strategies to resolve them. Strong crisis management frameworks that include a resolution toolkit for handling bank failures, as well as contingency planning for dealing with potential problems, will help to protect taxpayers while ensuring continuity in financial services. Reforms to develop such frameworks and strengthen crisis management planning have been a policy priority in recent years. Building on this progress to ensure that authorities have a broad range of policy tools remains important to ensure that banking systems are able to support a strong, sustainable, equitable recovery.
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However, early signs of distress are already visible in some countries. For example, in India bad loans as a share of gross loans surpassed 10 percent in the first half of 2021 (Sanglap 2021). In the Philippines, the nonperforming loan ratio is expected to double to 8.2 percent in 2022 (Villaneuva 2021). The World Bank COVID-19 Crisis Response Survey (http://bit.do/WDR2022-Covid-19_survey) indicates that as of June 2021, 25 upper-middle-income, 14 lower-middle-income, and 6 low-income countries had in place credit forbearance policies for individuals. Also in response to the pandemic, 25 upper-middleincome, 20 lower-middle-income, and 6 low-income countries had in place credit forbearance policies for small businesses and firms. The impact of the COVID-19 crisis on asset quality in the banking sector varies across countries and depends on a complex interplay of factors, including the severity of the pandemic, the duration and rigor of containment measures, the importance of hard-hit economic sectors, as well as the financial capacity of banks to absorb rising credit losses and their operational readiness to work out rising volumes of bad debt. Some countries will be hit harder than others. Aiyar et al. (2015) document that NPLs in several European countries exceeded 10 percent between 2008 and the end of 2014. By reporting NPLs at their historical average, the authors estimate that banks could have provided new lending of up to 5.3 percent of the gross domestic product (GDP) of the countries in their sample at the end of 2014. The same authors also argue that persistent, excessive NPLs are associated with a private debt overhang, which entails weaker investment and slower economic recovery after a recession. In addition, the negative economic effects associated with high NPLs may be amplified by a previous large buildup of excessive credit, eventually leading to a severer economic recession and slower recovery (Jordà, Schularick, and Taylor 2013).
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Cerra and Saxena (2008). Analysis of the sectoral heterogeneity can reveal how COVID-19 is having a differential impact across and within loan portfolios. For example, Müller and Verner (2021) find that credit booms driven by household credit and credit to the nontradable sector are asso ciated with lower growth in the medium term. Countries enacting measures to support borrowers have stressed their extraordinary and temporary nature. Deciding when and how to unwind them is nonetheless challenging. Withdrawing measures before the pandemic and the macroeconomic outlook have stabilized can permanently reduce economic growth potential through unnecessary insolvencies and unemployment, increasing NPLs and credit losses and triggering disorderly adjustments of asset prices (Kongsamut, Monaghan, and Riedweg 2021). On the other hand, extending support measures risks distorting resource allocation and asset prices, weakening repayment discipline, postponing structural adjustment in the economy, and draining fiscal resources. Policy dilemmas about whether to extend, amend, or end support measures will likely become acuter as the pandemic persists. Further discussion of the timing and strategy for unwinding fiscal and monetary supports appears in chapter 6. See also FSB (2021). A useful distinction is between high levels (stock) of NPLs and increases in NPL ratios (flows). High levels of NPLs may influence permanently the provision of credit through regulatory restrictions, funding costs stemming from market pressures, and risk-taking behavior such as the tendency to invest in riskier assets to “gamble for resurrection” (Rochet 1992). Increases in NPL ratios temporarily affect income statements and may modify lending policies while banks adjust provisioning (see Balgova, Nies, and Plekhanov 2016). To keep bad loans in check and limit capital absorption due to higher regulatory requirements, banks may
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