Excessive Credit and Bank Risk

Abstract

This paper analyzes whether it is reasonable to base the regulatory measure of countercyclical capital buffer on the credit-to-GDP gap. While the credit gap has been found to be a good predictor for banking crises, it remains ambiguous whether this high probability of financial distress in times of excessive credit is due to an ‘exogenous’ increase in banks’ contribution to systemic risk arising from the economic context or whether banks actively change their behavior by choosing higher asset risk. We find a positive correlation between bank systemic risk and excessive credit that continues to be present once we control for the economic context in terms of asset price booms and the economic perspective. Additionally, we find higher bank asset risk for an increasing credit-to-GDP gap. These results suggest that banks domiciled in credit booming economies actively choose a riskier asset structure rather than suffer solely from increasing systemic risk arising from exogenous factors.