The effect of nonperforming loans on credit expansion: do capital and profitability matter? Evidence from European banks

We examine whether the effect of NPLs on bank credit growth differs depending upon the level of bank capital and profitability in a panel of up to 521 banks from 28 European countries. Our main finding is that there is a significant positive interaction effect of NPLs and bank capital and NPLs and profitability on the supply of bank credit. Thus, whether NPLs impede the monetary policy transmission mechanism depends substantially on whether or not banks are sufficiently capitalized and profitable. Policy actions aimed at reducing NPLs to sustain bank credit should protect bank capital and profitability if they are to be effective, including by supporting efforts that aim at returning NPLs to good standing.