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Real Estate Booms and Banking Busts: An International Perspective

  • Richard J. Herring
  • Susan Wachter

Real estate cycles and banking cycles may occur independently but they are correlated in a remarkable number of instances ranging over a wide variety of institutional arrangements, in both advanced industrial nations and emerging economies. During the recent Asian financial crisis, the most seriously affected countries first experienced a collapse in property prices and a weakening of the banking systems before experiencing their exchange rate crises. Countries where banks play a more dominant role in real estate markets and hold a greater percentage of assets are the most severely affected during such a crisis. In this paper, the authors develop an explanation of how real estate cycles and banking crises are related and why they occur. The authors first discuss how real estate prices are determined and why they are so vulnerable to deviations from long-run equilibrium prices, paying special attention to the role of the banking system in determining prices. Increases in the price of real estate may increase the economic value of bank capital to the extent that banks own real estate. This then increases the value of loans collateralized by real estate and may lead to a decline in the perceived risk of real estate lending. For these reasons, an increase in real estate prices may increase the supply of credit to the real estate industry which is then likely to lead to further increases in real estate prices. The opposite is also true. A decline in the price of real estate will decrease bank capital by reducing the value of the bank's own real estate assets as well as reduce the value of loans collateralized by real estate. This may lead to defaults, thus further reducing capital. A decline in the price of real estate is also likely to increase the perceived risk in real estate lending. All of these factors reduce the supply of credit to the real estate industry. Supervisors and regulators may also react to the resulting weakening of bank capital positions by increasing capital requirements and instituting stricter rules for classifying and provisioning against real estate assets, leading to even further decline in prices and supply of credit to the real estate industry. In order to explain how real estate cycles begin, the authors turn to a model of land prices developed by Mark Carey that details the role of optimists in the process. They then bring in the role of non-financial variables as well as of banks and then turn to the part played by "disaster myopia" -- the tendency over time to underestimate the probability of low-frequency shocks -- in determining cycles. Other factors that contribute to cycles are inadequate data and weak analysis by bank managers as well as "perverse incentives" -- one result of "disaster myopia" that occurs when lenders believe that they can accept higher loan-to-value rations, weaker commitments or guarantees and looser loan covenants without increasing their risk of loss. Using this framework of the interactions between the real estate market and bank behavior, the authors interpret recent examples of real estate booms linked to banking crises in Sweden, the United States, Japan and Thailand. They then discuss measures that can be taken to limit the amplitude of real estate cycles and ways to insulate the banking system from real estate cycles. They believe that the heart of the problem is the structure of the real estate market and that cycles can be avoided by taking measures that counter: The bias towards optimism; Excessive leverage; Disaster myopia; Inadequate data and weak analysis; Perverse incentives. The authors detail their recommendations for avoiding these problems in the future. These include the development of an options market for commercial real estate, greater reliance on equity financing, changes in supervisory policy that allow the identification of vulnerable banks before they become weak banks, better publication of information relevant to the valuation of commercial real estate projects, and refraining from providing full protection to all bank creditors, especially sophisticated creditors such as corporations, banks, and institutional investors.

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File URL: http://fic.wharton.upenn.edu/fic/papers/99/9927.pdf
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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 99-27.

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Date of creation: Jul 1999
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Handle: RePEc:wop:pennin:99-27
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