The Relation between Credit Growth and the Expected Returns of Bank Stocks

Abstract

Higher bank credit growth implies that excess returns of bank stocks over the next one year are lower by nearly 3%. Credit growth tracks bank stock returns over the business cycle and explains nearly 14% of the variation in bank stock returns over a 1-year horizon. I argue that the predictive variation in returns reflects investors' rational response to a small time-varying probability of a tail event that impacts banks and bank-dependent firms. Consistent with this hypothesis, the predictive power, as measured by the absolute magnitude of the coefficient on credit growth and the adjusted-R^2 at the 1-year horizon, depends systematically on variables that regulate exposure to tail risk.

Keywords: Bank equity returns, Tail risk, Bank credit growth

JEL Classification: G01, G02, G15, G21