The Profit-Credit Cycle
68 Pages Posted: 13 Dec 2018 Last revised: 6 Dec 2019
Date Written: December 2, 2019
Bank profitability leads the credit cycle. An increase in return on equity of the banking sector predicts rising credit-to-GDP ratios in a panel of 17 advanced economies spanning the years 1870 to 2015. However, increases in profitability also predict elevated crisis likelihood a few years later. These results are consistent with behavioral credit cycle models in which banks extrapolate past loan losses to expected future credit outcomes: following a sequence of positive news bankers become increasingly optimistic, expand credit, but they are systematically disappointed by future realizations. Using recent US data, we show that survey-based measures of optimism and profitability expectations are indeed tightly linked to past profitability, forecast credit growth, and display predictable forecast errors.
Keywords: Credit cycles, bank profitability, financial crises.
JEL Classification: E32, E44, G01, G21
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