Credit Growth and Bank Soundness: Fast and Furious?

Abstract

This paper examines risks to bank soundness associated with rapid credit growth in a large set of countries. At a conceptual level, bank soundness may weaken during episodes of fast credit growth because of capacity constraints or competitive pressures as banks make riskier loans in order to expand their market shares. Credit growth may also be affected by bank soundness, however, the sign of the effect is ambiguous: it may be positive because sounder banks have more capacity or it may be negative because less sound banks become more aggressive in a last effort to survive. Using bank-level information in 90 countries between 1995 and 2005, we analyze the relationship between credit growth and bank soundness in an econometric setting that takes into account the potential two-way causality. We find limited evidence that credit growth deteriorates bank soundness. Yet, while sounder banks tend to grow faster at moderate-growth periods, credit growth becomes less dependent on soundness during credit booms. These findings shed some light on why, historically, credit booms are often associated with financial crises.