Elsevier

Journal of Banking & Finance

Volume 34, Issue 12, December 2010, Pages 2929-2940
Journal of Banking & Finance

Loan growth and riskiness of banks

https://doi.org/10.1016/j.jbankfin.2010.06.007Get rights and content

Abstract

We investigate whether loan growth affects the riskiness of individual banks in 16 major countries. Using Bankscope data from more than 16,000 individual banks during 1997–2007, we test three hypotheses on the relation between abnormal loan growth and asset risk, bank profitability, and bank solvency. We find that loan growth leads to an increase in loan loss provisions during the subsequent three years, to a decrease in relative interest income, and to lower capital ratios. Further analyses show that loan growth also has a negative impact on the risk-adjusted interest income. These results suggest that loan growth represents an important driver of the riskiness of banks.

Introduction

Can banks grow without becoming riskier? Is loan growth associated with higher or lower risk-adjusted profitability? What is the relation between loan growth and bank capital? In this paper, we investigate the intertemporal relation between loan growth and the riskiness of individual banks. The current financial crisis represents a drastic example of what can go wrong with respect to the interplay of growth and risk in bank lending. Specifically, the growth in subprime mortgage lending, fueled by low interest rates, booming housing markets, credit securitization, and lax credit standards, has led to unprecedented credit losses and serious consequences for the global economy, highlighting the importance of the growth-risk nexus in bank lending (e.g., Dell’Ariccia et al., 2008, Demyanyk and van Hemert, 2008, Gorton, 2009).

However, there is little evidence on the relation between loan growth and risk at the individual bank-level (e.g., Laeven and Majnoni, 2003, Berger and Udell, 2004). Beyond macroeconomic forces and structural trends that affect all banks in a similar way there are many important reasons why individual banks increase their lending. For instance, banks may intend to seize new lending opportunities, expand to new geographic markets or gain market share with existing products and markets. Potential motives associated with such a loan growth might be diversification of the loan portfolio or cross-selling (e.g., Lepetit et al., 2008, Rossi et al., 2009). Moreover, potential mechanisms to increase lending are lowering interest rates or relaxing collateral requirements, loosening credit standards, or a combination of both (e.g., Dell’Ariccia and Marquez, 2006, Ogura, 2006). In addition, some banks rely on internal growth but others follow an external growth strategy by means of mergers and acquisitions (M&A). Under the presumption that new loans are granted to borrowers that were previously rejected, that were previously unknown or non-existent, or that ask for too low loan rates or too little collateral relative to their credit quality, loan growth may have adverse effects on bank risk.

To address the questions raised above, we examine the link between loan growth and three fundamental dimensions: the default risk of the loan portfolio, the interest income from lending, and the capital structure. For each of the three dimensions we rely on different empirical measures to capture the credit risk associated with bank lending, the compensation for risk taking, and the overall fragility of banks. Based on Bankscope data from more than 16,000 individual banks in 16 major countries during the period 1997–2007, we test three hypotheses on the relation between abnormal loan growth and riskiness of banks from developed countries with large banking sectors. Abnormal loan growth is defined as the difference between an individual bank’s loan growth and the median loan growth of banks from the same country and year.

Hypothesis 1

First, we investigate if and how past abnormal loan growth affects loan losses of individual banks. Given the experience that borrowers do not immediately default after they have received a bank loan (“loan seasoning”; e.g., Berger and Udell, 2004), we expect that loan growth translates into an increase of loan loss provisions with a time lag of several years.

Hypothesis 2

Second, we examine how abnormal loan growth influences the profitability of individual banks. If new loans are granted at lower rates, the average outstanding loan volume generates a lower relative interest income.

Hypothesis 3

Third, we analyze the impact of abnormal loan growth on bank solvency. On the one hand, if banks mainly fund their loan growth with new debt, the equity-to-total assets ratio decreases. On the other hand, although the issuance of new equity is more difficult and therefore happens less frequently, it is also possible to fund loan growth by increasing equity through retained earnings. We expect that loan growth leads to a decrease of the equity-to-total assets ratio.

The empirical analyses of these three hypotheses indicate that past abnormal loan growth is significantly positively related to loan losses and significantly negatively associated with bank profitability and solvency.

Our paper contributes to the banking and finance literature in several ways. Most of the related studies analyze the link between economic cycles, loan growth, and loan losses at the aggregate level, focusing on the macroeconomic determinants of loan growth. Our paper goes beyond these studies by analyzing the effects of abnormal loan growth on the riskiness of individual banks, controlling for country- and year-specific macroeconomic conditions, including effects from monetary and fiscal policy. Moreover, we focus on the intertemporal relation between loan growth and bank risk while most of the related studies consider the contemporaneous relation in the context of procyclicality. We also provide a comprehensive view on the riskiness of banks, analyzing three fundamental dimensions: credit risk associated with lending, income from lending, and bank solvency. Finally, our study is based on a large and international micro dataset, including the most important banking systems as well as different types of banks, to obtain comprehensive and robust results.

The remainder of this paper is organized as follows. In Section 2 we review the related literature and in Section 3 we describe the data. In Section 4 we report our main results and in Section 5 we present findings from further empirical checks. Section 6 concludes.

Section snippets

Related literature

Although the intertemporal relation between loan growth and bank risk, especially credit losses, has been studied at the macroeconomic level in several strands of the literature (e.g., booms and busts in credit markets, banking crises, procyclicality of bank regulation; e.g., Borio et al., 2001, Keeton, 1999), research is rather silent about the cross-sectional differences in this link.

Early empirical studies based on US micro data indicate that loan growth may lead to a subsequent increase of

The data

We analyze yearly balance sheet and income statement data from Bankscope on more than 16,000 individual banks from 16 major countries during the period 1997–2007. Our sample includes banks from the US, Canada, Japan, and 13 European countries.1 The banking systems of these countries, as measured by total banking assets in 2002, are among

Loan growth and loan losses

We now analyze the impact of past abnormal loan growth on contemporaneous loan losses. As stated in H1, we intend to test whether rapid loan growth in the past is associated with a gradual decrease of the average credit quality in a bank’s loan portfolio. Therefore, we regress contemporaneous loan losses (LLi,t, as defined above) on past abnormal loan growth (ALGi,tk), as indicated in the following model:LOGLLi,t=α+β1LOGLLi,t-1+k=14(βk+1ALGi,t-k)+β6SIZEi,t+β7EQASSETSi,t+γspecialization dummies

Loan growth and banks’ distance-to-default

Loan loss provisions, our primary measure of bank risk that we have analyzed so far, are a proxy for credit risk, which allows us to demonstrate the intertemporal relation between abnormal loan growth and future loan losses. However, a bank’s decision to expand the amount of loans granted may also affect other aspects of bank risk, which translate into lower solvency as well. Thus, we consider a well-established alternative measure of bank risk: the z-score z=Mean(EQASSETS+ROA)Std.Dev.(ROA) (

Conclusions

This study provides new comprehensive evidence on the intertemporal relation between abnormal loan growth and the riskiness of individual banks. Using Bankscope data on more than 16,000 individual banks from 16 major countries during 1997–2007, we test three hypotheses on the relation between past abnormal loan growth and loan losses, bank profitability, and bank solvency, controlling for year- and country-specific effects.

First, with respect to H1 we find that past abnormal loan growth has a

Acknowledgements

We thank an anonymous referee for valuable comments and suggestions. We are also grateful to John H. Boyd, Peter Raupach, Klaus Schaeck, Haluk Ünal, Wolf Wagner, and participants at the 3rd FIRS Conference 2008, the Southwestern Finance Association Meetings 2008, the European Financial Management Association Meetings 2008, the European Banking Symposium (ProBanker) 2008, the 14th Annual Meeting of the German Finance Association, the 11th Annual Meeting of the Swiss Society for Financial Market

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