Finance: Research, Policy and Anecdotes

Capital buffer, loan growth and fragility

Two interesting papers from a recent conference in Frankfurt, showing the importance of too rapid expansion for both bank-level and systemic fragility and shedding doubt on whether the focus on higher capital standards should really be a first-order regulatory priority.

 

Moritz Schularick from Bonn likes to go for big questions – so in a recent paper with Oscar Jorda, Bjoern Richter and Alan Taylor, he asks whether bank capitalization can predict systemic fragility?  Using data for almost 150 years, the answer is: NO. Banks’ solvency has no value as a crisis predictor; liquidity indicators, such as the loan-to-deposit ratio and the share of non-deposit funding, have some predictive power, but the most robust and clearest crisis predictor is loan growth.  One consolation prize for the higher-capital-buffer-lobby: recoveries from financial crisis recessions are much quicker with higher bank capital (consistent with the recent experiences in U.S., Japan and Eurozone, I would add).

 

And to complement these macro findings with some micro-evidence, Rudiger Fahlenbrach, in joint work with Robert Prilmeier and Rene Stulz, uses bank-level from the U.S. over 40 years and shows that stocks of banks with high loan growth significantly underperform banks with low loan growth over the following three years, mostly due to higher loan losses stemming from riskier lending associated with rapid loan portfolio expansion. It is interesting that neither markets nor analysts pick up this phenomenon in time.

 

So, yes, capital buffers are important, but so is macro-prudential trying to affect the credit cycle!