A bank’s core role is to accept deposits and make loans. New research by Swiss Finance Institute Professor Rüdiger Fahlenbrach from the École Polytechnique Fédérale de Lausanne, Professor Robert Prilmeier from Tulane University, and Professor René Stulzfrom the Ohio State University shows that aggressive bank loan growth predicts poor subsequent bank stock returns. Banks, equity analysts, and investors alike seem to underestimate credit risks.

A bank’s core role is to accept deposits from clients with excess liquidity and to loan the resulting money to customers with a lack of it.

Swiss Finance Institute Professor Rüdiger Fahlenbrach from the École Polytechnique Fédérale de Lausanne, Professor Robert Prilmeier from Tulane University, and Professor René Stulz from the Ohio State University investigated the loan growth and subsequent bank stock returns of US publicly listed banks between 1972 and 2004. Their empirical results show that banks that grow quickly make loans that perform worse than the loans of other banks in the three years following the high-growth period irrespective of economic cycles. For the first time, the researchers use data on the loan portfolios and loan-loss provisions of individual banks instead of data aggregated at the country level. They find that high-growth banks simultaneously have a high return-on-assets rate and low loan-loss provisions. But during the three years following the high-growth period the return-on-assets rate quickly deteriorates and loan-loss provisions increase substantially. The main explanation for this boom-and-bust cycle is that bank analysts and investors do not adequately assess credit risks and are overly optimistic about the risks of new lending opportunities. Particularly bank analysts seem to believe that bank growth is very persistent and overestimate earnings for high-growth banks relative to low-growth banks by 6 percent for a three-year horizon.

The full version of the September issue of SFI’s Practitioner Roundups is available at http://sfi.ch/system/tdf/Roundup_September18_English.pdf?file=1.