A recent study by academics from the Southern Methodist University and the Wharton School of the University of Pennsylvania had very interesting findings (the actual full paper can be found here): banks based near booming housing markets charged higher interest rates and reduced loan amounts to companies, which ended up investing less than companies borrowing from banks located in stable (or falling) housing markets. They called this the “crowding-out effect of house-price appreciation”. The study gathered data from 1988 to 2006 in the US, during the Basel period. It would have been interesting to compare with the pre-Basel era and replicate it with European markets.
Conventional economic knowledge seemed to think that “to the extent that home prices begin to rise, consumers will feel wealthier; they’ll feel more disposed to spend…that’s going to provide the demand that firms need in order to be willing to hire and to invest.” (This is Ben Bernanke as quoted by The Economist, which mentioned this study a few weeks ago)
But our academics instead found an inverse relationship:
We estimate that a one standard-deviation increase in housing prices (about $79,700 in year 2000 dollars) that a bank is exposed to decreases investment by firms related to that bank by almost 6.3 percentage points, which is approximately 12% of a standard deviation for firm investment. Banks also increase the interest rate charged by 9 basis points, reduce outstanding loans by approximately 9%, and reduce loan size by approximately 4.5%. These results are consistent with banks reducing the supply of capital to firms in response to increased housing prices.
So much for the Keynesianism of housing bubbles…
Their findings was summarised in an easier to read single chart by The Economist:
I think they are spot on in identifying this crowding out effect but overlook the underlying importance of Basel’s risk-weighted assets in triggering the boom and forcing the reallocation of capital towards housing. In their paper, there is not a single reference to Basel, banks’ capital requirements (apart from one related to MBS) and RWAs. But their story matches almost perfectly the RWA-based ABCT model I described in my previous post on the topic.
What did my model say? That the supply of loanable funds would be reduced to businesses and increased to real estate as a result of capital-optimising choices made by banks (because of RWAs capital constraints). That consequently, interest rates would increase for businesses and be reduced for real estate. This is exactly what they found.
But it doesn’t stop here. The model also said that an increase in interest rates to businesses would shorten their structure of production as interest-sensitive long-term investments become unprofitable. What did they find? That businesses reduced investments despite the temporary boost in consumption due to the well-referenced wealth effects (which they also mentioned)…
However, they missed the deeper implications of banking regulation on the reallocation of capital from businesses to real estate. To them, house price increases seems to be the only factor diverting capital towards housing. I don’t deny that increasing house prices would bring about self-reinforcing house lending, even in a free market: as house prices increase, lending gets facilitated and speculators are attracted, pushing prices up even further. But my point is that regulation and RWAs can both trigger and exacerbate the process way beyond the self-correcting point at which it would normally stop (and collapse) in a free market environment.
There is catch though… If RWAs do indeed trigger a boom in house lending, how could they find some areas in the US within which the process actually wasn’t triggered (no increase in house prices/lending) despite being subject to the same regulatory framework? Well, there are possibly a few answers to that question. Some local banks could actually be in an area experiencing falling house prices for some reason (even though they increase nationally) and low mortgage demand. This would automatically limit the amount they lend and push RWAs on real estate up, making housing less attractive from a capital-optimisation point of view. Another possibility would be that those local banks are actually subsidiaries of other banks that try to optimise capital usage on an aggregate (national) basis. However, it is hard to say as the criteria used to build the sample of banks are not clear.
There is another, simpler, possible explanation: even in falling housing prices areas, local banks’ business lending was still constrained and mortgage lending still supported! Meaning that, in a RWA-free world (and excluding a recessionary environment), a decline in housing prices would have triggered an even sharper decrease/increase in mortgage/business lending. This cannot be proved with this study however. There could also be other explanations that haven’t come to my mind yet.
Overall, I remain slightly sceptical of statistical/regression/correlation-based economic studies and I’ll take this one with a pinch of salt, especially as they use various assumptions and proxies that could easily distort the outcome. Nonetheless, the results they obtained were quite significant. And they provide some empirical evidences to my very theoretical model.
Meanwhile, Nouriel Roubini on Friday, in a piece called Back to Housing Bubbles, listed all the markets in which there are signs of bubbles:
[…] signs of frothiness, if not outright bubbles, are reappearing in housing markets in Switzerland, Sweden, Norway, Finland, France, Germany, Canada, Australia, New Zealand, and, back for an encore, the UK (well, London). In emerging markets, bubbles are appearing in Hong Kong, Singapore, China, and Israel, and in major urban centers in Turkey, India, Indonesia, and Brazil.
Real estate bubbles existed before Basel introduced risk-weighted assets, but nothing on that scale and in so many countries at the same time. Time for policy-makers to wake up.
RWA-based ABCT Series:
- Banks’ risk-weighted assets as a source of malinvestments, booms and busts
- Banks’ RWAs as a source of malinvestments – Update
- Banks’ RWAs as a source of malinvestments – A graphical experiment
- Banks’ RWAs as a source of malinvestments – Some recent empirical evidence
- A new regulatory-driven housing bubble?
About two weeks ago, the US-based think tank Cato organised its annual monetary conference. Great panels and very interesting speeches.
Three panels were of particular interest to me: panel 1 (“100 Years of the Fed: What Have We Learned?”), panel 2 (“Alternatives to Discretionary Government Fiat Money”), panel 3 (“The Fed vs. the Market as Bank Regulator”).
In panel 1, George Selgin destroys the Federal Reserve’s distorted monetary history. Nothing much new in what he says for those who know him but it just never gets boring anyway. He covers: some of the lies that the Federal Reserve tells the general public to justify its existence, pre-WW2 Canada and its better performing monetary system despite not having a central bank, the lack of real Fed independence from political influence and……the Fed not respecting Bagehot’s principles despite claiming to do so. In this panel, the speech of Jerry Jordan, former President of the Federal Reserve Bank of Cleveland, is also very interesting.
In panel 2, Larry White speaks about alternatives to government fiat money, counterfeiting laws and state laws making it illegal to issue private money. Scott Sumner describes NGDP level targeting. Here again, nothing really new for those who follow his blog, but interesting nonetheless (even though I don’t agree with everything) and a must see for those who don’t.
In panel 3, John Allison provides an insider view of regulators’ intervention in banking (he used to be CEO of BB&T, an American bank). He argues that mathematical risk management models provide unhelpful information to bankers. He would completely deregulate banking but increase capital requirements, which is an original position to say the least. Kevin Dowd’s speech is also interesting: he covers regulatory and accounting arbitrage (SPEs, rehypothecation…) and various banking regulations including Basel’s.
Overall, great stuff and you should watch the whole of it (I know, it’s long… you can probably skip most Q&As).