The Effect of Banks’ Financial Position on Credit Growth: Evidence from OECD Countries David Rappoport Yale University PhD Student Research Workshop April 11th , 2011

Motivation • credit is important for the transmition of financial shocks into real activity and the lending channel of monetary policy • investigate the effect of banks’ financial position (profits, capital, liquidity) on credit growth, using a panel of 29 OECD countries • investigate the generality of previous findings using cross-section of banks in a single country • use of dynamic panel estimation techniques provides a nice alternative for the identification problem of this literature. Rappoport

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Outline

1

Economic Model

2

Data Description

3

Econometric Model a

identification

b

instrument set

4

Results

5

Robustness

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1. Economic Model • dependent variable: growth rate of outstanding loans, Lit

∆`it = log Lit − log Li,t−1 • might depend on lagged values (loan maturities > 1 year) • Banks’ financial position: 1

profits

2

equity capital

3

liquidity

• Other controls Rappoport

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Preliminaries Bank’s Balance Sheet Assets (Ait )

Liabilities

Lit + Lit + Secit + Mit

Dit + DIB it + Eit

IB

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Preliminaries Bank’s Balance Sheet Assets (Ait )

Liabilities

Lit + Lit + Secit + Mit

Dit + DIB it + Eit

IB

• loan-to-assets ratio, δit =

Lit , Ait

then

∆`t = ∆ log δt + |{z} ∆at | {z } portfolio choice

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The Effect of Banks’ Financial Position on Credit Growth

asset growth

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Preliminaries Bank’s Balance Sheet Assets (Ait )

Liabilities

Lit + Lit + Secit + Mit

Dit + DIB it + Eit

IB

• loan-to-assets ratio, δit =

Lit , Ait

then

∆`t = ∆ log δt + |{z} ∆at | {z } portfolio choice

• leverage, λit =

Rappoport

asset growth

Ait Eit

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Banks’ financial position 1

profits • Yi,t−1 (after tax) profits in year t − 1, if used to increase equity capital keeping leverage constant:

∆Ait = Yi,t−1 λi

or

∆ait =

Yi,t−1 λi = ROEi,t−1 Ai,t−1

• if Eit < 0 assume ∆Ait = 0 and set ROEi,t−1 = 0

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Banks’ financial position 1

profits

2

equity capital • cheaper source of funds managers moral hazard (Holmstrong and Tirole, 1997) • capital requirement imply nonlinear effect cf. Peek and Rosengren (1995); Thakor, (1996)

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Banks’ financial position 1

profits

2

equity capital

3

liquidity • selling securities cheaper source of funds adverse selection it • balance sheet liquidity, BSLit = Sec Ait Kashyap and Stein (2000)

• small banks more sensitive to this adverse selection, interacted this measure with fraction of small banks’ assets

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Other Controls • Economic conditions: • cost of deposits: ratio of total interest expenses to total deposits/deposits interest rates • expected returns: government bonds (Bernanke and Blinder, 1988) securities: return on domestic security markets probability of borrower’s default: (loan) provisions • business cycle: affect both the demand for credit and lending standards

• Organization of the bank sector bank size and diversification economies of scale in lending activities Rappoport

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2. Data Description • Aggregate information on banks at country level from OECD Bank Statistics database for 1980-2009 • Information available for bank groups in each country all banks: commercial banks (large and foreign), saving banks, cooperative banks, and other miscellaneous monetary institutions

• consider information at the country level, using the most comprehensive bank group for each country • database contains income statements and balance sheets (end of the period) • local currency figures transformed to real values using individual countries’ consumer price indices (CPI) Rappoport

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2. Data Description (cont’d) Lit Yit Eit Ait Secit INTEREST EXPENSESit Dit TOTAL PROVISIONSit iLENDING it πit iLONG-TERM it Pit AGG. DEMANDit GDPit

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outstanding loans (item 16) after-tax income (item 11) capital and reserves (item 19) balance sheet total (e-o-y item 25) securities (item 17) interest expenses (item 2) non-bank deposits (item 22) total provisions (item 8) nominal lending rate (IFS line 60P..ZF...) effective CPI inflation (OECD Price Indices) nominal long-term rate (OECD Fin Indicatros and IFS) nominal stock market index (OECD Fin Indicators and IFS) real private C + G + I (OECD GDP) real GDP (2000 prices OECD GDP)

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2. Data Description (cont’d) Lit Yit Eit Ait Secit INTEREST EXPENSESit Dit TOTAL PROVISIONSit iLENDING it πit iLONG-TERM it Pit AGG. DEMANDit GDPit

outstanding loans (item 16) after-tax income (item 11) capital and reserves (item 19) balance sheet total (e-o-y item 25) securities (item 17) interest expenses (item 2) non-bank deposits (item 22) total provisions (item 8) nominal lending rate (IFS line 60P..ZF...) effective CPI inflation (OECD Price Indices) nominal long-term rate (OECD Fin Indicatros and IFS) nominal stock market index (OECD Fin Indicators and IFS) real private C + G + I (OECD GDP) real GDP (2000 prices OECD GDP)

∆`it = log Lit − log Li,t−1 Yi,t−1 Ei,t−1 Ei,t−1 = Ai,t−1

ROEi,t−1 = CAPi,t−1 Rappoport

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2. Data Description (cont’d) Lit Yit Eit Ait Secit INTEREST EXPENSESit Dit TOTAL PROVISIONSit iLENDING it πit iLONG-TERM it Pit AGG. DEMANDit GDPit

outstanding loans (item 16) after-tax income (item 11) capital and reserves (item 19) balance sheet total (e-o-y item 25) securities (item 17) interest expenses (item 2) non-bank deposits (item 22) total provisions (item 8) nominal lending rate (IFS line 60P..ZF...) effective CPI inflation (OECD Price Indices) nominal long-term rate (OECD Fin Indicatros and IFS) nominal stock market index (OECD Fin Indicators and IFS) real private C + G + I (OECD GDP) real GDP (2000 prices OECD GDP)

BSLi,t−1 = DEPOSIT COSTSi,t−1 = PROVISIONSi,t−1 = Rappoport

Seci,t−1

Ai,t−1

INTEREST EXPENSEi,t−1

Di,t−1

TOTAL PROVISIONSi,t−1

Li,t−1

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2. Data Description (cont’d) Lit Yit Eit Ait Secit INTEREST EXPENSESit Dit TOTAL PROVISIONSit iLENDING it πit iLONG-TERM it Pit AGG. DEMANDit GDPit

outstanding loans (item 16) after-tax income (item 11) capital and reserves (item 19) balance sheet total (e-o-y item 25) securities (item 17) interest expenses (item 2) non-bank deposits (item 22) total provisions (item 8) nominal lending rate (IFS line 60P..ZF...) effective CPI inflation (OECD Price Indices) nominal long-term rate (OECD Fin Indicatros and IFS) nominal stock market index (OECD Fin Indicators and IFS) real private C + G + I (OECD GDP) real GDP (2000 prices OECD GDP)

LENDING RATEi,t−1 = LONG TERM RATEi,t−1 =

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iLENDING it πit iLONG-TERM it

The Effect of Banks’ Financial Position on Credit Growth

πit

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2. Data Description (cont’d) Lit Yit Eit Ait Secit INTEREST EXPENSESit Dit TOTAL PROVISIONSit iLENDING it πit iLONG-TERM it Pit AGG. DEMANDit GDPit

outstanding loans (item 16) after-tax income (item 11) capital and reserves (item 19) balance sheet total (e-o-y item 25) securities (item 17) interest expenses (item 2) non-bank deposits (item 22) total provisions (item 8) nominal lending rate (IFS line 60P..ZF...) effective CPI inflation (OECD Price Indices) nominal long-term rate (OECD Fin Indicatros and IFS) nominal stock market index (OECD Fin Indicators and IFS) real private C + G + I (OECD GDP) real GDP (2000 prices OECD GDP)

STOCK RETURNSit = log Pit − log Pi,t−1 − πit ASSETS/GDPit =

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Ait CPIit GDPit

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3. Econometric Model ∆`it = α(L)∆`it + β0 Xit + µt + µi + vit

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The Effect of Banks’ Financial Position on Credit Growth

(1)

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3. Econometric Model ∆`it = α(L)∆`it + β0 Xit + µt + µi + vit

(1)

i h Xit = Xitpre Xitendo

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3. Econometric Model ∆`it = α(L)∆`it + β0 Xit + µt + µi + vit

(1)

i h Xit = Xitpre Xitendo • Xitpre predetermined at the beginning of period t

"

ROEi,t−1 CAPi,t−1 CAP2i,t−1 DEPOSIT COSTSi,t−1 PROVISIONSi,t−1

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The Effect of Banks’ Financial Position on Credit Growth

BSLi,t−1 ASSETS/GDPi,t−1

#

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3. Econometric Model ∆`it = α(L)∆`it + β0 Xit + µt + µi + vit

(1)

i h Xit = Xitpre Xitendo • Xitpre predetermined at the beginning of period t

"

ROEi,t−1 CAPi,t−1 CAP2i,t−1 DEPOSIT COSTSi,t−1 PROVISIONSi,t−1

BSLi,t−1 ASSETS/GDPi,t−1

#

• Xitendo endogenous to the idiosyncratic shock vit

"

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LENDING RATEit STOCK RETURNSit

LONG TERM RATEit ∆AGG. DEMANDi,t

The Effect of Banks’ Financial Position on Credit Growth

#

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2.a. Identification Assumption 1 (weak exogeneity)


… vit ∆`i,t−1 , Xitpre , ∆`i,t−2 , Xi,t−1 , . . . , ∆`i1 , Xi1 = 0

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2.a. Identification Assumption 1 (weak exogeneity)


… vit ∆`i,t−1 , Xitpre , ∆`i,t−2 , Xi,t−1 , . . . , ∆`i1 , Xi1 = 0

Assumption 2 (i.i.d. idiosyncratic shocks)

…[vit vi,t−1 ] = 0

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2.a. Identification Assumption 1 (weak exogeneity)


… vit ∆`i,t−1 , Xitpre , ∆`i,t−2 , Xi,t−1 , . . . , ∆`i1 , Xi1 = 0

Assumption 2 (i.i.d. idiosyncratic shocks)

…[vit vi,t−1 ] = 0 • vit could be correlated with future predetermined and contemporaneous endogenous variables

• banks can be forward looking, as long as they do not have information about future shocks Rappoport

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Dynamic Panel Bias • ∆`i,t−1 is correlated with µi

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Dynamic Panel Bias • ∆`i,t−1 is correlated with µi ⇒ OLS upward biased

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Dynamic Panel Bias • ∆`i,t−1 is correlated with µi ⇒ OLS upward biased • within group transformation:

∆`i,t−1 −

Rappoport

1 T−1


∆`i1 + . . . + ∆`it + . . . + ∆`i,T−1
1 vi1 + . . . + vi,t−1 + . . . + vi,T−1 vit − T−1

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Dynamic Panel Bias • ∆`i,t−1 is correlated with µi ⇒ OLS upward biased • within group transformation:

∆`i,t−1 −

1 T−1


∆`i1 + . . . + ∆`it + . . . + ∆`i,T−1
1 vi1 + . . . + vi,t−1 + . . . + vi,T−1 vit − T−1

⇒ FE downward biased

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Dynamic Panel Bias • ∆`i,t−1 is correlated with µi ⇒ OLS upward biased • within group transformation:

∆`i,t−1 −

1 T−1


∆`i1 + . . . + ∆`it + . . . + ∆`i,T−1
1 vi1 + . . . + vi,t−1 + . . . + vi,T−1 vit − T−1

⇒ FE downward biased • differenced model:

∆2 `it = α(L)∆2 `it + β0 ∆Xit + ∆µt + ∆vit

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Dynamic Panel Bias • ∆`i,t−1 is correlated with µi ⇒ OLS upward biased • within group transformation:

∆`i,t−1 −

1 T−1


∆`i1 + . . . + ∆`it + . . . + ∆`i,T−1
1 vi1 + . . . + vi,t−1 + . . . + vi,T−1 vit − T−1

⇒ FE downward biased • differenced model:

∆2 `it = α(L)∆2 `it + β0 ∆Xit + ∆µt + ∆vit • ∆`i,t−1 and Xi,t correlated with vi,t−1 Rappoport

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2.b. Instrument Set • Difference GMM estimator: Arellano and Bond (1991) instruments for differenced model

Rappoport

∆2 `i,t−1

∆`i,t−2 , ∆`i,t−3 , . . .

∆Xitpre ∆Xitendo

pre pre ,... , Xi,t−2 Xi,t−1 endo endo Xi,t−2 , Xi,t−3 ,...

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2.b. Instrument Set • Difference GMM estimator: Arellano and Bond (1991) instruments for differenced model

∆2 `i,t−1

∆`i,t−2 , ∆`i,t−3 , . . .

∆Xitpre ∆Xitendo

pre pre ,... , Xi,t−2 Xi,t−1 endo endo Xi,t−2 , Xi,t−3 ,...

• System GMM estimator: Arellano and Bover (1995); Blundell and Bond (1998) combine with instruments for original model

Rappoport

∆`i,t−1

∆2 `i,t−1 , ∆2 `i,t−2 , . . .

Xitpre Xitendo

pre ∆Xitpre , ∆Xi,t−1 ,... endo endo ∆Xi,t−1 , ∆Xi,t−2 ,...

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GMM Instruments • In GMM framework using zi,t−1 gives T − 1 meaningful moment conditions:        

0 zi,1 0 .. .

0 0 zi,2 .. .

··· ··· ··· .. .

0 0 0 .. .

0

0

···

zi,T−1

       

• This make sense in “short” panels where T is small • Here 2 ≤ Ti ≤ 28 with T¯ = 16.6

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GMM Instruments • In GMM framework using zi,t−1 gives T − 1 meaningful moment conditions:        

0 zi,1 0 .. .

0 0 zi,2 .. .

··· ··· ··· .. .

0 0 0 .. .

0

0

···

zi,T−1

       

collapse

−−−−−−→

  0  z  i,1  ..  .  zi,T−1

      

• This make sense in “short” panels where T is small • Here 2 ≤ Ti ≤ 28 with T¯ = 16.6

⇒ collapse the instrument set Rappoport

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Table: Estimations by OLS, Fixed Effects and Difference GMM (1 lag of ∆`it ) Dependent Variable: ∆`it ∆`i,t−1 ROEi,t−1 CAPi,t−1 CAP2i,t−1 BSLi,t−1 DEPOSIT COSTSi,t−1 PROVISIONSi,t−1 LENDING RATEit LONG TERM RATEit STOCK RETURNSit ∆AGG. DEMANDit ASSETS/GDPi,t−1 Country effects H0 : CAPi,t−1 = CAP2i,t−1 = 0 Sargan test Arellano-Bond test Number of instruments R2 Number observations Number countries

(1) OLS 0.318*** 0.0505 -0.0741 0.00751 0.0759 -0.243*** -0.0681 0.424** 0.491* 0.0436* 1.250*** 0.00548 No [0.882]

(2) FE 0.188** 0.0446 -0.178 0.0384* 0.177* -0.0519 -0.428 0.106 1.068** 0.0269 1.079*** -0.0309*** Yes [0.021]

0.462 480 29

0.435 480 29

(3) 2 lags 0.182** 0.0446 -0.203 0.0373* 0.191* -0.0710 -0.484 0.0875 1.150*** 0.0298 1.101*** -0.0325*** Yes [0.004] [0.134] [0.004] 444

(4) 2 collapsed 0.106 -0.00231 -0.434 0.0312 0.0149 -0.222 -0.727 1.500* -0.0499 0.205*** 0.694 -0.103** Yes [0.059] [0.053] [0.013] 52

446 29

446 29

All regressions include year effects. Heteroskedasticity robust standard errors in parentheses. P-values in brackets. ***, **, * denote significant at 1%, 5% and 10%, respectively.

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Table: Estimations by OLS, Fixed Effects and GMM (2 lags of ∆`it ) Dependent Variable: ∆`it ∆`i,t−1 ∆`i,t−2 ROEi,t−1 CAPi,t−1 CAP2i,t−1 BSLi,t−1 DEPOSIT COSTSi,t−1 PROVISIONSi,t−1 LENDING RATEit LONG TERM RATEit STOCK RETURNSit ∆AGG. DEMANDit ASSETS/GDPi,t−1 Country effects ∆`i,t−1 + ∆`i,t−2 H0 : CAPi,t−1 = CAP2i,t−1 = 0 Sargan test Arellano-Bond test Number of instruments R2 Number observations Number countries

(1) OLS 0.215*** 0.267*** 0.0519 -0.173 0.0127 0.107* -0.297*** -0.0787 0.410** 0.548** 0.0493** 1.193*** 0.00477 No 0.482 [0.538]

(2) FE 0.151** 0.208*** 0.0465 -0.223* 0.0389** 0.211** -0.113 -0.334 0.0466 1.163*** 0.0347 1.093*** -0.0291*** Yes 0.359 [0.028]

0.510 464 29

0.467 464 29

(3) Difference GMM 0.153** 0.204*** 0.0296 -0.747 0.00241 0.0661 -0.367 -0.0118 1.744 -0.0436 0.225*** 0.560 -0.0702 Yes 0.356 [0.033] [0.717] [0.691] 52

(4) System GMM 0.243*** 0.241*** 0.0598 -0.389* 0.0521 0.0886 -0.486*** 0.288 1.521* -0.405 0.243*** 0.723* 0.00939 Yes 0.483 [0.029] [0.771] [0.983] 65

430 29

464 29

All regressions include year effects. Heteroskedasticity robust standard errors in parentheses. P-values in brackets. ***, **, * denote significant at 1%, 5% and 10%, respectively.

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Predicted Credit Growth by CAP 2 FE

∆l

system GMM

it

1.5

1

0.5

0

+1 s.d.

−0.5 mean

−1 s.d. −1 0

2

4

6

8

10

CAPi,t−1 Rappoport

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Predicted Credit Growth by CAP 2 FE

∆l

system GMM

it

1.5

1

• at sample mean: 0.5

• +1 s.d. 80/156 bp 0

• -1 s.d. -29/-55 bp +1 s.d.

−0.5 mean

−1 s.d. −1 0

2

4

6

8

10

CAPi,t−1 Rappoport

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Table: Estimates of the Effect of Bank Financial Position Dependent Variable: ∆`it ROEi,t−1

(1) 0.0598 (0.0651)

(2) ROE 0.0554 (0.0649)

(3) CAP

(4) BSL

ROE2i,t−1 CAPi,t−1

-0.389* (0.221) 0.0521 (0.0355) 0.0886 (0.185)

CAP2i,t−1 BSLi,t−1

-0.295 (0.264) 0.0515 (0.0398) 0.0553 (0.211)

(5) ROE2 0.165* (0.0997) 0.00174* (0.00103) -0.465** (0.230) 0.0558* (0.0331) 0.0957 (0.184)

BSL2i,t−1 ∆`i,t−1 + ∆`i,t−2 H0 : CAPi,t−1 = CAP2i,t−1 = 0 H0 : ROEi,t−1 = ROE2i,t−1 = 0 H0 : BSLi,t−1 = BSL2i,t−1 = 0 Sargan test Arellano-Bond test Number of instruments Number observations Number countries

0.483 [0.029]

0.473

0.515 [0.076]

0.482

0.457 [0.019] [0.189]

[0.771] [0.983] 65 464 29

[0.693] [0.972] 56 464 29

[0.638] [0.922] 59 464 29

[0.689] [0.967] 56 464 29

[0.869] [0.859] 68 464 29

(6) BSL2 0.0568 (0.0631)

-0.414* (0.244) 0.0453 (0.0349) 0.116 (0.744) -0.00152 (0.0183) 0.470 [0.023] [0.950] [0.871] [0.985] 71 464 29

All regressions include country and year effects and other controls. Heteroskedasticity robust standard errors in parentheses. P-values in brackets. ***, **, * denote significant at 1%, 5% and 10%, respectively.

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Table: Estimates Using Alternative Profit Measures Dependent Variable: ∆`it ROEi,t−1

(1)

0.0598 (0.0651)

(2) ROE even if E < 0 0.0594 (0.0652)

ROAi,t−1

(3) ROA

1.917 (1.451)

LEVERAGEi,t−1 CAPi,t−1

-0.389* (0.221) CAP2i,t−1 0.0521 (0.0355) BSLi,t−1 0.0886 (0.185) ∆`i,t−1 + ∆`i,t−2 0.483 H0 : CAPi,t−1 = CAP2i,t−1 = 0 [0.029] H0 : ROAi,t−1 = LEVERAGEi,t−1 = 0 Number of instruments 65 Number observations 464 Number countries 29

-0.399* (0.223) 0.0528 (0.0357) 0.0884 (0.185) 0.483 [0.029]

-0.433* (0.245) 0.0505 (0.0307) 0.0655 (0.180) 0.457 [0.025]

65 464 29

65 464 29

(4) ROA and LEVERAGE

1.882 (1.845) -1.570 (1.849) -15.40 (21.27) 0.799 (1.142) 0.0630 (0.148) 0.469 [0.692] [0.490] 68 463 29

All regressions include country and year effects and other controls. Heteroskedasticity robust standard errors in parentheses. P-values in brackets. ***, **, * denote significant at 1%, 5% and 10%, respectively.

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Table: Estimates Using Alternative Liquidity Measures Dependent Variable: ∆`it

ROEi,t−1

(1)

0.0598 (0.0651) -0.389* (0.221) 0.0521 (0.0355) 0.0886 (0.185)

CAPi,t−1 CAP2i,t−1 BSLi,t−1 BSLi,t−1 ∗ SMALLi,t−1

(2) BSL * SMALL 0.414** (0.175) -0.963*** (0.348) 0.0145 (0.0363)

(3) restricted sample -0.291*** (0.0987) -0.674* (0.394) 0.0292 (0.0357) 0.191 (0.183)

(4) SEC + RES ASSETS 0.0681 (0.0650) -0.392* (0.235) 0.0491 (0.0338)

0.00874* (0.00526)

(SEC+RES)/ASSETSi,t−1

-0.0588 (0.131)

DEPOSITS/ASSETSi,t−1 ∆`i,t−1 + ∆`i,t−2 H0 : CAPi,t−1 = CAP2i,t−1 = 0 Sargan test Arellano-Bond test Number of instruments Number observations Number countries

(5) DEPOSITS ASSETS 0.0874 (0.0661) -0.358 (0.250) 0.0472 (0.0332)

0.483 [0.029] [0.771] [0.983] 65 464 29

0.414 [0.00008] [0.002] [0.940] 65 249 18

0.632 [0.046] [0.002] [0.171] 65 249 18

0.460 [0.022] [0.779] [0.970] 65 464 29

-0.174* (0.0908) 0.508 [0.068] [0.423] [0.992] 65 464 29

All regressions include year effects and other controls. Heteroskedasticity robust standard errors in parentheses. P-values in brackets. ***, **, * denote significant at 1%, 5% and 10%, respectively.

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4. Robustness

• Results are robust to: • using DEPOSIT RATE instead of DEPOSIT COSTS • controlling for INFLATION and UNEMPLOYMENT • controlling for ∆GDP instead of ∆AGG. DEMAND • controlling for the components of ∆AGG. DEMAND: ∆CONSUMPTION, ∆INVESTMENT and ∆GOVERNMENT

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Table: Estimates Using Loan Provisions Dependent Variable: ∆`it ROEi,t−1 CAPi,t−1 CAP2i,t−1 BSLi,t−1 PROVISIONSi,t−1

(1)

0.0598 (0.0651) -0.389* (0.221) 0.0521 (0.0355) 0.0886 (0.185) 0.288 (0.678)

(2) LOAN PROVISIONS -0.0339 (0.0594) -0.135 (0.234) 0.107*** (0.0347) 0.538*** (0.179)

LOAN PROVISIONSi,t−1 ∆`i,t−1 + ∆`i,t−2 H0 : CAPi,t−1 = CAP2i,t−1 = 0 Sargan test Arellano-Bond for AR(2) Number of instruments Number observations Number countries

0.483 [0.029] [0.771] [0.983] 65 464 29

-1.476* (0.819) 0.549 [0.00002] [0.317] [0.669] 65 354 29

(3) restricted sample 0.0414 (0.0614) -0.256 (0.287) 0.102*** (0.0377) 0.453** (0.201) 0.324 (0.754)

0.530 [0.000001] [0.206] [0.664] 65 354 29

All regressions include year effects and other controls. Heteroskedasticity robust standard errors in parentheses. P-values in brackets. ***, **, * denote significant at 1%, 5% and 10%, respectively.

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Conclusions

• Between profits, capital and liquidity, capital appears to be the most important variable explaining subsequent bank loan growth in OECD countries • Profits do have some explanatory power and liquidity appears to be more important in countries with a larger fraction of smaller banks • The effect of capital is non-linear, as was expected due to regulation

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