Earnings Momentum and Bank Loan Quality

Abstract

In the aftermath of the financial crisis, bankers, regulators, lawmakers, and others claimed that bank CEOs’ incentives to sustain high past earnings growth (earnings momentum) led banks to originate lower quality loans, which subsequently defaulted at high rates in the financial crisis. We examine this claim. Using a sample of 267 U.S. bank holding companies from 2001 to 2009, we find banks with high earnings momentum have more future non-performing loans (NPLs). In contrast, neither CEO compensation incentives nor benchmark beating metrics are associated with future NPLs. Consistent with career concerns, the effect of earnings momentum on future NPLs is concentrated in banks with younger CEOs. We also find earnings momentum is positively associated with bank failures. Further analyses show results are independent of competition pressures and earnings guidance. Our study contributes to the literature on factors associated with the dramatic collapse of the banking system during the financial crisis.