Banking with an Overreaction

We analyze the expectations of U.S. banks using the construct of “expected loss” from loan loss provisions and find evidence of departure from rational expectations, in particular overreaction to losses observed in the recent past. Our findings are explained by a model of belief distortion rather than any strategic accrual manipulation. To capture the unjustified belief (or sentiment) of banks, we construct a “Credit Risk Sentiment” (CRS) metric. Using CRS, we find the following evidence of neglect of risks by banks: improvement in sentiment is associated with a contemporaneous rise in credit growth and poor financial performance (as measured by an increase in bad loans and decline in profitability) in the future. But despite the neglect of risks by banks, shareholders fail to discipline them; CRS predicts lower equity returns in subsequent one to three years