Bank Credit and the Risk of Recession: The Role of Business Cycle Shocks

Abstract

What is the relationship between current credit expansions and future recession risks and how do the business cycle shocks shape it? Using a quarterly dataset on 25 emerging and advanced economies, we document the boom-bust real effects of credit expansions: a one standard deviation increase in the bank credit growth reduces the risk of recession by 3 pp in one year but then raises it by nearly 10 pp in three years. The medium-run effect of credit on recession is not driven by endogenous monetary tightening---it is robust, though quantitatively slightly weaker, to controlling for the monetary conditions after a credit expansion and before the economy enters a recession. Further, we establish that the boom-bust recession response to bank credit is due to exclusively household credit expansions, especially when these expansions are driven by shocks to aggregate demand in advanced economies. In contrast, firm credit expansions exhibit no boom-bust effects and immediately increase the risk of recession, and this increase is primarily driven by an exogenous easing of credit supply by banks. As for a mechanism, we find that firm credit supply expansions lead to a rapid reduction of the total factor productivity. We show that this negative effect has substantial cross-sectional variation driven by the observed differences in asset prices (collateral booms), which jointly point to rising misallocation.

Keywords: Credit expansion, Household credit, Firm credit, Total factor productivity (TFP), Asset prices, Structural VAR, Local projection

JEL Classification: E32, E37, F32