Banking with an Overreaction

Abstract

Using data on loan loss provisions, we analyze expectations of US banks and find evidence of departure from rational expectations. In particular, we find that banks over- react to actual losses incurred in the recent past. In good times, the presence of overreaction leads to neglect of risks, resulting in a rise in credit growth. This subsequently results in higher non-performing loans and lower return on assets for banks when the risks get realized in future. Additionally, shareholders fail to adequately recognise the risky lending behavior of such banks, and earn predictably lower returns in subsequent years.

Keywords: Loan Loss Provision, Overreaction, Credit Growth, Equity Return

JEL Classification: G12, G21, G41