Non-Performing Loans, Moral Hazard & Supervisory Authority: The Italian Banking System

This paper aims to identify the existence of an opportunistic form of behaviour – i.e. moral hazard – within the Italian banking sector. Applying a fixed effect threshold panel analysis approach to a dataset of 298 Italian banks from 2006 to 2014, we investigate whether banks’ lending behaviour is sensitive to high levels of NPLs (Non-Performing Loans) and whether banks, with higher NPLs, tend to adopt a more aggressive and riskier lending strateg y. We also empirically test the hypothesis that the supervisory activity of the Italian banking authority – through credit risk sanctions – is effective in providing incentives for banks to limit their risky lending strategy. Banks, with significant previous losses and significant levels of gross non-performing loans, can reduce the NPLs ratio temporarily by making additional loans due to the dilution effect. However, bank managers may have to accept riskier positions to obtain additional loans potentially generating higher future losses. The empirical results show that banks may be affected by moral hazard problems, but we find no effect of the enforcement action on reducing it. To account for endogeneity, robustness tests are also conducted as part of the study.