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Why does rapid loan growth predict poor performance for banks?

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By Rüdiger FahlenbrachProfessor of the Swiss Finance Institute 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 the cause of this poor performance is less clear. This could be explained by macroeconomic phenomena. In this view, banks would rationally grant more loans due to the existence of good lending opportunities, without taking more risks, but the economy would unexpectedly suffer a shock that would end the credit boom and lead to bad performance. Therefore, a credit boom would be followed by slow economic growth. This view was prevalent among central bankers and practitioners during the boom years leading up to the recent financial crisis. For example, both Alan Greenspan and Ben Bernanke in testimonies attributed the initial growth in mortgage credit and house prices to fundamental economic improvements, such as increased productivity and increased incomes.

However, it could also be that the end of a credit boom is the result of the poor performance of weak loans made by banks during this credit boom. From this perspective, bank lending increases because banks fail to fully understand the risks of new lending and therefore lend riskier than they realize. As the risks of these loans materialize, poorly performing loans weaken banks and reduce the supply of credit, and the unavailability of new loans leads to poor economic performance. A supply-based explanation of mortgage credit expansion would argue, for example, that subprime credit was funded by the rapidly developing securitization market and that the 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 managers, it is important to understand whether the bad end of a credit boom is due to a decrease in demand for new loans or a reduction in the number of new loans made by over-expanding banks. . If it is the former, banks need to focus on risk management processes that allow them to react quickly to changing macroeconomic conditions, so that they correctly understand changing demand for loans and don’t misinterpret it as evidence that their loans are too expensive. If it is the latter, then banks need to be wary of rapidly growing their loan portfolios and need to ensure that when they do, it is not because they are charging too little for larger loans. risky.

Recent evidence helps shed light on these questions. A review of all publicly traded U.S. banks between 1972 and 2014 shows that aggressive growth in bank loans predicts subsequent weak returns from bank stocks. The effect is considerable; the difference in equity performance between high loan growth banks and low loan growth banks over the three years from the measurement date exceeds minus 12 percentage points. The results cannot be explained by the effects of economic conditions, as 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 puzzling at first glance. How can we explain it? A bank can quickly grow its loan portfolio by undervaluing its loans. As a result, she will face strong demand for her loans, and her loans will increase if she has enough capital to support more loans. In the short term, investors generally won’t be able to gauge whether the bank’s lending is increasing because it undervalues ​​its lending. However, riskier loans will eventually have a higher default rate and it will become apparent that the bank has grown by making riskier loans. Such a bank will experience an increase in loan loss provisions compared to other banks. A bank that undervalues ​​loans may do so because it is too optimistic about borrowers’ future performance, in which case its concurrent loan provisions will be lower and not reflect the fact that it is making riskier loans.

Evidence suggests that banks that grow their loan portfolios faster provide worse loans. Banks with fast-growing loan portfolios have a much higher return on assets (ROA) than banks with the lowest loan portfolio growth over the measurement period. However, for three consecutive years after a period of strong loan growth, banks that grew rapidly experienced a significant decline in their ROA compared to other banks. Banks with high loan growth also have lower loan loss provisions than banks that experienced low loan growth in high growth years. But again, the order reverses over the next three years, so that by the third year following the high-growth period, the high-growth banks have significantly higher loan loss provisions than the low growth banks. High-growth bank loan loss provisions increase significantly relative to low-growth bank loan loss provisions each year for the next three years. These conclusions are not consistent with the fact that banks choose to grow their loan portfolios by granting riskier loans and by correctly provisioning the higher risk incurred. If this were the case, a bank’s loan loss provisions should be higher and should reflect the higher risk of new loans. An excess of optimism, however, could explain these results: banks that grow rapidly thanks to loan growth do not seem to believe that they are lending worse than banks that grow slowly. It can also be shown that equity analysts are also surprised by the poorer performance of high-growth banks insofar as their forecasts are too optimistic with regard to high-growth banks compared to low-growth banks.

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

In summary, the evidence suggests that banks that grow their loan portfolios quickly make loans that underperform other banks’ loans; that investors and equity analysts do not anticipate this poorer performance; and that these banks do not constitute sufficient reserves for the 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, less benign explanations are also possible. It could be, for example, that in their growth spurt, the managers of a bank establish incentives that lead loan officers to grant riskier loans along dimensions that are not directly observable by the managers who monitor the growth. risk of these loans.

The references

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