Experience from around the world indicates that poor credit quality coupled with weak credit management practices continue to be a dominant factor in bank failures and banking crises. Many of the credit losses suffered by banks, thrifts and insurance companies in the United States in the early 1990s have resulted from excessive portfolio concentrations of loans in the real estate industry (residential mortgages, commercial real estate mortgages and commercial real estate loans). More specifically, US banks loaned enormous amounts of money to commercial real estate companies, for the period 1989-1994, based on optimistic projections of rental income growth and increased asset values (Browne & Case, 1992). “When the (real estate) bubble burst, banks had to charge off around $34 billion in real-estate-related loan losses” (Caouette et al.,1998; FDIC, 1997). A similar crisis in the US sub-prime loan market is currently taking place but it is too early to comment on the likely causes and assess the effects and the consequences of this crisis.
European countries such as Switzerland, Sweden and the UK – as well as Japan (Siebert, 2002: 116-119) and East Asia (Hilbers et al., 2001; Collyns & Senhadji, 2002; Quigley, 2001) – experienced similar crises in the 1970s and 1990s. Historical data show that there is a very close relationship between the over-borrowing of the real estate companies, the real estate bubbles and the banking crises (see BCBS April 2004). The interlinkages between banks and real estate companies involve an inherent transfer of credit risk.
Does the commercial property market have characteristics that make commercial real estate lending hazardous for banks? Real estate development companies are, by nature, highly leveraged companies (Ball et al., 1998; Harvey & Jowsey, 2004). They use high debt in order to finance the construction of large buildings for residential or commercial use. High gearing ratios make them sensitive to interest rate swings, particularly in countries like the UK where most debt is at floating interest rates (Rowlatt, 1993; Artis & Lewis, 1993; Lewis, 1994; Miles, 1994). This particular characteristic of the real estate industry is an important parameter that needs to be considered within the profit equation of banks and in assessing their likely survival. Another interesting question is why banks are attracted to property lending. It seems that commercial banks, in their attempt to increase their market share, very often concentrate their portfolios in particular sectors. For example, it is evident that around 10% of the total bank loans in the UK were diverted to property companies in the early 1990s (Ball et al., 1998: Fig. 12.2, p. 326). Real estate lending accounted for around 30% of lending to all private non-financial companies in early 2003 (Whitley & Windram, 2003).
It became obvious from the property market collapses and banking crises of the 1970s and the early 1990s, around the world, that prudence needed to be reinforced by some form of regulation of the financial system in order to prevent a repetition of such crises. Along these lines, the Basel Committee for Banking Supervision (BCBS hereafter), which was established in 1975, called for progress in the area of market discipline of financial institutions in general and, in particular, banks. The Committee’s aspiration as outlined both at Basel I (1988) and Basel II (2006) is to stabilize the relationship between commercial banks’ equity capital – as expressed by its core (Tier I) and supplementary (Tier II) elements – and their risk-weighted assets. We review here both Basel I and the recently initiated Basel II regulatory framework with particular reference to real estate lending. We argue that property is only a small part of the New Basel Capital Accord which consists of three pillars. Finally, we believe that the sections dealing with real estate lending need to be further explored.
In section 2, we show how major failures in the real estate sector have been accompanied by banking failures in the UK during the 1973 banking crisis and the 1990 economic recession. Section 3 discusses the lessons to be learnt from these macroeconomic and banking crises. We then examine in section 4 the Basel I and Basel II regulatory framework (Pillar 1 - Minimum Capital Requirements) and we present our criticism (and scepticism) regarding the sections of the Basel II proposals dealing with real estate lending. Section 5 concludes the paper.
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