The idea that banks can get get carried away during a property bubble is not a new one. Will Hutton recently explained how the process worked in one of his columns in the Observer. What's interesting though is the role of the banks when the bubble bursts. Below is a nice and clear description of how this might work taken from an essay by Richard Herring (this one, not this one) and Susan Wachter in the bubble book I'm reading this week:
Bank behaviour may also play an important role in exacerbating the collpase of real estate prices. A decline in the price of real estate will decrease bank capital directly by reducing the value of the bank's own real estate assets. It will also reduce the value of loans collateralized by real estate and may lead to defaults, which will further reduce capital. Moreover, a decline in the price of real estate is likely to increase the preceived risk in real estate leding. All these factors are likely to reduce the supply of credit to the real estate industry. In addition, supervisors and regulators may react to the resulting weakening of bank caapital positions by increasing capital requirements and instituting stricter rules for classifying and provisioning against real estate assets. these measures will further diminish the supply of credit to the real estatte industry and place additional downward pressure on real estate prices.
That sounds pretty believable to me, though it does suggest if I understand it right that if banks' capital ratios are to be revisited then we might want to wait a bit. In addition the essay also makes the point that depositor protection (which is clearly a good thing) has the effect of insulating banks against market pressure. Why pull your money Northern Rock style if you know it is underwritten by an insurance scheme?
There's another interesting bit later in the essay where they discuss herding by banks in respect of risk. Herding is something that will be very familiar to anyone who has looked at active fund managers, and it was explored quite a bit in the Myners Review of course. I've never really considered how it might affect banks though, especially in the midst of a crisis. Here's what they say:
A bank knows that if it takes on an idiosyncratic risk exposure and loses, it may face harsh regulatory disciline, including termination. But if it is careful to keep its risk exposures in line with those of other banks, even if a disaster occurs, the regulatory consequences will be much lighter. The supervisory authorities cannot terminate all banks or even discipline them harshly. Indeed, the authorities may be obliged to soften the impact of the shock on individual banks in order to protect the banking system.
When you think about it, this makes a lot of sense (from the banks' point of view) but it is also really annoying. These massive financial rewards are handed over to financial institutions for their expertise and insight, yet it seems a lot of what they do involves just sticking with the pack, even when the pack is behaving in a very risky way.
Anyway, it's turning out to be a great book.