It is well-known that bank lending and bank performance have been strongly affected on frequent occasions by asset price fluctuations, at times culminating in banking crises. Among various key assets, commercial real estate is of special interest, not only because commercial property loans are an important component of bank assets, but also because of the widespread use of commercial property as collateral of other types of loans. Whereas there is a fairly extensive literature on the relation between bank lending and commercial property prices at a macro level (see recent work and a literature survey in a companion paper by Davis and Zhu (2004)), there is much less extant work on the impact of commercial property prices on the lending decisions, risk and profitability of individual banks. Evidence of a clear and consistent link to bank performance would underline the importance of commercial property prices as a key macroprudential indicator, as well as being relevant to the monetary transmission process.
This paper seeks to fill the gap by undertaking an extensive analysis of a sample of 904 banks worldwide over the period 1989-2002. We seek to assess the effect of changes in commercial property prices on bank behaviour and performance in 15 industrialised economies, extending the existing micro literature in this area. The results suggest that, consistent with macro-level studies, commercial property prices have a marked impact on the behaviour and performance of individual banks. Such an impact exists even when conventional independent variables determining bank performance are included. Moreover, there is evidence that the magnitude of this impact is related to the size of the bank, the direction of commercial property price movements, and regional factors. The results have implications for risk managers, regulators and monetary policy makers.
To motivate the analysis, Table 1 indicates major differences in bank behaviour and performance during the up- and downswings in commercial property prices in 13 major OECD countries. During an upswing of commercial property price movements, the default risk of bank loans tends to be much lower, and bank profitability rises above its average. Banks are therefore encouraged to extend extra loans to the business sector. The reverse effects are observed when commercial property prices fall.
We organise the remainder of this paper as follows. Section II reviews the existing literature and highlights the contributions of our study. Section III introduces the framework for the empirical analysis, listing all independent variables and their possible impact on bank behaviour and performance. Section IV describes the data, followed by empirical results in Section V. Section VI concludes.
