Asset quality metrics: NPL ratio, coverage and cost of risk

NPL ratio = 12bn / 100bn = 12%

That is high. For context, benchmarks worth memorizing (all approximate, and they move with the cycle):

• US banks: the aggregate noncurrent loan rate has typically sat around 1% or below in recent years, per FDIC quarterly data. (The FDIC, Federal Deposit Insurance Corporation, is the US bank regulator and deposit insurer.)
• Euro area banks: the aggregate NPL ratio has fallen dramatically, from roughly 8% around 2014 to under 2% by the mid-2020s, per European Banking Authority (EBA) reporting. Italy specifically ran above 15% at the peak.

So a 12% NPL ratio would flag Banca Esempio as a problem bank by 2026 standards, though it would have looked normal in Italy a decade earlier.

Metric 2: The coverage ratio

An NPL ratio tells you how many loans went bad. It does not tell you whether the bank is prepared for the losses. That is what the coverage ratio does.

When a loan looks doubtful, the bank books a provision: an accounting charge that sets aside money against the expected loss. The stock of these set-asides is the loan loss allowance (or loan loss reserves).

Worked example

Back to Banca Esempio: 12 billion in NPLs, and suppose it has set aside 6 billion in allowances.

A 50% coverage ratio means the bank has already recognized losses on half the face value of its bad loans. The interpretation:

• High coverage (say 60 to 70%+): the bank has been conservative. Future losses are less likely to surprise the market. Little "hidden" risk left.
• Low coverage (say 30 to 40%): the bank is betting it will recover more of these loans (often via collateral, such as property backing a mortgage). If it is wrong, more losses are coming.

European banks have typically targeted coverage in the 40 to 60% range in recent years. The exact "right" number depends on collateral: a mortgage book backed by real estate can justify lower coverage than an unsecured credit-card book, because the bank can seize and sell the house.

Metric 3: Cost of risk

The NPL ratio and coverage ratio are snapshots (stocks). The cost of risk is a flow: how much new loss the bank is booking this year, relative to its lending.

It is usually quoted in basis points (bps), where 100 bps = 1%.

Worked example

If Banca Esempio books 800 million euros of new provisions this year against its 100 billion loan book:

Benchmarks to anchor on:

• A normal, benign cost of risk for a developed-market bank is often in the 20 to 50 bps range.
• In a recession or crisis, it can spike to 100 to 200 bps or more as banks provision heavily.
• During the 2020 pandemic shock, many large banks temporarily pushed cost of risk well above 100 bps, then released provisions in 2021 when losses did not materialize (a swing that flattered profits).

Cost of risk is the metric that hits the income statement directly. Higher provisions mean lower profit, which is why analysts watch it every quarter.

Why Italy ran at 15% and the US at 1%

Now the payoff: why the same business produced a tenfold gap. Four drivers, all worth knowing.

1. Bankruptcy and foreclosure speed

This is the biggest one. In the US, a bank can foreclose and clear a bad loan relatively quickly. In Italy, recovering collateral through the courts historically took several years (estimates of 4 to 8 years were commonly cited). A loan stays classified as non-performing until it is resolved. Slow courts mean NPLs pile up on the books instead of flowing off. The stock stays high even if new defaults are similar.

2. No deep secondary market (until later)

US banks routinely sell or write off bad loans fast. For years, Europe lacked a liquid market to offload NPL portfolios. Italian banks were stuck holding them. The market did eventually develop: large NPL portfolio sales and securitizations, helped by Italy's GACS scheme (a state guarantee on senior tranches of securitized bad loans), drove the ratio down sharply in the late 2010s.

3. The double-dip recession

The euro area suffered two downturns back to back: the 2008 to 2009 financial crisis, then the 2011 to 2013 sovereign debt crisis. Italy's economy barely grew for a decade. More borrower defaults, fewer recoveries.

4. Regulatory tightening forced the cleanup

The European Central Bank (ECB) took over supervision of the largest euro area banks in 2014 under the Single Supervisory Mechanism (SSM). It pressured banks to recognize bad loans honestly and set NPL reduction targets. The ECB's guidance to banks on NPLs accelerated the fall. What looks like a natural decline was partly regulators forcing the issue.

Reading the three metrics together

Never read one in isolation. A worked comparison:

| Bank | NPL ratio | Coverage | Read |

|------|-----------|----------|------|

| Bank A | 2% | 65% | Clean book, conservatively provisioned. Healthy. |

| Bank B | 2% | 30% | Clean-looking, but under-reserved. Watch for surprises. |

| Bank C | 10% | 60% | Ugly book, but losses largely recognized. Known problem. |

| Bank D | 10% | 30% | Ugly book AND under-reserved. The danger zone. |

Bank D is where crises start. High bad loans plus thin coverage means large unrecognized losses lurking. When they surface, capital gets wiped out fast.

This is exactly the profile many Italian and Greek banks showed in the early 2010s, and why the cleanup took a decade and, in some cases, state intervention.

A quick note on the newer term: NPE

You will increasingly see NPE (Non-Performing Exposure) instead of NPL in European reporting. It is a broader EBA-defined measure that includes not just loans but other exposures such as debt securities and off-balance-sheet commitments. For most analysis the intuition is identical: it is the share of credit that has gone bad. Just know that NPE ratios can differ slightly from old NPL ratios for the same bank.

Key takeaways

• NPL ratio = bad loans / total gross loans. US aggregate has run near or below 1% recently; euro area fell from roughly 8% (2014) to under 2% by the mid-2020s. Italy peaked above 15%.
• Coverage ratio = allowances / NPLs. It tells you whether losses are already recognized. Europe often targets 40 to 60%. Low coverage plus high NPLs is the danger zone.
• Cost of risk = period provisions / total loans, in bps. Benign is 20 to 50 bps; crises push it past 100 bps. This is the metric that directly cuts profit.
• The Italy vs US gap was structural, driven mainly by slow foreclosure courts, a thin secondary market, a double-dip recession, and later ECB-forced cleanup, not by wildly worse lending.
• Always read the three together. A single ratio can mislead; the combination reveals whether a bank's problem is visible, provisioned, and manageable, or hidden and dangerous.