Does credit growth predict lower returns for large banks?

Abstract

Prior research finds that bank credit growth predicts lower bank equity returns in subsequent years. Stocks of banks with high credit growth are initially overvalued. Eventually, these banks underperform. Shareholders realize their mistakes and lower share price, thus generating lower returns. We argue that such correction of mispricing happens to a lesser extent for large banks and show that for large banks, the decline in equity return following an increase in credit growth is minimal. This finding is consistent with government guarantees that protect shareholders of large banks, but not small banks.