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This paper investigates the presence of spatial dependence in the non-performing loans (NPLs) ratio of small Italian cooperative banks. As these financial intermediaries operate in a delimited area, the strategies they adopt to recover NPLs can produce spatial spillover effects on the ability of neighbouring banks to recover credit. Furthermore, small banks’ reliance on the relationship lending technique to select and monitor borrowers suggests a similar ability to identify underperforming borrowers, which may have a negative impact on the community in which those banks operate. Our empirical estimations provide strong evidence for both spatial and spatial–temporal variables driving impaired loans in local banks. The results indicate different effects of the spatial terms, showing a direct positive effect of the contemporaneous spatial lag variable and a negative effect of the space–time autoregressive coefficient. Whereas the former effects can be ascribed to changes in the macroeconomic cycle, the latter confirms the insight that the recovery capacities of local banks can be harmed by neighbouring banks’ credit recovery policies.