Does Fast Loan Growth Predict Poor Performance of

Commercial Banks? The case of commercial banks in

Nepal
1.1 Background of the study
The main investment portfolio of depository financial institutions, loan portfolio,
depends on various factors like the general economic condition, industry specific
slackness or peak, government regulation, catastrophic events, funding sources, cost of
fund, loan interest rate, competition and more (Rose & Hudgins, 2008). The growth and
decline in value of loan portfolio is explained by these factors. The performance of bank
depends on how their loan portfolio performs and how effectively the bank has scanned
its borrowers’ creditworthiness. The non-performance of loan results in various types
of risks like reduced profitability due to high bad debts; liquidity risk due to the
mismatch in cash inflows and outflows or mismatch between maturities of assets and
liabilities; and interest rate risk due to change in interest rate risk. Similarly, the
objective of value maximization also depends on the performance of loan. The outsiders
and the stock holders also look at the loan portfolio and its riskiness while making
investment decision.
The economic development of any country is also determined by the
development of banking system of that country (Asteriou & Spanos, 2018). In
expansionary economy, bank credit also expands and the riskiness of loan portfolio also
increases. The credit boom generally ends with the poor economic performance and
sometime the crash. More credit-intensive expansions tend to be followed by deeper
recessions (in financial crises or otherwise) and slower recoveries and such financial
recession are costlier (Jorda, Schularick, & Taylor, 2013). The expansion of credit is
necessary for the expansion of economy or the development of an economy but the fast
expansion or credit may result in an accident. The boom in credit to the household
sector and the enterprises that ate not financial are the important in explaining in
financial crashes or instability in financial system (Anundesen, et al. 2016). They also
found that global housing market developments have predictive power for domestic
financial stability and the probability of a crisis increases markedly when bubble-like
behavior in house prices coincides with high household leverage.
According to Baker (2008), the subprime credit crisis was started in the US in
2007 by the failure of a giant bank of America, Lehman Brothers, a 158-year old
investment bank, which affected the whole world. It has developed into an international
financial crisis with potentially severe consequences for the developing countries and
their growth models. The financial crisis happened because banks were able to create
too much money, too quickly, and used it to push up house prices and speculate on
financial markets. Fueled by the access to cheap credit, a housing bubble developed in
the US from 2001, outstanding credit volumes skyrocketed. The Federal US followed
a low interest rate policy, while the banks marketed risky mortgage products
aggressively and increased the lending to sub-prime customers at reduced risk
premiums.
While providing the loan to the customers, banks collect and analyze detailed
and exclusive information about the financial prospects of their customers, many of
whom are local businesses and households. The growth of loan to the business indicates
that the business are growing and requiring more loan which is the indication of good
economic prosperity in coming future. Therefore, banks’ loan portfolios contain
potentially useful information about local economic conditions as commercial banks
are the main financial institutions whose activities directly reflect the true economic
conditions. Information in loan portfolios aggregated to the state level is associated with
current and future changes in statewide economic conditions (Khan & Ozel, 2016).
Furthermore, the provision for loan and lease losses contains information incremental
to leading indicators of economic activity and recessions. Loan portfolio information
also roughly helps to improve predictions of economic conditions.
The high growth of loan is also related to the credit standards set by bank. A
loose credit standard promotes more loan more borrowers who are substandard in loan
repaying capacity. A bank with loose credit policy may have to bear more default loan
and more loan loss provision. This types of risk (default risk) also affect the liquidity
position and profitability of the bank. The loan growth is also an indicator of riskiness
and future performance of bank. Foos, Norden, & Weber (2010) also found that loan
growth leads to an increase in loan loss provisions, to a decrease in relative interest
income, and to lower capital ratios. Further, loan growth also has a negative impact on
the risk-adjusted interest income. These results suggest that loan growth represents an
important driver of the riskiness of banks.

Data
10 years of loan provided by bank
Annual growth rate and 3year compounded growth rate
All commercial banks
Pooled data
Analysis in portfolio level
Portfolio according to size and loan growth rate (4 quartiles)

Performance measures:
1. profitability
Return on loan
Return on equity
Return on total assets
Interest spread
 2. liquidity
cd ratio
nrb to total deposit
nrb balance to total liability
3. market performance
return on stock (capital gain)
dividend yield
beta
jensen’s alpha
sharpe idex
treynor’s index

Test of Granger causality = market return is causes loan growth or loan growth causes
market return?

How earlier the market price of share can predict poor/better performance of a bank?
Auto regressive model.

Anundesen, A. K., Gerdrup, K., Hansen, F., & Kragh-Sorenson, K. (2016). Bubbles and Crises:
The Role of House Prices and Credit. Journal of Applied Econometrics, 31(7).
doi:10.1002/jae.2503

Asteriou, D., & Spanos, K. (2018). The Relationship between Financial Development and
Economic Growth during the recent Crisis: Evidence from the EU. Financial Research
Letters. doi:10.1016/j.frl.2018.05.011

Baker, D. (2008). The housing bubble and the financial crisis. Real-world economics review,
46.

Foos, D., Norden, L., & Weber, M. (2010). Loan growth and riskiness of banks. Journal of
Banking and Finance, 34, 2929-2940. doi:10.1016/j.jbankfin.2010.06.007

Jorda, O., Schularick, M., & Taylor, A. M. (2013). When Credit Bites Back. Journal of Money,
Credit and Banking, 45(2), 3-28. doi:10.1093/qje/qjx004

Khan, U., & Ozel, N. B. (2016). Real Activity Forecasts Using Loan Portfolio Information.
Journal of Accounting Research, 54(3), 895-937. doi:10.1111/1475-679X.12110

Rose, P. S., & Hudgins, S. G. (2008). Bank Management and Financial Services. Boston:
McGraw-Hill.