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. Within a large empirical literature focusing on the effects of macroeconomic disturbances on the banking system, a stream of research considers loan losses as an important factor for banking stability and aims to identify explanatory variables for this critical indicator. This paper tests the impact of both real and financial fragility on Italian banks’ default losses over the period 1990-2007. To this end the ratio of non-performing loans to total loans is regressed on the business cycle and firms’ indebtedness. The analysis considers 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. Based on the interaction model, the results show that the actual impact of financial fragility on default losses depends on the business cycle phase.