Bank Efficiency, Risk-Based Capital, and Real Estate Exposure: The Credit Crunch Revisited

Article excerpt


During the period 1990-1993 there was a pronounced shift in bank assets away from real estate lending. The reallocation was so significant that the real estate literature has characterized the period as a "real estate credit crunch" (Tuccillo 1991). In contrast, the banking literature described the asset shift as an "increase" in bank security holdings and focused more on whether the change denied credit to small business, than on credit rationing to real estate demanders (Keeton 1994).

To the extent that the real estate and banking literature observed the same phenomena from different perspectives, much of the subsequent research attempted to explain factors that might have precipitated the change. A shortcoming of the banking literature is the paucity of research on how the suggested factors influenced specific assets such as real estate loans, while the real estate literature has failed to analyze real estate lending in relation to other loans in the bank loan portfolio. Consequently, there is little research documenting how the changing bank regulatory environment, especially the implementation of risk-based capital (RBC) standards, affected real estate and other assets in the bank loan portfolio.

Risk-based capital standards established a system of weights that requires greater bank equity capital for more risky assets. Although there is a consensus that bad real estate loans contributed to the crisis that foreshadowed RBC standards (see Hancock and Wilcox 1994; Peek and Rosengren 1994), anecdotal evidence suggests that aggressive intervention by regulators may have exacerbated the real estate liquidity crunch (Seiders 1989; Tuccillo 1991).

In an attempt to identify the impact of RBC standards on bank real estate lending, we estimate the output distance function and generate a measure of overall technical efficiency for banks. While bank equity capital determines the level of potential lending, the literature suggests banking can be modeled as a multi-output production process utilizing inputs of physical capital, labor and deposits. (Berger, Hunter and Timme 1993) A bank's overall technical efficiency is decomposed into pure technical efficiency, scale efficiency and regulatory efficiency. If a bank is inefficient in any of these components, it can expand real estate lending by reducing the inefficiency. Banks can realize greater pure technical efficiency through better managerial oversight of the real estate loan portfolio - for example, by reducing bad real estate loans. Greater scale efficiency can occur when banks change their size and move toward the range of constant returns to scale. Regulatory efficiency gains may be possible if the bank raises additional equity capital or changes its mix of assets. The 1990 and 1993 potential gains in real estate lending from reducing each kind of inefficiency are identified for specific asset categories in the real estate loan portfolio. The real estate portfolio includes construction loans secured by real estate, farm loans secured by real estate, one- to four-family residential loans, multi-family residential loans and other loans secured by real estate. Although the implementation of RBC standards coincided with a recession, the results should provide some insight into how the standards influenced real estate lending.

The next section provides a brief review of the literature on bank portfolio composition and the real estate liquidity crisis of the late 1980s and early 1990s. The third section describes the methodology followed by a section of empirical results. The final section provides a summary and conclusions.

The Literature on the 1990-1993 Real Estate "Credit Crunch"

Fergus and Goodman (1994) provide a chronology of events that contributed to the real estate lending environment of the early 1990s. During the 1980s, financial-institution disintermediation, changes in tax law and more aggressive lending policies by some large banks contributed to the impending real estate crisis. …