How Do Banks Respond to Non-Performing Loans?

We exploit the first European Central Bank's Asset Quality Review as a quasi-experiment to investigate the effect on banks' balance sheets of a shock to Non-Performing Loans (NPLs). We found that the banks included in the review with higher unexpected changes to their NPLs, deleveraged and reduced their lending more than non-reviewed banks. The effect is non-linear and is stronger among reviewed banks located in high-NPL countries. The banks affected the most were undercapitalised and unprofitable, suggesting that NPLs influence the credit supply via a capital/profitability channel.