Monday, December 5, 2011

Credit Growth and Bank Soundness: Fast and Furious?

Episodes of rapid growth in bank credit to the private sector are rather frequent events(Terrones, 2004; Barajas et al., 2007). In the business cycle context, financial accelerator mechanisms can explain such episodes relatively well: favorable investment opportunities and vigorous economic activity push asset prices up, which in turn increase the creditworthiness of borrowers and let them borrow more against higher values of collateral.

Hence, credit is procyclical and grows in tandem with income. In addition, countries move up the ladder in terms of financial development, generating an upward trend in credit-to-GDP ratio. Several factors driving financial development can push the growth rate of credit far above the growth rate of income. For instance, financial deregulation (including lifting of capital account restrictions), increased competition, and financial innovation could cultivate credit booms, i.e., episodes of above-trend growth in credit-to-GDP ratio.

While increased credit availability often spurs economic growth helping savings to be channeled into investment, rapid credit growth also raises concerns about prudential risks. Prudential risks, defined as threats to financial stability stemming from the financial position of banks, can emerge both at the micro and macro levels. At the micro level, fast expansion of loan portfolios may lead to capacity constraints (to manage risks, gather information, or assess quality of applications) starting to bind and new loans being originated without adequate screening and risk management (Berger and Udell, 2004).

At the macro level, expansion may involve strategic competition concerns whereby banks take on more risks or financial institutions become more interconnected and the system, as a whole, becomes riskier. Or, it may involve reliance on the same asset classes and marginal loans, i.e., loans made to borrowers that are riskier and potentially more exposed to shocks that may be correlatedacross borrowers. For instance, in the run-up to the recent global financial crisis, several studies identify the mortgage credit boom in the U.S. as one of the culprits because it increased the exposure of the financial system to a single shock, that is, a fall in house prices (see, for instance, Dell’Ariccia, Igan, and Laeven, 2008). Hence, rapid credit growth episodes can decrease loan quality, increase systemic risk, and deteriorate bank soundness.

This posited relationship between credit growth and bank soundness is a dynamic one. In other words, credit growth affects and is affected by bank soundness. While most theoretical models predict a negative relation running from credit growth to bank soundness (see Dell’Ariccia and Marquez, 2006, and references therein), the sign of the feedback effect is ambiguous. It could be the case that bank soundness feeds positively into credit growth because sounder banks have more capacity (to manage risks or to deploy additional employees) and they can expand faster than others. Or, the feedback effect may be negative because less sound banks become more aggressive and take more risks as they bet all their resources in a last effort to survive.

This paper examines the risks associated with rapid credit growth taking into account the role of bank soundness as a determinant of credit growth. The econometric analysis is based on a simultaneous equation framework, where credit growth and bank soundness are modeled as depending on lagged values of each other and various macroeconomic and bank-specific factors. Thus, the analysis tests two hypotheses about the risks associated with rapid credit growth. The first is that rapid credit growth weakens banks. The second is that credit grows more rapidly in sounder/less sound banks.

World Bank. Author/Editor:Igan, Deniz;Pinheiro, Marcelo.December 01, 2011.Working Paper No. 11/278

Credit Growth and Bank Soundness: Fast and Furious?