On modelling non‐performing loans in bank efficiency analysis

Abstract

This paper introduces a methodological framework for the examination of non‐performing loans (NPLs) as reverse outputs under the extended strong disposability assumption, which does not require NPLs to be jointly produced with net loans, as it is implied when they are modelled as undesirable outputs. A directional distance function model with reverse outputs is used and is compared with the models that treat NPLs as an undesirable output under the weak disposability and the constrained weak disposability assumptions with uniform and non‐uniform abatement factors. The model is applied at the case of European banks and for the sample to be representative the banks are chosen based on the European Banking Authority (EBA) stress test of 2021. The results indicate that the reverse output model have greater discriminatory power relative to all other models.