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The Winner's Curse: Evidence on the Danger of Aggressive Credit Growth in Banking

Core Content

This document explores the concept of the "Winner's Curse" in the context of banking, focusing on how aggressive credit growth can lead to financial instability and increased loan write-offs. The authors, Thomas Kick, Thilo Pausch, and Benedikt Ruprecht, examine both theoretical and empirical evidence to support their analysis, using data from the German banking sector.

Main Questions

1. Can we theoretically explain why banks engage in excessive lending, leading to a Winner's Curse situation?
2. Can we identify weak banks that engage in excessive lending?
3. Is there empirical support for the Winner's Curse using data on German micro-level lending and industry loan portfolio information?

Key Theoretical Insights

• Winner's Curse in Banking: Banks with overly optimistic private signals about credit risk may extend more loans than optimal, leading to higher loan write-offs and financial instability.
• Auction Theory: Banks in the credit market receive noisy signals about the true risk level, which can lead to misjudged lending decisions.
• U-shaped Relationship: There is a U-shaped relationship between market power (measured by the Lerner index) and loan losses. Initially, higher market power reduces loan losses, but at higher levels, it increases them.
• Lending and Risk: Excessive lending can result in higher risk exposure and lower financial stability.

Empirical Analysis

The authors use a combination of macro and micro approaches to analyze credit growth and its impact on loan losses. They apply the HP-filter methodology to isolate the long-term trend in credit growth and use dummy variables to control for regional and temporal effects.

Definitions

• Adequate Credit Growth: Credit expansion that does not negatively impact risk exposure or earnings.
• Excessive Credit Growth: Lending beyond the optimal level, leading to higher loan write-offs and potential financial distress.

Variables Used

Main Findings

• Negative Coefficients: Indicate that adequate credit growth has a negative impact on loan write-offs.
• Positive Coefficients: Show that excessive credit growth leads to higher loan write-offs and an increased likelihood of capital support and restructuring mergers.
• U-shaped Pattern: Market power (Lerner index) initially reduces loan losses but increases them at higher levels, supporting the findings of Martinez-Miera & Repullo (2010).
• Robustness Checks: The use of county and administrative district dummies along with time dummies confirms the robustness of the results.

Empirical Results

Pooled OLS with Dummy Large Credit Growth

Pooled OLS with Gap Excessive Credit Growth

Pooled OLS with Relative Gap Excessive Credit Growth

Conclusion

• Theoretical Contribution: The authors provide a theoretical explanation for the Winner's Curse using auction and banking theory, linking it to overly optimistic expectations and excessive lending.
• Empirical Support: Excessive credit growth, identified through HP-filter measures, is associated with higher loan write-offs and an increased likelihood of financial distress.
• Market Power: The U-shaped relationship between market power and loan losses supports earlier findings by Martinez-Miera & Repullo (2010).
• Regulatory Implications: The study highlights the importance of both micro and macroprudential regulation in curbing excessive lending and maintaining financial stability.