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

I find that a 1% increase in aggregate bank credit growth implies that the excess returns of bank stocks over the next one year are lower by nearly 3%. Unlike most other forecasting relationships, 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. This effect is robust to the exclusion of data from the crisis years and to the inclusion of several popular forecasting variables used in the literature. Credit growth also predicts returns of investment banks and of bank-dependent firms but does not predict returns for any other asset class. I show that this predictive variation in returns reflects the representative agent’s rational response to a small time-varying probability of a tail event that impacts banks and bankdependent firms. Consistent with this hypothesis I show that the predictive power, as measured by the absolute magnitude of the coefficient on credit growth and the adjusted-R at the the 1-year horizon, depends systematically on variables that regulate exposure to tail risk. Historically, the probability of a tail event increases in a recession, therefore this mechanism also explains the observed correlation between variation in aggregate bank credit level and business conditions. ∗First draft: January 2011; John E. Anderson School of Management, University of California at Los Angeles, CA 90095; Email: [email protected]; Tel: (310) 740 0196. I would like to express my immense gratitude to my Committee Co-Chairs, Francis Longstaff and Hanno Lustig, for their invaluable guidance. I would also like to thank Antonio Bernardo, Mark Garmaise, Ivo Welch, Andrea Eisfeldt, Eduardo Schwartz, and seminar participants at the UCLA Brown Bag for helpful comments. All errors are my responsibility.