February 5, 2023

A business journal from the Wharton School of the University of Pennsylvania
Banks become preoccupied with real estate lending during housing booms, at the cost of lending to other parts of the economy, according to research co-authored by Wharton’s Itay Goldstein.
Itay Goldstein
Shankar Parameshwaran
Banks love housing booms because they offer attractive returns on investment. But they also get preoccupied with real estate during those boom times at the cost of lending to other parts of the economy, according to research by Wharton finance professor Itay Goldstein, Miami Business School finance professor Indraneel Chakraborty, and Virginia Tech professor Andrew MacKinlay.
“Banks are drawn to do more of real estate lending because it’s very profitable, especially when real estate prices are going up and they can use housing easily as a collateral,” said Goldstein.
In a paper titled “Housing Price Booms and Crowding-Out Effects in Bank Lending,” the authors analyzed bank lending during the 1988–2006 real estate boom, and documented that banks that are active in strong housing markets increase mortgage lending and decrease commercial lending. As a result, firms that borrow from these banks have significantly lower investment.
Specifically, for a one-standard-deviation increase in house prices in areas where a bank has branches, it reduced lending growth to firms that borrow from that bank by 42%, and total investment by the affected firms fell by 21%, their research found.
The crowding-out effect was more pronounced among banks “that are more constrained to begin with,” said Goldstein. He pointed out that “smaller banks are more financially constrained” than others. “When a bank is more financially constrained, it can’t raise deposits as easily as others,” he said. And so, when such banks channel their resources into mortgages, their commercial and industrial (C&I) lending will decline, he added.
“Banks are drawn to do more of real estate lending because it’s very profitable, especially when real estate prices are going up….” — Itay Goldstein

Also, the phenomenon of reduced investment was pronounced for firms that were more capital constrained than others or that borrowed from more-constrained banks. The researchers interpreted that to mean that “commercial loans were crowded out by banks responding to profitable opportunities in mortgage lending,” instead of changes in demand for those loans. “The results suggest that housing prices appreciations have negative spillovers to the real economy, which were overlooked thus far,” their paper stated.

According to the paper, the C&I loan profitability of banks is sensitive to increases in housing prices. “As housing prices increase, banks cut more C&I loans, and so the loans they continue to extend have higher average profitability,” it stated. “We show that while both commercial lending and mortgage lending profitability increase in response to increasing housing prices, mortgage lending profitability increases more, supporting the basic claim that housing price increases make lending opportunities in the housing market more lucrative and trigger the crowding out of C&I loans.”

Filling a Gap in Research

“Much has been written about the negative real effects of asset price crashes … [but] much less is known about the real effects of the boom phase in asset prices,” the paper noted. The paper is the first to empirically document the role of bank lending during an asset price boom, thereby filling a crucial gap in research on the subject. The results of the study will find resonance across alternating boom-bust cycles in the real estate industry for how they impact commercial and industrial (C&I) lending elsewhere in the economy.

As it happens, The Economist referenced the paper in a recent article on the impact of rising housing prices. “High and rising property prices can have damaging economic effects, by crowding out productive investment and leading to a misallocation of capital,” it stated, citing the paper.

“The premise underlying this crowding-out behavior is that banks are constrained in raising new capital or selling their loans, and so when highly profitable lending opportunities arise in one sector (mortgage lending), they choose to pursue them by cutting their lending in another sector (commercial lending),” The Economist continued. Consistent with that argument, it found that across different specifications, the crowding-out results hold “much more strongly and significantly for constrained banks; these are the banks which are smaller, more levered, and less active in securitization markets.”

“A lot of research has shown that during the [2008] financial crisis, C&I lending was hurt,” said Goldstein. “Now, we show that it was hurt during the housing boom as well. It’s a bit of a lose-lose with all these booms and busts in housing — C&I lending is the one that is always getting hurt.”

“If you focus too much on the housing market, you might divert resources away from the real economy.”— Itay Goldstein

The empirical analysis covered data on more than 750 lenders linked to 120 bank holding companies (BHCs). Significantly, it studied differences across banks in their exposure to the real estate market. For this, it used the location of banks’ deposit branches to proxy for the location of mortgage activity, “since banks are more likely to do mortgage lending if there is larger price appreciation in the areas where they have branches.” It then compared the behavior of banks that are more exposed with that of banks that are less exposed to housing price booms, and explored the implications for firms related to them.

That crowding-out effect was documented in a follow-up paper by the same authors in 2020, titled “Monetary Stimulus and Bank Lending.” They found that as the Federal Reserve bought mortgage-backed securities and Treasury securities as part of its “quantitative easing” policy, banks that benefitted from those purchases increased mortgage origination and reduced commercial lending, with the result that firms that borrowed from these banks decreased investment.

Policy Takeaway

The main policy takeaway from the research is that “there is damage in housing booms beyond what was previously recognized,” Goldstein said. “People typically think that everything is good during a housing boom. But [our research shows that] even during a housing boom, there are some damages because resources are pulled away from other parts of the economy — the real economy in particular — and moved into housing.” Policymakers tend to focus on measures that are geared “to help and stimulate the housing market,” he continued. “Maybe they should not worry as much about the housing market, but rather think more about the real economy.”

After a boom during the COVID pandemic, the U.S. housing market is now showing signs of weakness as mortgage rates increase. “Whenever house prices start going down, there is this attempt to try to stimulate the housing market and prevent housing prices from going down too much,” said Goldstein. “One wants to be cautious with that, because if you focus too much on the housing market, you might divert resources away from the real economy.”

Also, the phenomenon of reduced investment was pronounced for firms that were more capital constrained than others or that borrowed from more-constrained banks. The researchers interpreted that to mean that “commercial loans were crowded out by banks responding to profitable opportunities in mortgage lending,” instead of changes in demand for those loans. “The results suggest that housing prices appreciations have negative spillovers to the real economy, which were overlooked thus far,” their paper stated.
According to the paper, the C&I loan profitability of banks is sensitive to increases in housing prices. “As housing prices increase, banks cut more C&I loans, and so the loans they continue to extend have higher average profitability,” it stated. “We show that while both commercial lending and mortgage lending profitability increase in response to increasing housing prices, mortgage lending profitability increases more, supporting the basic claim that housing price increases make lending opportunities in the housing market more lucrative and trigger the crowding out of C&I loans.”
Filling a Gap in Research
“Much has been written about the negative real effects of asset price crashes … [but] much less is known about the real effects of the boom phase in asset prices,” the paper noted. The paper is the first to empirically document the role of bank lending during an asset price boom, thereby filling a crucial gap in research on the subject. The results of the study will find resonance across alternating boom-bust cycles in the real estate industry for how they impact commercial and industrial (C&I) lending elsewhere in the economy.
As it happens, The Economist referenced the paper in a recent article on the impact of rising housing prices. “High and rising property prices can have damaging economic effects, by crowding out productive investment and leading to a misallocation of capital,” it stated, citing the paper.
“The premise underlying this crowding-out behavior is that banks are constrained in raising new capital or selling their loans, and so when highly profitable lending opportunities arise in one sector (mortgage lending), they choose to pursue them by cutting their lending in another sector (commercial lending),” The Economist continued. Consistent with that argument, it found that across different specifications, the crowding-out results hold “much more strongly and significantly for constrained banks; these are the banks which are smaller, more levered, and less active in securitization markets.”
“A lot of research has shown that during the [2008] financial crisis, C&I lending was hurt,” said Goldstein. “Now, we show that it was hurt during the housing boom as well. It’s a bit of a lose-lose with all these booms and busts in housing — C&I lending is the one that is always getting hurt.”
“If you focus too much on the housing market, you might divert resources away from the real economy.”— Itay Goldstein

The empirical analysis covered data on more than 750 lenders linked to 120 bank holding companies (BHCs). Significantly, it studied differences across banks in their exposure to the real estate market. For this, it used the location of banks’ deposit branches to proxy for the location of mortgage activity, “since banks are more likely to do mortgage lending if there is larger price appreciation in the areas where they have branches.” It then compared the behavior of banks that are more exposed with that of banks that are less exposed to housing price booms, and explored the implications for firms related to them.

That crowding-out effect was documented in a follow-up paper by the same authors in 2020, titled “Monetary Stimulus and Bank Lending.” They found that as the Federal Reserve bought mortgage-backed securities and Treasury securities as part of its “quantitative easing” policy, banks that benefitted from those purchases increased mortgage origination and reduced commercial lending, with the result that firms that borrowed from these banks decreased investment.

Policy Takeaway

The main policy takeaway from the research is that “there is damage in housing booms beyond what was previously recognized,” Goldstein said. “People typically think that everything is good during a housing boom. But [our research shows that] even during a housing boom, there are some damages because resources are pulled away from other parts of the economy — the real economy in particular — and moved into housing.” Policymakers tend to focus on measures that are geared “to help and stimulate the housing market,” he continued. “Maybe they should not worry as much about the housing market, but rather think more about the real economy.”

After a boom during the COVID pandemic, the U.S. housing market is now showing signs of weakness as mortgage rates increase. “Whenever house prices start going down, there is this attempt to try to stimulate the housing market and prevent housing prices from going down too much,” said Goldstein. “One wants to be cautious with that, because if you focus too much on the housing market, you might divert resources away from the real economy.”

The empirical analysis covered data on more than 750 lenders linked to 120 bank holding companies (BHCs). Significantly, it studied differences across banks in their exposure to the real estate market. For this, it used the location of banks’ deposit branches to proxy for the location of mortgage activity, “since banks are more likely to do mortgage lending if there is larger price appreciation in the areas where they have branches.” It then compared the behavior of banks that are more exposed with that of banks that are less exposed to housing price booms, and explored the implications for firms related to them.
That crowding-out effect was documented in a follow-up paper by the same authors in 2020, titled “Monetary Stimulus and Bank Lending.” They found that as the Federal Reserve bought mortgage-backed securities and Treasury securities as part of its “quantitative easing” policy, banks that benefitted from those purchases increased mortgage origination and reduced commercial lending, with the result that firms that borrowed from these banks decreased investment.
Policy Takeaway
The main policy takeaway from the research is that “there is damage in housing booms beyond what was previously recognized,” Goldstein said. “People typically think that everything is good during a housing boom. But [our research shows that] even during a housing boom, there are some damages because resources are pulled away from other parts of the economy — the real economy in particular — and moved into housing.” Policymakers tend to focus on measures that are geared “to help and stimulate the housing market,” he continued. “Maybe they should not worry as much about the housing market, but rather think more about the real economy.”
After a boom during the COVID pandemic, the U.S. housing market is now showing signs of weakness as mortgage rates increase. “Whenever house prices start going down, there is this attempt to try to stimulate the housing market and prevent housing prices from going down too much,” said Goldstein. “One wants to be cautious with that, because if you focus too much on the housing market, you might divert resources away from the real economy.”
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