Over-Optimism, Credit Expansion and Banks’ Risk and Return

Abstract

This paper examines the relationship between periods of rapid credit expansion and predictors of the future substandard performance of banks. Findings based on European and U.S. samples indicate that rapid credit expansion is significantly related to elevated future credit risk and poor future returns of individual banks. We consider the over-optimism hypothesis as a plausible explanation for this phenomenon: increasing past loan growth is related to increasing future bad loans and decreasing bank returns. This key factor, which seems to be the case in both Europe and the U.S., could be the outcome of general over-optimism concerning the bank’s prospects that justify credit expansion as an appropriate reaction to competitive advantages possessed by the bank. Finally, from a macroeconomic perspective, credit risk is found to be countercyclical (procyclical) to increasing GDP per capita, while economic freedom contributes to decreasing credit risk and inflation increases bad loans. We view over-optimism as a form of excessive risk-taking by bankers that, ultimately, is going to generate concerns over long-term bank performance.