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

But house prices were rising rapidly

 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

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

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 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 Source: Dell’Ariccia, Igan, and Laeven 2009

Bubbles  Normal times: prices reflect fundamentals  Bubble: speculative motive allows for deviation from fundamentals (Allen/Carletti, 2011)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

FX lending and credit boom

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

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

Korea: Effective LTV Limits, but Difficult Calibration?

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