How bad is a bad loan? Distinguishing inherent credit risk from inefficient lending (Does the capital market price this difference?)

Small community banks and the largest banks experience higher ratios of nonperforming loans than other sizes of banks. To what extent does their nonperformance result from lending to riskier borrowers, and to what extent does it result from a lack of proficiency at loan making? Does market discipline punish or reward credit risk and lending proficiency? Using stochastic frontier estimation, we develop a technique to decompose banks’ ratio of nonperforming loans to total loans into three components: the best-practice ratio representing the inherent credit risk of the loan portfolio, the excess ratio representing lending inefficiency, and statistical noise. We apply the decomposition technique to data from 2010, 2013, and 2016 on top-tier U.S. bank holding companies. The largest banks with consolidated assets exceeding $250 billion experience the highest ratio of nonperformance among the five size groups. Our decomposition shows that the high ratio of nonperformance of the largest banks appears to result from lending to riskier borrowers, not inefficiency at lending. Restricting the sample to publicly traded bank holding companies, we find that the nonperformance ratio is negatively related to market value except at the largest banks. When the two components of the nonperformance ratio are used instead, we uncover a more informative underlying story: taking more inherent credit risk enhances market value at many more large banks and the value-enhancing effect increases sharply from 2010 to 2016, whereas lending inefficiency is negatively related to market value at all banks and more so from 2010 to 2016. Market discipline appears to reward riskier lending at large banks and discourage lending inefficiency at all banks − incentives that are both increasing over time.