Credit Expansion and Neglected Crash Risk*

Abstract

By analyzing 20 developed economies over 1920–2012, we find the following evidence of overoptimism and neglect of crash risk by bank equity investors during credit expansions: (i) bank credit expansion predicts increased bank equity crash risk, but despite the elevated crash risk, also predicts lower mean bank equity returns in subsequent one to three years; (ii) conditional on bank credit expansion of a country exceeding a 95th percentile threshold, the predicted excess return for the bank equity index in subsequent three years is −37.3%; and (iii) bank credit expansion is distinct from equity market sentiment captured by dividend yield and yet dividend yield and credit expansion interact with each other to make credit expansion a particularly strong predictor of lower bank equity returns when dividend yield is low.

Waking Up from the American Dream: On the Experience of Young Americans during the Housing Boom of the 2000s

“…This literature has generally found that the substantial rise in mortgage lending that fueled the housing boom was preceded by a large decline in lending standards and by a dramatic increase in securitization (e.g., Mian and Sufi , Demyanyk and Van Hemert , Dell'Ariccia, Igan, and Laeven ), although there is little evidence that individual financiers were aware of the macroeconomic consequences of their actions (Cheng, Raina, and Xiong ). More generally, our results on young households ending up with more mortgage debt in boom areas speak to the literature on the role of overoptimism in (housing market) boom‐bust cycles (see, e.g., Burnside, Eichenbaum, and Rebelo , Barron and Xiong, ). Finally, by incorporating home ownership in the analysis, we contribute to the recent literature that has attempted to link demography to business cycle fluctuations and wealth inequality (Jaimovic and Siu , Beaudry, Green, and Sand , Liang, Wang, and Lazear , Wolff ).…”

Real Anomalies

“…In addition, while we measure alphas relative to the CAPM, investment alphas survive when considering other often‐used benchmark asset pricing models, which highlights the robustness of this finding. Finally, as discussed in the introduction, similar empirical patterns apply for banks, which underscores the economic significance of the friction we analyze (Baron and Xiong (), Fahlenbrach, Prilmeier, and Stulz ()).…”

“…See also Baron and Xiong () for a cross‐country analysis suggesting a relation between aggregate credit expansion and bank overpricing.…”

Nonfinancial Firms as Cross‐Market Arbitrageurs

“…">Case 2.Even when equity and debt markets are integrated, mispricings can arise not just because of misperception of total firm value. They may also arise because of misperception of other factors such as volatility or tail risks (Baron and Xiong ()). When these possibilities are allowed, equity mispricing is not a sufficient statistic, and there can be separate movements in debt and equity mispricings. …”