Why does rapid loan growth predict bad performance for banks?

By Rüdiger Fahlenbrach, Swiss Finance Institute Professor at the Ecole Polytechnique Fédérale de Lausanne (EPFL), Switzerland

It is well known that credit booms usually end badly and are followed by poor economic performance. But it is less clear what is causing this poor performance. It could be explained by macroeconomic phenomena. With this in mind, banks would rationally grant more loans because of the existence of good lending opportunities, without taking more risks, but the economy would unexpectedly experience a shock that would end the credit boom and lead to bad lending. performance. Therefore, a credit boom would be followed by slow economic growth. This view was prevalent among central bankers and practitioners in the boom years leading up to the recent financial crisis. For example, Alan Greenspan and Ben Bernanke both testified that the initial growth in mortgage credit and housing prices was attributed to fundamental economic improvements, such as increased productivity and increased income.

However, it may also be that the end of a credit boom is the result of the poor performance of weak loans made by banks during that credit boom. In this light, bank lending increases because banks fail to fully understand the risks of new loans and thus offer riskier loans than they realize. As the risks of these loans materialize, underperforming loans weaken banks and reduce the supply of credit, and the unavailability of new loans leads to poor economic performance. A supply-side explanation for the expansion of mortgage credit would argue, for example, that subprime credit was funded by the rapidly developing securitization market and that lax lending standards associated with securitization led to riskier loans. The resulting difficulties for banks then spilled over to the real economy.

From the perspective of bank executives, it is important to understand whether the bad end of a credit expansion is due to a decrease in demand for new loans or a reduction in the number of new loans granted by banks over- developed. If this is the case, banks should focus on risk management processes that allow them to react quickly to changes in macroeconomic conditions, so that they correctly understand the changing demand for loans and do not interpret them. mistakenly as proof that their loans are too expensive. If it is the latter case, banks must be careful not to increase their loan portfolios quickly and must ensure that when they do, it is not because they are charging too little for loans. riskier loans.

Recent evidence helps shed light on these issues. A review of all publicly traded U.S. banks between 1972 and 2014 shows that aggressive growth in bank lending predicts low stock market returns later. The effect is significant; the difference in stock market performance between high-growth lending banks and low-growth banks over the three years after the measurement date exceeds minus 12 percentage points. The results cannot be explained by the effects of economic conditions because the study only examines banks headquartered in the United States, and therefore economic conditions are common to all banks. Fast growing US banks are compared to slow growing US banks.

The underperformance of fast-growing banks seems confusing at first glance. How can we explain it? A bank can quickly grow its loan portfolio by undervaluing its loans. As a result, he will face strong demand for his loans, and his loans will increase if he has enough capital to support more loans. In the short term, investors generally won’t be able to assess whether the bank’s lending is increasing because it is undervaluing its loans. Ultimately, however, the riskier loans will have a higher default rate, and it will become evident that the bank has grown by offering riskier loans. Such a bank will experience an increase in loan loss provisions relative to other banks. A bank that undervalues ​​loans may do so because it is overly optimistic about the future performance of borrowers, in which case its provisions for concurrent loans will be smaller and will not reflect the fact that it is making riskier loans.

Evidence suggests that banks that grow their loan portfolios faster make lower quality loans. Banks with fast growing loan portfolios have a much higher return on assets (ROA) than banks with the lowest loan portfolio growth during the measurement period. However, for three years in a row after a period of strong loan growth, banks that grew rapidly experienced a significant drop in their ROA compared to other banks. Banks with high loan growth also have lower loan loss allowances than banks that experienced low loan growth in years of high growth. But again, the order reverses over the next three years, so that in the third year after the high growth period, high growth banks have significantly higher loan loss provisions than non-cash banks. low growth. The loan loss provisions of high-growth banks increase significantly compared to the loan loss provisions of low-growth banks every year over the next three years. These results are inconsistent with the fact that banks choose to increase their loan portfolios by making riskier loans and properly provisioning the larger risks involved. If this were the case, a bank’s loan loss allowance would have to be higher and reflect the increased risk of new loans. Too much optimism, however, could explain these findings: Banks that grow rapidly on loan growth don’t seem to believe they are lending worse than slow-growing banks. It can also be shown that equity analysts are also surprised by the poorer performance of high growth banks as their forecasts are too optimistic for high growth banks compared to low growth banks.

These results cannot be explained by post-merger integration problems. One way for banks to grow quickly is to acquire other banks and their loan portfolios, and banks could face unexpected difficulties and costs when integrating an acquired bank. But when one distinguishes between organic loan growth and loan growth through acquisitions, the evidence of riskier loans is mainly due to organic loan growth. In other words, high growth banks do not seem to be acquiring banks with riskier loans; they provide these riskier loans themselves.

In summary, the evidence suggests that banks that increase their loan portfolios quickly make loans that underperform loans from other banks; that investors and equity analysts do not anticipate this lower performance; and that these banks do not build up sufficient reserves for loans, which suggests that they underestimate the risk of these loans. The phenomenon described could arise because a bank is overly optimistic about the outlook for its loans. However, other somewhat less benign explanations are also possible. It could be, for example, that in their effort to grow, the managers of a bank put in place incentives that lead loan officers to grant riskier loans according to dimensions that are not directly observable by the managers who monitor the risk of these loans.

The references

Fahlenbrach, Rüdiger, Robert Prilmeier and René M. Stulz, 2016, Why does rapid loan growth predict bad performance for banks? Swiss Finance Institute working document, downloadable free of charge from: http://ssrn.com/abstract=2744687.