size, as measured by market capitalization, and increases in leverage, and in the proportion of short-
term debt employed by the bank.
The forecasting relation between bank credit growth and bank stock returns is robust to several
empirical specifications. The results hold when I exclude the data for the financial crisis, and when I
include other forecasting variables used in the literature. Bank credit growth does not predict future
cash flows of bank stocks. It does, however, predict returns for investment banks and bank-dependent
firms. Tail events that impact banks can also affect investment banks. Like banks, investment banks
employ high leverage, rely on short-term debt, do not own substantial tangible assets and are more
sensitive to changes in the probability of a tail event. Finally, an increase in tail event risk also increases
expected returns of any direct equity claim on bank-funded projects, and this explains the negative
correlation between bank credit growth and returns of bank-dependent firms.
Bank credit growth does not strongly predict returns of any other asset class (non-financial firms,
treasury bonds or corporate bonds). This is possible if tail events result in large losses for projects
funded by banks, but do not impact other projects in the economy. Examples of such events are the Less
Developed Country Debt crisis of 1982, the Mexico crisis of 1994, the East Asian crisis of 1997, and
the Long-Term-Capital-Management crisis of 1998. Each of these events resulted in a large loss of cash
flows from projects funded by banks, and a significant drop in bank profitability and valuation.
However, there was no measurable effect on the performance of other projects in the economy. These
crises were not accompanied by a recession, and other important asset markets such as the stock and
housing markets, were relatively unaffected.
My paper is related to seminal work by Ba ron and Xiong (2017) and Schularic k and Taylor
(2012), who analyze the relati on between bank credit, macroe conomic conditions, and equit y
markets in more than 46 countries ov er 100 years. Schularick and Tayl or (2012), show that bank
credit expansion increases macroeconomic (crash) ris k in the near future. Baron and Xio ng (2017)
also document a negative cor relation between bank cred it and equity returns. Howev er, given the
results in Schularick and Tay lor (2012), they attribut e this negative relation to th e neglect of crash
risk by investors.
My results contrast with Baron and Xiong (2017) and Schularick and Taylor (2012) and are
consistent with a significantly different insight: bank credit simply responds to exogenous changes in
macroeconomic conditions as one would expect. As macroeconomic (tail) risk declines, bank credit
increases, and vice-versa. In other words, worsening macroeconomic conditions increase the risk of
potential borrowers (they hurt borrower's net worth or collateral values), and forward-looking
decisions by bank managers anticipate time variation in macroeconomic conditions. Thus, the
predictive ability of bank credit for equity returns is due to a simple ‘price of risk’mechanism: bank
credit increases, but expected equity returns are reduced with improving macroeconomic conditions.
My results are also consistent with the NPV rule (or the Q-theory) of investments that prescribes
banks evaluate lending opportunities by discounting projected cash flows at discount rates that
appropriately reflect investment risk. Thus, bank credit growth should be negatively correlated with
future macroeconomic (tail) risk.
Yet, Baron and Xiong (2017) and Schularick and Taylor (2012) document that bank credit
growth is sometimes positively correlated with future macroeconomic (crash) risk. How does one
reconcile the results? One possibility is that market frictions can sometimes cause deviations from
the NPV rule (Q-theory) of investments. An example of such a market friction is the agency cost of
One implication of this hypothesis is that banks actively fund projects with higher exposure tail risk. I return to this
question in section 3 below.