Property Prices and Bank Risk Taking

Giovanni Dell’Ariccia (IMF and CEPR)

The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF, its Executive Board, or Management.

Norges Bank Macroprudential Regulation Workshop, Oslo, November 29-30, 2012

Monetary policy to focus on inflation and output gap

Asset prices a concern only through their impact on GDP and inflation (exceptions RBA, Riksbank, some EMs)

Benign neglect approach to boom/busts:

Bubbles difficult to identify

Costs of clean up limited and policy effective

Better clean up than prevent

Bank risk taking important, but job of regulators

Before the crisis …A policy gap

Regulatory policy focused on individual institutions

Limited attention to credit aggregates or asset price dynamics

Ill equipped to deal with booms:

Correlated risk taking

Fire sales and other externalities

Few regulators had necessary tools (exceptions: Spain/Colombia)

Before the crisis … A policy gap

Macro literature: Financial intermediation seen as macro neutral

Asset prices (including property prices) did matter. They could accentuate the cycle through financial accelerator

But macro models largely ignored their impact on bank risk taking. In equilibrium, no bank defaults

Banking literature Focused on excessive risk taking by intermediaries operating

under limited liability and asymmetric information

There are defaults/crises in equilibrium

But there is little attention to macro and monetary policy

Before the crisis … A theory gap

Before crisis … Macro looked OK

-3

-2

-1

0

1

2

2000 02 04 06 08:Q4

Output Gap2Core CPI Inflation

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2000 02 04 06 08:Q4

Euro area United States Average of other economies1

1 Japan omitted.2 Estimate of output gap using rolling Hodrick-Prescott filter.

But house prices were rising rapidly

-40

-20

0

20

40

60

80

JPN

DE

U

AU

T

PR

T

CH

E

NL

D

GR

C

US

A

ITA

NO

R

FIN

AU

S

CA

N

SW

E

DE

N

GB

R

FR

A

IRL

NZ

L

ES

P

Change in real house prices (2001:Q4-2006:Q3)

Real house price falls from recent peak

Standard policies rapidly hit their limits

Limited effectiveness of less traditional policies

Large fiscal and output costs

Multiple banking crises; especially in countries with their own real estate booms

Then the crisis came …

7

House boom/busts and great recession

AUS

AUT

BGR

CAN

CHN

HRV

CYP

CZEDNK

EST

FIN

FRA

GRC

HUN

ISL

IND

IRL

ITA

KOR

LVALTU

NLD

NZL

NOR

POL

PRT

SVN

ZAFESP

SWE

CHE

UKR

GBR

USA

y = -0.0416x - 4.1152R² = 0.1496

-30

-20

-10

0

10

-20 0 20 40 60 80 100 120 140 160 180 200 220 240

Cum

ulat

ive

dec

line

in G

DP

fro

m s

tart

to e

nd o

f re

cess

ion

Change in house prices f rom 2000 to 2006

Figure 2. House Price Run-Up and Severity of Crisis

Source: Claessens et al (2010).

Bubble size shows the change in bankcredit f rom 2000 to 2006.

A closer look at real-estate booms and bank risk taking behavior Most large banking crises preceded by some form

of property price boom Scandinavia 1990s Asia 1997 Japan 1990 More recently: US, Spain, Ireland, Iceland, Latvia,…

Property cycles can have macro consequences, even without open banking crises Borrower debt overhang

But things are worse when credit booms (and lax standards) are involved

Boomfollowed by

financial crisis

followed by poor

performance

followed by financial crisis

or poor performance

followed by financial crisis

and poor performance

Number of countries

Real estate 53% 77% 87% 43% 30Credit 67% 78% 93% 52% 27

Real estate but not credit 29% 71% 71% 29% 7

Credit but not real estate 100% 75% 100% 75% 4

Both 61% 78% 91% 48% 23

Neither 27% 18% 45% 0% 11

Text Table 1. Booms, Crises, Macroeconomic Performance

Notes: The sample consists of 40 countries. The numbers, except in the last column, show the percent of the cases in which a crisis or poor macroeconomic performance happened after a boom was observed (out of the total number of cases where the boom occurred). The last column shows the number of countries in which a boom occurred. A real estate boom exists if the annual real house price appreciation rate during 2000-2006 is above the ad-hoc threshold of 1.5 percent or the annual real house price appreciation rate in the upward phase of the housing cycle prior to the crisis exceeds the country-specific historical annual appreciation rate. A credit boom exists if the growth rate of bank credit to the private sector in percent of GDP is more than the arbitrary cut-off of 20 percent or it exceeds the rate implied by a country-specific, backward-looking, cubic time trend by more than one standard deviation. A financial crisis is a systemic banking crisis as identified in Laeven and Valencia (2010). Poor performance is defined as more than 1 percentage point decline in the real GDP growth rate in 2008-09 compared to the 2003-07 average.

-30 -20 -10 0 10 20 30-50

-25

0

25

50

75

100

87.51578

84.61261

50.05025

201.0558

44.3627100000001

169.9191

30.92781

78.211990000000255.32269

90.01009

97.90594

25.949219999999951.81

98.76449

19.5002919.91

35.17473

109.2423

44.31

41.0997500000001

139.3958

60.00078

65.96198

31.07376

138.7727

59.939925.9416299999999

161.8021

38.6253500000002

166.3921

91.67

42.53386

60.15205

103.877597.8950744.48181

63.39933

157.1905

64.19488

36.152.46726

85.66792

47.11219

20.7203524.644.07178

22.5424199999999

39.48

77.78537

11.7157618.08

107.8282

38.21

25.06

35.17784

27.484937.7531

118.03

172.7685

95.59301

95.13801148.7592

27.23902

31.29615

60.6406548.32169

11.99246

25.07045

82.87102

103.8533

13.675412.56504

54.93

17.59686

31.06

14.94018

13.33

25.87158

33.2915100000001

43.34382

35.74367

49.290920000000134.4719410.46573

25.066739999999918.4

22.17047

15.80233

44.95334

47.54016

28.841529999999964.0134.5632161.0091712.66331

20.18507

85.93

25

20.55589

41.1675842.78

71.21608

12.8617.996489999999917.28

36.15777

22.73

21.9544299999999

14.2867.45574

39.51122.51

24.60602

108.7962

Credit Growth and Depth of Great Recession

Change in GDP from 2007 to 2009

Ch

an

ge

in c

red

it-to

-GD

P r

atio

fro

m 2

00

0 to

20

06

Bubble size shows the level of credit-to-GDP ratio in 2006.

Real-estate cycles and bank behavior

Credit constraints – Leverage cycles

Adverse selection and strategic interaction

Bubbles

Govt. guarantees - Risk externalities

Financial Accelerators – Leverage Cycles Collateralized credit as solution to agency problems

(Kiyotaki/Moore, 1997)

Cycle emerges: asset prices credit aggregates investment/demand asset prices

Effect magnified if logic applied to intermediaries (Kiyotaki/Gertler, 2009, Iacoviello, 2011)

Further widening if leverage is cyclical (Adrian/Shin, 2009/Geanakoplos 2010)

Regulation may also contribute (Herring/Wachter, 1999)

But most models do not deal with risk taking

Magnified macro fluctuations

0

1

2

3

4

5

6

Credit Boom House Price Boom

Recoveries withoutRecoveries withRecoveries with Strong

* *

0

1

2

3

4

5

Credit Crunch House Price Bust

Recessions withoutRecessions withRecessions with Severe

* *

Duration of recession (quarters)

Time to return to trend (quarters)

Source: Claessens/Kose/Terrones, 2008

Adverse selection and strategic effects Rising house prices reduce incentives to screen

borrowers Even bad borrowers can refinance/sell property

Winner curse reduced in good times: My competitors screen less More untested applicant borrowers Better distribution of applicants Less incentives to screen

“Conservative” lending punished Investor pressure on managers (compensation schemes) Borrowers shop for lax standards

Easy mortgages during U.S. boom

68

70

72

74

76

78

80

82

84

86

0

10

20

30

40

50

60

70

80

2001 2002 2003 2004 2005 2006 2007

Decline in Lending Standards(share of no-downpayment and limited documentation loans in

originations; combined loan-to-value in percent)No downpayment & limited documentation No downpayment Limited documentation Combined LTV

Source: Dell’Ariccia, Igan, and Laeven 2009

0 20 40 60 80 100 120 140 160

-50

0

50

100

150

200

250

19.3324.1816.59

22.13 51.77

25.02

32.3378.1840.92

54.84

19.27

63.99

12.13

32.00

20.81

8.49

9.9410.74

18.25

29.81

40.35

18.54

9.22

24.24

22.50

16.48

26.18

32.349.31

8.34

20.75

21.83

28.34

47.98

25.90

9.29 10.71

38.06

14.85

34.57

30.38

13.6118.03

13.38

24.0737.43

18.61

31.28

8.41

12.43

24.39

Subprime Boom and Defaults

House price appreciation, 2000-06

Ch

an

ge

in m

ort

ga

ge

de

linq

ue

ncy

ra

te, 2

00

7-0

9

Bubble size shows the percentage point change in the ratio of mortgage credit outstanding to household income from 2000 to 2006.

Bubbles Normal times: prices reflect fundamentals

Bubble: speculative motive allows for deviation from fundamentals (Allen/Carletti, 2011)

Banks may fund speculators: Govt. guarantees Risk shifting (limited liability) Can’t separate speculators from “legitimate” consumers

Increasing recourse to instruments with correlated risks U.S.: teaser-rate/interest-only loans East Europe: FX denominated loans

Interest-only loans and boom

Source: Barlevy and Fisher (2011)

Credit and housing booms in East Europe

Bulgaria

Czech Republic

Estonia

Hungary

Serbia

Lithuania

Poland

Russia

Slovak Republic

y = 3.0989x - 16.334R² = 0.3625

0

50

100

150

200

250

-50

0

50

100

150

200

250

0 10 20 30 40 50 60

Change in

real h

ousi

ng p

rice

s, 2

003–

08

Change in private sector credit-to-GDP ratio, 2003–08

Sources: IMF International Financial Statistics; and country statistical offices.1As the boom in the Baltic states ended in 2007, data for the Baltics refer to 2002–07.

Figure A1. Selected CEE Countries: Private Sector Credit and Housing Prices, 2003–081

Croatia

Ukraine

Slovenia

FX lending and credit boom

0

20

40

60

80

100

120

0

20

40

60

80

100

120

Est

onia

Latv

ia

Bul

garia

Ukr

aine

Hun

gary

Cro

atia

Lith

uani

a

Bos

nia

& H

erze

govi

na

Cze

ch R

epub

lic

Pol

and

Slo

vak

Rep

ublic

Mac

edon

ia

Rus

sia

Ser

bia

Rom

ania

Mol

dova

Alb

ania

Turk

ey

Bel

arus

National currencyForeign currencyForeign currency indexed

Sources: National authorities; and IMF, International Financial Statistics.

Emerging Europe: Total Private Sector Credit by Currency, 2008(Stock in percent of GDP)

Strategic complementarities Government guarantees

Do not want to die alone (Farhi/Tirole, 2012) Greenspan put FX in Eastern Europe

Risk taking externalities Poor incentives structure if systemic banks take

excessive risk Correlated risk taking Self fulfilling equilibria

Ex-post … Macro bailouts did occur

If benign neglect is dead, then what? Asset price booms difficult to spot But other policy decisions also taken under uncertainty Booms involving leveraged agents more dangerous Real estate case

Objectives? Prevent unsustainable booms altogether Alter lender/borrower behavior Increase resilience to busts

No silver bullet Broader measures: hard to circumvent but more costly Targeted tools: limited costs but challenged by loopholes

A new policy consensus?

23

Natural place to start

Credit highly correlated with monetary aggregates

Increase cost of borrowing, decrease loan demand, lower collateral values

Risk-taking channel

Potential issues

Conflict of objectives

Impact on balance sheets

Capital inflows (especially in SOEs)

Switch to riskier lending (FX, IO loans)

Monetary policy

9

Figure 8. Credit Growth and Monetary Policy(Selected countries that had a boom in the run-up and a crisis in 2007-08)

Sources: IMF International Financial Statistics, World Economic Outlook; staff calculations.Notes: Credit is indexed with a base value of 100 five years prior to the crisis.

0

50

100

150

200

250

0

1

2

3

4

T-5 T-4 T-3 T-2 T-1 T

United Kingdom 2007

Core inf lationCredit (right axis)

0

50

100

150

200

250

0

1

2

3

4

T-5 T-4 T-3 T-2 T-1 T

Ireland 2008

Core inf lationCredit (right axis)

0

50

100

150

200

250

0

1

2

3

4

T-5 T-4 T-3 T-2 T-1 T

Spain 2008

Core inf lationCredit (right axis)

0

50

100

150

200

250

0

1

2

3

4

T-5 T-4 T-3 T-2 T-1 T

Greece 2008

Core inf lationCredit (right axis)

Credit Growth and Core Inflation

Evidence of risk shifting

Source: Landier et al. 2011

Prudent stance can: Reduce overheating Buffer for bailout/stimulus during a potential bust Reduce incentives for leverage (deductibility, FAT)

Time lags make it an impractical tool Some measures hard to use countercyclically “Tax planning”, circumvention, calibration

Little evidence of effectiveness in stopping booms… …but fiscal room critical in busts

Fiscal policy

Most ‘experiments’ in emerging markets, particularly Asia

Common tools: Maximum LTV/DTI limits Differentiated risk weights on high-LTV loans Dynamic provisioning

Discretion rather than rule-based

Mixed evidence on effectiveness

Macro-Prudential Tools

Hong Kong: Limited Effectiveness of LTV Limits

110

120

130

140

150

160

70

90

110

130

150

170

2009 - Mar 2009 - May 2009 - Jul 2009 - Sep 2009 - Nov 2010 - Jan 2010 - Mar 2010 - May 2010 - Jul

New loans approved Prices

October 2009:Maximum LTV for properties over HK$20 million lowered to 60 percent, maximum loan size for mortgage insurance eligibility reduced and non-owner-occupied properties disqualified.

August 2010:LTV for properties over HK$12 million lowered to 60 percent, applications for mortgage insurance exceeding 90% LTV and 50% DTI suspended, maximum loan size for mortgage insurance eligibility if LTV>90%.

Korea: Effective LTV Limits, but Difficult Calibration?

0

1

2

3

4

5

6

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

2000 - Jan 2001 - Apr 2002 - Jul 2003 - Oct 2005 - Jan 2006 - Apr 2007 - Jul 2008 - Oct 2010 - Jan

September 2002:Introduced LTV limits

June 2003:Lowered LTV in speculative areas

October 2003:Lowered LTV in speculative areas

July 2009:Lowered LTV in non-speculative areas

February 2007:Tightened DTI

August 2005:Introduced DTI limits

September 2009:Tightened DTI

Month-on-month house price changes in 'speculation zones' (LHS)

Policy rate (RHS)

Conclusions Benign neglect might be dead, so …

Emerging consensus that leveraged bubbles (real estate in particular) are dangerous

What to do. Still many open questions: Monetary policy remains blunt instrument Fiscal impractical. Perhaps helpful on liability structures Macroprudential tools promising …

But it will take time: Develop new macro models Design/calibrate macroprudential tools Build institutions to control them

Limited liability and speculators

q

1-q

H-P(1+r)

L-P(1+r)

q

1-q

H-P(1+r)

L-P(1+r)

Unlevered consumer

Levered speculator