BANK LENDING, BANK PERFORMANCE AND COMMERCIAL PROPERTY PRICES

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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

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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

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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

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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

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• 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

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• 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

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• 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

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• (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

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• (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)

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• 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.

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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

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Model

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

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• 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)

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• 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.

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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

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• 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

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Results of panel estimation
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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

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• 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

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• 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

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VECM variance decomposition
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• 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

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Impulse response of prices to credit
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Impulse response of prices to GDP
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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.

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• 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

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PAPER 2COMMERCIAL PROPERTY PRICES AND BANK
PERFORMANCEE Philip Davis and Haibin Zhu 

• Published in Quarterly Review of Economics and
  Finance

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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?

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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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• 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)

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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.

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• 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

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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.

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• 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)

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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