From the 'Long Depression' to the 'Great Recession': Bank Credit, Macroeconomic Risk, and Equity Returns

Abstract

In the U.S., over 1873-2014, an increase in bank credit is associated with a lower risk of a financial crisis in the near future. Bank credit expansion predicts lower excess returns and volatility for the aggregate stock market, and this predictive relation varies in the cross-section and is stronger for firms with higher "cash flow risk". Unlike recent literature, these results suggest that bank credit responds to rather than causes an increase in future macroeconomic risk. These novel results are attributable to the fact that I extend existing time-series data for bank credit in the U.S. by nearly a quarter-century, and use a measure of bank credit that accurately captures new credit actually available in the economy.

Keywords: bank credit, business cycles, rare events, return predictability

JEL Classification: E32, E43, E44, G11, G12