Credit: the lifeblood of banking

Keynote speech by Sharon Donnery, Member of the Supervisory Board of the ECB, at the Credit Management Summit 2025 organised by Il Sole 24 Ore

Milan, 18 June 2025

Introduction

Thank you for inviting me to this year’s credit management summit.^[1]

Talking here about the importance of credit feels a bit like portare acqua al mare – bringing water to the sea. But just as water sustains life, credit sustains the economy.

Banks are our economy’s beating heart. They channel vital resources from savers to investors, driving economic growth with loans that fuel innovation, employment and prosperity. Every new venture, every business expansion, every family's dream of owning their own home depends on credit.

And yet, every extension of credit also inherently involves risk. Borrowers can default and loans can sour. Risk lies at the very core of banking and it cannot be avoided. Instead, it must be effectively priced and managed so that banks can create value and support the economy. Managing credit risk properly is the keystone of a sound banking system and, by extension, a healthy economy, as it provides the stability that allows banks to fulfil their fundamental role in society. This is exactly what I will discuss in my speech today.

I will make three main points:

First, the European banking sector has made significant progress since the introduction of European banking supervision. Banks are in a much better position than in 2014, with healthier balance sheets and stronger financial foundations. Part of this improvement should be credited to more solid European regulation, including the phase-in of Basel III. Another sizeable part, the one I would like to focus on today, can be attributed to the combined effort by banks, supervisors and policymakers to reduce non-performing loans (NPLs).

The second point I would like to address is that the high uncertainty surrounding the macroeconomic and geopolitical outlook demands continued vigilance. While the overall asset quality outlook remains stable, pockets of vulnerability persist and require close attention. Banks must remain agile and forward-looking to anticipate and respond to emerging risks effectively.

Third, and perhaps most importantly, bad loans are often made in good times, so strong credit underwriting frameworks are critically important. Put simply: good bankers should remember the lessons of tough times, even when skies are clear and the sun is shining.

A foundation of resilience

Creating banking union, and with it, European banking supervision, was a direct response to the sovereign debt crisis and the accumulation of bad loans that weighed on the balance sheets of European banks.

At the start of ECB Banking Supervision in November 2014, the volume of NPLs held by significant institutions stood at around €1 trillion. After reaching a low of €340 billion in mid-2023, the volume of NPLs has been gradually increasing and today stands at €357 billion.

When initially confronted with this mountain of bad loans, ECB Banking Supervision made reducing them and tackling credit risk a top priority from the outset.

The ECB guidance setting out supervisory expectations for the coverage of legacy NPLs^[2]played a major role in cleaning up bank balance sheets. It clearly stated that any shortfall in provisioning would trigger a specific capital add-on, always taking into account bank-specific circumstances in line with our supervisory mandate.

We called on banks with high NPL levels to draw up ambitious, credible strategies to reduce them. We wanted banks to tackle these challenges head-on by considering all the options on the table and pursuing diversified strategies with measurable targets – not only to clean up their balance sheets, but also to lay the groundwork for building a stronger financial system. Banks were asked to integrate these strategies across all levels of their institutions, ensuring clearly defined responsibilities and effective governance structures.

We complemented this approach by introducing supervisory coverage expectations to tackle legacy NPLs via Pillar II measures. At the same time, legislators stepped up. They adopted clear, consistent provisioning rules tied to a uniform provisioning calendar. This was no small step: it ensured a predictable, transparent framework for dealing with NPLs.^[3]

We have also benefited greatly from the significant progress made in removing impediments to the prompt resolution of NPLs. An obvious, yet no less important, milestone was the introduction of a common EU definition of NPLs in 2014.^[4] This was fundamental for enhancing the quality and consistency of information available to both supervisory authorities and the wider public. Key policy initiatives, such as improvements to insolvency and foreclosure frameworks, more efficient judicial processes, the development of an NPL servicing industry and the creation of broader and deeper NPL markets, have played a crucial role in helping banks reduce their NPL stocks. At the same time, we should acknowledge that reducing NPLs through sales or securitisation may indeed improve bank balance sheets, but the underlying debt does not simply vanish. For consumers and businesses, that burden remains. This is why consumer protection authorities need to stay attentive in order to ensure fair treatment and sustainable debt resolution for households and businesses.

Over the past decade, the collective efforts of supervisors, banks and policymakers have proven effective. Looking at the euro area banking sector today, we think it is fair to say that we have accomplished the mission of repairing bank balance sheets.

As a result, Europe’s banking sector has proven resilient amid unforeseen challenges, including the COVID-19 pandemic, the energy supply shock following Russia’s invasion of Ukraine and high inflation.

Importantly, European banks continued to provide credit during the pandemic, at a time when we were concerned about potential procyclicality in their lending decisions. This leads me to another significant point.

Credit is inherently cyclical. On the one hand, there is ample evidence that credit growth is a powerful predictor of financial crises.^[5] In periods of credit growth, competition often intensifies, collateral becomes ample and advantageously priced, and banks’ risk sensitivity declines. This can sometimes tempt bankers to loosen their credit underwriting standards, potentially to dangerous levels.^[6] As I said, bad loans are often made in good times. And once these bad loans are created, they can erode a bank's profitability, tie up capital and hinder its ability to lend to households and businesses, thereby stifling economic growth.

On the other hand, as vividly demonstrated during the pandemic, it is important that banks sustain credit provision during downturns to counteract excessive procyclicality and mitigate economic damage. Balancing these roles – restraining credit exuberance in good times while actively supporting the economy in challenging times – is crucial for keeping the banking system safe and sound.

Let me add that credit risk should always be seen in the broader context of the fiscal and monetary policy environment. While it is true that banks have weathered recent crisis episodes reasonably well, we should not forget that policymakers mitigated some of these shocks effectively. In response to the sharp decline in economic activity during the pandemic, fiscal measures helped stabilise the financial position of households and businesses while accommodative monetary policy protected the credit supply. This in turn limited corporate insolvencies and credit losses.

Now, we see loan growth gradually recovering after the most recent monetary policy tightening. However, comparing current loan and credit growth with past economic recoveries indicates relatively weak loan growth. And bank lending to firms as a share of GDP, and to households as a share of disposable income, has declined consistently in the aftermath of the pandemic and now stands at comparatively low levels.

Chart 2

Bank lending to the euro area non-financial private sector

(outstanding amounts; left-hand side: percentage of GDP; right-hand side: percentage of nominal gross disposable income)

Credit risk has been a key priority for European banking supervision for many years and this focus is reflected across the full spectrum of our supervisory activities. In 2024, 40% of all supervisory measures issued addressed weaknesses related to credit risk, making it the most significant risk category. Notably, three-quarters of these measures originated from on-site activities, primarily internal model investigations. This emphasis is also mirrored in our Supervisory Review and Evaluation Process (SREP), in which credit risk accounted for the highest number of qualitative measures issued across all risk categories in 2024. In this cycle, supervisors addressed bank-specific concerns about credit risk management by applying 141 qualitative measures to 74 banks across all business models.^[7]

Chart 3

Credit risk-related qualitative measures in the 2024 Supervisory Review and Evaluation Process

(percentages)

Nearly half these measures targeted institutions with elevated NPL levels compared with their peers, focusing on strategic and operational planning, prudential coverage expectations and related reporting.

In line with our supervisory priorities for 2024–26, 46% of the measures addressed broader shortcomings in credit risk management frameworks beyond non-performing exposures (NPEs), including issues linked to internal models, the internal capital adequacy assessment process (ICAAP) and foreign exchange (FX) settlement risk. Meanwhile, there was a notable increase in measures related to governance, data and reporting, and a decline in those related to IFRS 9 and prudential classification.

Credit risk landscape

Let me now turn to the assessment of the current credit risk landscape.

Aggregate asset quality for banks under European banking supervision remains robust. The aggregate NPL ratio is at historic lows, even after a slight uptick in 2024. Similarly, stage 2 loans, which are critical early warning indicators of credit deterioration, have remained stable. This underscores the banking sector’s resilience.

However, the aggregate figures only tell part of the story. Beneath the overall stability lie divergent trends that demand our attention. In some countries with historically low NPL ratios, we are now witnessing a rise in NPLs and stage 2 loans which warrants closer scrutiny. At the same time, euro area countries that faced significant challenges during the sovereign debt crisis have taken impressive strides, successfully reducing their long-standing NPL stocks through disciplined disposal strategies. A nuanced and granular approach to credit risk management is essential for identifying and addressing pockets of vulnerability hiding beneath the surface.

In commercial real estate (CRE), for instance, the risks are particularly uneven. While the aggregate NPL ratio in this sector rose only marginally in 2024, and at a slower pace than the previous year, this aggregate figure masks considerable disparities. CRE markets may have bottomed out in 2024, but risks remain as uncertainty lingers. The NPL ratio of US-based CRE exposures has risen by nearly four percentage points since the end of 2023.^[8] These exposures, concentrated primarily in a few banks in Germany and Austria, now account for a substantial share of total CRE NPLs. By contrast, euro area CRE loans have performed relatively well. While CRE in both European and US markets is showing some signs of stabilisation, transaction volumes are still quite low and the sector is always sensitive to the wider economic environment. The outlook is particularly challenging for non-prime segments where environmental, social and governance risks are heavily affecting demand.

Small and medium-sized enterprises (SMEs) also present a mixed picture. The SME NPL ratio rose gradually for much of 2024 before easing slightly in the final quarter. However, early arrears picked up again in the second half of 2024, signalling mounting pressures in this segment.^[9] SMEs in general have a higher cyclical sensitivity, meaning that vigilance is crucial, particularly in the face of a softening economic environment.

In the household sector, consumer loans have shown early signs of strain. While the overall NPL ratio has remained broadly stable, early arrears ticked upward in the fourth quarter of 2024. Given the inherently cyclical nature of consumer lending, banks must prepare for the possibility of further credit quality deterioration if economic conditions worsen.

For residential real estate, it is important to have a nuanced view as our targeted review showed last year.^[10] The review revealed that banks’ residential real estate business and risk management practices differ across European countries and clearly lack homogeneity. As of late 2024, house prices in the euro area had risen by 4.2% year-on-year, supported by rising demand for housing loans, easing lending standards and improving consumer confidence. Yet forward-looking indicators, such as subdued construction activity and rising building costs, hint at potential imbalances in supply and demand that could sustain upward pressure on prices. Therefore, banks should maintain prudent lending standards and rigorously stress test their mortgage portfolios to guard against these vulnerabilities.

Finally, the size of banks is also relevant for a holistic picture of the current credit risk landscape: the smaller banks in the euro area, known as the less significant institutions (LSIs), have seen their collective NPL ratio rise notably since its historical low reached in 2022, although its overall level remains moderate for the time being.^[11] While uneven across countries, this recent trend is driven strongly by the aforementioned challenges facing CRE and SME portfolios. These portfolios have a particularly large weight in the loan books of small banks in Germany and Austria, which account for the bulk of the LSI population. Beyond those recent developments, broader structural factors warrant continued scrutiny of LSIs: reduction of old NPL stocks has, over the last decade, proven more challenging for small banks than their larger peers, making resilience towards further potential credit losses on those exposures an important focus point for supervisors.

Beyond sector-specific risks, while declining interest rates and the gradual recovery in euro area economic growth that is expected in the medium term^[12] should support asset quality, the current geopolitical environment adds a new layer of uncertainty and is a source of downside risk to the outlook. Rising global trade tensions and supply chain disruptions also pose risks to banks with significant exposures to export-oriented industries, such as manufacturing. Sectors like the automotive industry, which rely heavily on extra-EU trade, have already seen declining profitability that may erode corporate credit quality. In an adverse scenario, these pressures could spill over into household loan portfolios, as layoffs in affected industries weaken consumer sentiment and borrowers’ ability to repay.

Banks are unable to capture these geopolitical risks in a fully functional and validated statistical model – simply because the data do not exist. And this is unlikely to change anytime soon. In this environment, the best way to account for novel risks is through an overlay – one that is grounded in sound methodologies such as simulations and scenario analysis. Our targeted review on provisioning for novel risks showed that many banks have made clear progress. But it also revealed that some institutions still rely on approaches that fail to capture the nuanced, sector-specific impacts of geopolitical risk.^[13]

On top of these challenges, provisioning costs are likely to rise. While provisioning levels have been subdued in recent years, they typically increase as new NPLs age. For example, coverage ratios average 44% for loans on the books for less than a year, but this rises to 68% for loans held for more than two years. Compounding this trend is the shrinking share of pandemic-related government-guaranteed loans, which has more than halved since its peak in the third quarter of 2022. This decline is, in some ways, a positive development. According to our estimates, roughly €150 billion of these loans remain on the balance sheet of supervised institutions.

ECB research shows that these loans display notably weaker asset quality compared with the rest of banks’ loan portfolios from that period. With fewer guarantees to cushion against losses and a subdued growth outlook for 2025, expected losses under IFRS 9 accounting standards may increase, driving up provisioning costs further. Banks must remain proactive in refining their provisioning models – incorporating scenario-based approaches to prepare for a range of potential outcomes.

The importance of sound credit underwriting and management

This leads me to my final point: the importance of a forward-looking approach to credit risk. In our work, we pay particular attention to the application of sound lending standards, as today’s loans can easily become the NPLs of tomorrow. Sound underwriting practices are fundamental to banking. They shape not only a bank’s legacy, but also its resilience in the face of potential credit losses. Of course, not all credit losses are caused by low credit standards; sometimes exogenous events, such as the pandemic or Russia’s war in Ukraine, can lead to unexpected deterioration in asset quality for entire sectors. However, even in these challenging circumstances, robust credit underwriting standards can help banks mitigate potential losses and withstand downside risk from external factors, such as geopolitical tensions which remain high on our agenda.

The ECB has consistently assessed the quality of banks’ underwriting frameworks, combining quantitative and qualitative analyses, and we will continue this important work in the years to come.

Every loan granted must be based on a thorough assessment of the borrower’s creditworthiness, and these assessments must be made using reliable and verifiable information. Guarantees should only come in as a secondary source of repayment. To ensure that credit decisions are made responsibly, banks are expected to establish clear internal governance arrangements with appropriate oversight by the management body and a culture of sound risk management.

Lending decisions should be aligned with banks’ risk appetites and business strategies, and supported by well-defined credit policies and procedures. Banks should incorporate forward-looking considerations that take into account the outcome of stress test and scenario analysis, at a sectoral level where necessary, in order to evaluate a borrower’s capacity to repay under adverse conditions. Robust procedures for collateral valuation and monitoring must be in place to ensure that values remain accurate over time.

When it comes to pricing, institutions should align their frameworks with their credit risk appetite, ensuring that loan pricing reflects both profitability and the risk profile of the borrower. This means that pricing should consider factors like product characteristics, market conditions, competition and risk differentiation across borrower types, supported by clear governance structures like pricing committees.

If borrowers start to become distressed, early and proactive engagement is crucial to avoid future NPL build-up. It also supports viable borrowers and, ultimately, the economy. Banks should promptly identify borrowers experiencing potential financial difficulties and actively engage with them to develop sustainable solutions. By investing in appropriate IT systems, robust reporting mechanisms and granular portfolio segmentation, banks can swiftly detect early warning signs and respond appropriately. A proactive approach not only helps maintain the economic viability of distressed borrowers, but also limits potential losses arising from escalating arrears – this preserves both underlying asset value and financial stability overall.

Conclusion

Let me close by reiterating my three main points.

First, the European banking sector has come a long way since 2014 thanks to the collective efforts that banks, supervisors and policymakers have put into strengthening balance sheets and reducing NPLs. This progress is a sound foundation on which we can build.

Second, uncertainty in the macroeconomic and geopolitical landscape calls for continued vigilance, and banks must remain agile and forward-looking to navigate risks effectively.

Third, sound credit underwriting is not just a regulatory obligation; it is a cornerstone of long-term financial stability. Bad loans are made in good times. And the best time to prevent bad loans is precisely when things look good. Or, to quote John F. Kennedy, “The time to repair the roof is when the sun is shining”.