How banks respond to NPLs. Evidence from the Euro area

We study how deterioration in asset quality influenced the way euro area banks adjusted their balance sheets in 2010-2015. Fixed-effect analysis finds strong evidence of a negative correlation between asset quality and the growth in assets and lending. To determine the direction of causality, we exploit the 2014 ECB Asset Quality Review exercise in a diff-in-diff framework. We uncover a strong direct negative effect of higher NPLs on banks' credit supply. AQR banks plagued by high levels of problem loans reacted more sharply than reviewed banks with a low level of troubled assets.