Does Faster Loan Growth Lead to Higher Loan Losses

Abstract

During the last couple of years, concern has increased that the exceptionally rapid growth in business loans at commercial banks has been due in large part to excessively easy credit standards. Some analysts argue that competition for loan customers has greatly increased, causing banks to reduce loan rates and ease credit standards to obtain new business. Others argue that as the economic expansion has continued and memories of past loan losses have faded, banks have become more willing to take risks. Whichever explanation is correct, the acceleration in loan growth could lead eventually to a surge in loan losses, reducing bank profits and sparking a new round of bank failures. As the experience of the early 1990s made clear, such a slump in banking could not only threaten the deposit insurance fund but also slow the economy by discouraging banks from granting new loans.> The view that faster loan growth leads to higher loan losses should not be dismissed lightly; nor should it be accepted without question. If loan growth increases because banks become more willing to lend, credit standards should fall and loan losses should eventually rise. But loan growth can increase for reasons other than a shift in supply, for example, businesses may decide to shift their financing from the capital markets to banks, or an increase in productivity may boost the returns to investment. In such cases, faster loan growth need not lead to higher loan losses.> Keeton explains why supply shifts are necessary for faster loan growth to lead to higher loan losses and determines if supply shifts have caused loan growth and loan losses to be positively related in the past. On balance, he finds limited support for the view that supply shifts have caused loan growth and loan losses to be positively related. Data on business loans and delinquencies show that states experiencing unusually rapid loan growth tended to experience unusually big increases in delinquency rates several years later. His finding is tempered, however, by evidence on business loan growth and business credit standards suggesting that changes in loan growth are not always due to shifts in supply.

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