It has been both theoretically and empirically established that increase in bank lending causes asset price bubbles, leading to increase in bank leverage too. But the converse is also true. When the real estate price decline, the demand for bank lending diminishes and this in turn deleverages the banks’ balance sheet (Hofmann, 2003).
As real estate prices start to decline, the investors who have held the property for speculative reasons, start selling them. This further drives down the prices, rendering the common people who had taken bank loans to buy houses, foreclose in case of default.
It has been established that the default rates also tend to grow during such times as the money is scarce in the market and the interest rates climb up, forcing people to default on their payments (Davis & Zhu, 2004).
As number of defaulters grows, banks foreclose more and more number of properties, but are unable to fully recover its exposure as the price crash has eroded value. This in turn also means that the bank’s balance sheet contracts (Hofmann, 2003).
Further, during these distressed times, no one is taking loans to buy property, the demand for bank credit decreases, further contracting the bank’s balance sheet. Thus we see that the bank’s capital position deleverages due to two reasons, decline in loan demand and increase in prepayments and foreclosures, during a real estate price crash (Davis & Zhu, 2004).
We witnessed similar phenomenon during the 2007-09 global financial crisis, when the increase in property defaults resulted in enormous real estate bubble burst, bringing down banks’ balance sheets and also deleveraging them. Further, with economic activity slowing down, the demand for bank credit declined, two phenomenon that are interlinked with each other.
References
Hofmann, B. (2003). Bank Lending and Property Prices: Some International Evidence. HKIMR Working Paper, 22.
Davis, E. P., & Zhu, H. (2004). Bank lending and commercial property cycles: some cross-country evidence. BIS Working Papers, 150.
