Indebtedness, macroeconomic conditions and banks’ loan losses: evidence from Italy

The Basel II capital accord has fostered the debate over the financial stability of the aggregate banking sector. There is a large empirical literature focused on the effects of macroeconomic disturbances on the banking system. Specifically, loan losses are an important factor for the banking stability and a stream of research in this field aims to identify explanatory variables for this critical indicator. This paper focuses on Italian banks data over the period 1990-2007 and investigates the relationship between the ratio of non-performing loans to total loans, the business cycle and firms’ indebtedness so as to test the impact of both real and financial fragility on banks’ default losses. We use a regression model with an interaction term representing the joint effect of real and financial fragility, which to our knowledge has never been applied before to Italian default data. The results show that the impact of financial fragility on default losses is enhanced by adverse economic conditions.