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BANK LENDING, BANK PERFORMANCE AND COMMERCIAL PROPERTY PRICES

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Title: BANK LENDING, BANK PERFORMANCE AND COMMERCIAL PROPERTY PRICES


1
BANK LENDING, BANK PERFORMANCE AND COMMERCIAL
PROPERTY PRICES
Course on Financial Instability at the Estonian
Central Bank, 9-11 December 2009 Lecture 9
  • E Philip Davis
  • NIESR and Brunel University
  • West London
  • e_philip_davis_at_msn.com
  • www.ephilipdavis.com
  • groups.yahoo.com/group/financial_stability

2
PAPER 1BANK LENDING AND COMMERCIAL PROPERTY
PRICESsome cross-country evidence E Philip
Davis and Haibin Zhu
  • Revise and resubmit in Journal of International
    Money and Finance

3
Introduction
  • Growing interest in commercial property cycles
    and link to financial stability
  • Likely to be more volatile than residential given
    no intrinsic reservation value
  • Key role of banks in financing commercial
    property, while CP is also widely used as
    collateral for non-CP lending
  • Little empirical evidence on link from commercial
    property cycle to credit cycle, notably at
    international level

4
Literature review
  • Explanations of real estate cycles
  • Value determined by discounted future rents and
    investment by a valuation ratio
  • Distinctive features of asset market including
    heterogeneity, lack of central trading, high
    transactions costs, supply constraints
  • and use as collateral for bank loans
  • while external financing needed for construction
    and occupancy generally bank debt

5
  • So optimism raising demand can drive up prices
    while supply response slow - when supply comes on
    stream may be excessive relative to demand,
    driving prices down
  • Traditionally such a pattern is seen as requiring
    not just sticky supplies and rents but also
    irrationality basing expected profitability of
    construction on current prices
  • Examples are rules of thumb, myopic expectations,
    disaster myopia

6
  • Some urge cycles impossible with rational
    expectations, but following are possible
    rational causes
  • No short selling possible to stabilise market
  • Option value of investment in anticipated
    uncertainty
  • Long leases and use of credit
  • Collateral effects on borrowing capacity,
    including the financial accelerator
  • Risk shifting behaviour by banks
  • Empirical work in real estate literature
    illustrates interaction of investment, rents and
    prices, as well as scope for bubbles

7
  • Property prices and bank lending
  • Background commercial property price booms and
    busts preceding banking crises. Three dimensions
    of interaction
  • (i) Reasons property prices affect credit
  • Investment channel
  • Wealth effect on borrowers boosting credit demand
  • Banks ownership of property boosting capital base
    increases banks lending capacity
  • Financial accelerator effect making lending
    procyclical, especially if default risk
    underestimated in booms

8
  • (ii) Reasons lending could affect property prices
  • Liquidity effect
  • Credit raising real estate demand short term
    positive effect
  • Credit raising real estate supply long term
    negative effect
  • Supply of credit boosted when banks compete, e.g.
    after financial liberalisation
  • Directed to real estate if high quality borrowers
    shift to securities market or internal finance
  • Aggravated by moral hazard

9
  • (iii) Common economic factors for lending and
    real estate prices
  • Credit affected by shocks to variables such as
    GDP and interest rates
  • which also provoke demand and supply imbalances
    in real estate
  • (iv) Will changing nature of finance affect the
    credit-property price interrelation?
  • Note in particular that in financially-liberalised
    regime, effect of credit on prices is less
    likely (lending accomodates to demand rather than
    being rationed, while prices adjust in forward
    looking manner)

10
  • Extant empirical work
  • Country-specific studies of interaction with
    banking system
  • international studies mainly use residential or
    mixed prices, including prediction of financial
    instability
  • But no major academic research project has yet
    looked at threats to financial stability from the
    commercial property sector on a systematic,
    empirical, cross-country basis. This is an
    important motivation for our own work.

11
A model of real estate cycles (based on Carey and
Wheaton)
  • Economic environment
  • N investors
  • Heterogeneous valuation of properties, with a
    distribution of F(P)
  • Banks lending attitude varies over time wt
  • Bank lending function for investors L(Y, i, P,
    wt)
  • Supply K is fixed in short run but adjusts slowly
    in response to prices exceeding replacement cost,
    with separate lending function B(Y,I,P,wt)
  • Investment depends on current property prices,
    for reasons set out above irrationality, bank
    capital effects and credit market imperfections

12
Model
  • Market demand function (1), supply adjustment
    (2), new investment (3) and market clearing (4)

13
  • Relationship between property prices and bank
    lending (LtBt)
  • Higher current property prices increase bank
    lending
  • Higher Lt (e.g. due to financial liberalisation
    w) increases current property prices
  • Higher Bt reduces future property prices
  • Both affected by macroeconomic factors (Y, i)
  • Simplification 2 equations, 2 unknowns (K, P)

14
  • Hypothesis I (collateral/financial accelerator
    effect) An increase in commercial property prices
    has a positive impact on bank credit.
  • Hypothesis II (liquidity effect) Bank credit can
    have offsetting impacts on commercial property
    prices. New credit to the demand (investor) side
    may increase property prices in the short run,
    while new lending to the supply (constructor)
    side may tend to reduce property prices in the
    long run.
  • Hypothesis III (macro effect) Commercial
    property prices adjust to changes in
    macroeconomic conditions. Their dynamic
    adjustment depends on the characteristics of the
    property market in each country. In particular,
    if the supply is more elastic than the demand,
    the market reacts to a macro shock in the form of
    an oscillation around the new steady state
    otherwise property prices overshoot and then
    gradually converge to the new steady state.

15
Empirical analysis
  • Data
  • 17 countries Australia, Belgium, Canada,
    Denmark, Finland, France, Germany, Ireland,
    Italy, Japan, Netherlands, Norway, Spain, Sweden,
    Switzerland, the UK and the US
  • Main focus interrelation of real commercial
    property prices, GDP, investment, real credit and
    real short rates
  • Most countries true data is annual mainly
    used in our work
  • Stationarity as preliminary all have unit root
    except real short rate

16
  • Determination of commercial property prices
  • Error Correction estimation
  • Panel estimation, GLS, cross section weights,
    White standard errors. ECM tends to be highly
    significant
  • For all countries
  • Strong short run effect of GDP and credit growth
    implies high cyclical volatility consistent
    with model
  • Long run positive link to GDP and negative to
    credit plausible in terms of model
  • Positive real short rate financial
    liberalisation?
  • Subgroups
  • G-7, SOEs, bank and market oriented, crisis
    countries broadly similar to full panel
  • Main contrast is with crisis countries over
    1985-95 long run positive credit and negative
    investment effect, very high short run
    elasticities

17
Results of panel estimation
18
Interaction between bank lending and commercial
property prices
  • Above evidence gives no view on causality links
    between credit, commercial property prices and
    macroeconomic fundamentals
  • Granger causality suggests that commercial
    property prices most commonly precede credit (9
    countries) (possibly via effects on collateral
    and capital), but some reverse causality and
    interactions (7 countries)
  • Granger causality needs supplementing as only
    bivariate

19
  • Test for dynamic interaction
  • Method VECM if there exists cointegration
    (Johansen) VAR otherwise (CA, FI, IT, DK, NO,
    CH)
  • Endogeneity issue
  • Need for choice of recursive ordering in order to
    undertake Choleski decomposition
  • Preferred ordering GDP, commercial property
    prices, credit, investment, real short rates
  • GDP first and interest rate last reflects
    transmission mechanism lags
  • Investment after credit and prices due to supply
    lags
  • Prices before credit reflects role of collateral
    and price stickiness

20
  • Variance decomposition shows autonomy of
    commercial property prices (47 in 5 years)
  • Link to credit only significant in BE, IT, SE and
    CH - suggests Granger Causality suffered omitted
    variables bias
  • Wider range of countries show link to GDP main
    external influence on commercial property prices
  • Credit less autonomous, main influences on
    variance are GDP (33) and commercial property
    prices (20)
  • Overall, confirms influence of external shocks
    (GDP) on the nexus and of prices on credit
  • Variants largely confirm these results

21
VECM variance decomposition
22
  • Impulse response function
  • Response of CPP to credit positive short-term
    effect but negative long-term impact in most
    countries consistent with theory.
  • Response of CPP to GDP differ by characteristics
    of national markets. Two types of responses
  • Overshooting in 9 countries (Australia is a
    typical case)
  • Oscillation in 5 countries

23
Impulse response of prices to credit
24
Impulse response of prices to GDP
25
Conclusions
  • Presented a theoretical model which shows cycles
    emerge under plausible assumptions and generating
    predictions for effects of GDP, interest rates
    and credit
  • Commercial property prices show degree of
    autonomy, link to GDP but influence on credit
  • Predominant direction of causality is from CPP to
    credit rather than vice versa
    collateral/financial accelerator and not
    liquidity effect latter effect possibly dampened
    as financial liberalisation
  • Important effect of GDP on both CPP and credit.

26
  • Policy aspects include
  • Collateral-based amplification bank credit
    policy
  • Maximum LTV
  • Portfolio limits on loan concentration
  • Valuation method long run view of valuation vs.
    current market value
  • Financial crises caused by real-estate bubbles
  • Further research needed
  • effects of property prices on bank profitability
    at micro level paper 2
  • Can commercial property prices predict banking
    crises research to be pursued

27
PAPER 2COMMERCIAL PROPERTY PRICES AND BANK
PERFORMANCEE Philip Davis and Haibin Zhu 
  • Published in Quarterly Review of Economics and
    Finance

28
Introduction
  • Role of asset prices in bank lending and bank
    performance
  • Particular role of commercial property prices, as
    witness major differences in bank behaviour and
    performance during the up- and downswings in
    commercial property prices
  • Extensive macro work on commercial property
    prices and lending (paper 1), but less micro
    estimation on lending and performance
  • Is there a direct impact on the lending
    decisions, risk and profitability of individual
    banks?

29
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  • We analyse a sample of 904 banks worldwide over
    the period 1989-2002.
  • Seek to assess the effect of changes in
    commercial property prices on bank behaviour and
    performance in a range of industrialised
    economies, focusing on determination of lending,
    margins, ROA, bad debts and provisioning
  • Consistent with macro-level studies, commercial
    property prices have a marked impact on the
    behaviour and performance of individual banks,
    over and above conventional determinants
  • Results have implications for risk managers,
    regulators and monetary policy makers.

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32
  • Micro work empirical analysis
  • Provisioning (Laeven and Majnoni)
  • Bank profitability and margins (Demirgüç-Kunt and
    Huizinga)
  • Bad loan ratios (Salas and Saurina)
  • Lending (Bikker and Hu)
  • Rare studies looking at CPP and bank performance
  • Austria (Arpa et al)
  • Japan (Gan)
  • Hong Kong (Gerlach et al)
  • US (Hancock and Wilcox)

33
Empirical work
  • Our advance on earlier literature
  • First international study on how commercial
    property price movements affect individual banks
    lending strategies and performance after we
    control for the effects of conventional
    explanatory variables (macro factors,
    bank-specific variables and country-specific
    factors)
  • Micro-level data allow us to examine whether the
    determination of bank performance and the role of
    commercial property prices vary across different
    groups of banks and across countries.
  • Examine whether commercial real estate booms and
    busts tend to have asymmetric impacts on bank
    performance.

34
  • Use of panel GLS or GMM (robustness check)
  • Control variables
  • Macro growth rate of real GDP, inflation and
    short-term interest rates
  • Bank loan-to-asset ratios, real loan growth
    rate, capital strength, net interest margin, bank
    size dummies
  • Country dummies
  • Growth of real commercial property prices

35
Issues of endogeneity
  • Basic GLS equations ignore dynamic interaction of
    variables
  • No lagged dependent variable
  • Bank specific variables lagged
  • Nationwide CPP likely to be exogenous to lending
    behaviour of individual bank
  • Previous results showed CPP largely autonomous of
    credit even at macro level
  • Major loss of observations
  • Robustness checks
  • Using lagged CPP
  • Using difference and levels GMM estimation

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Conclusions
  • Results indicate that commercial property prices
    have a major impact on a wide range of bank
    performance variables
  • Signs found are consistent with a view that
    commercial property provides important forms of
    collateral perceived by banks to reduce risk and
    encourage lending
  • Results hold consistently across a number of
    econometric specifications, as well as for
    regions.

42
  • Interesting differences in response of small and
    large banks
  • Commercial property price movements having a
    smaller effect on the loan quality and provisions
    of small than large banks
  • Small bank profits less geared to commercial
    property prices than are those of large banks.
    Consistent with large banks being more willing to
    take risk as a consequence of the safety net and
    moral hazard.
  • Generally, results underline crucial relevance of
    commercial property prices as macroprudential
    variable. Need for good data on prices
  • Also highlight the need to develop indicators of
    individual bank exposure to the property market
    for stress testing (note wider than CP lending
    per se given use as collateral)

43
References
  • Davis E P and Zhu H (2004), "Bank lending and
    commercial property prices, some cross country
    evidence", BIS Working Paper No 150
  • Davis E Philip and Haibin Zhu (2005), "Commercial
    property prices and bank performance", BIS
    Working Paper No 175 and Quarterly Review of
    Economics and Finance, 49, 1341-1359
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