Academic journal article The Journal of Real Estate Research

Bank Corporate Governance and Real Estate Lending during the Financial Crisis

Academic journal article The Journal of Real Estate Research

Bank Corporate Governance and Real Estate Lending during the Financial Crisis

Article excerpt

Abstract This paper examines the effects of bank corporate governance on real estate lending and loan losses during the recent financial crisis. The results indicate that banks with stronger corporate governance mechanisms had higher profitability during the period 2006-2009. Our findings on the effects of corporate governance on real estate lending performance are mixed and depend on the definition of the crisis period. Although banks with stronger governance practices had a lower amount of real estate loan losses during 2006-2008, our results also show that these banks experienced significantly larger losses in 2009.

This paper examines the effects of corporate governance on real estate lending and loan losses around the recent financial crisis and the meltdown of the real estate market. In particular, we assess whether banks with stronger corporate governance mechanisms were associated with less severe real estate loan problems during the crisis. Given that the recent financial turmoil is to a large extent attributable to excessive risk taking by banks, particularly in terms of real estate lending, we consider the crisis to provide an expedient setting to examine whether effective governance practices enhance the performance and lending behavior of banks during periods of severe market stress.

In essence, corporate governance is the mechanism for addressing agency problems and controlling risk within the firm. In the aftermath of the recent financial crisis, banking supervisors, central banks, and other authorities have argued that flaws in corporate governance practices may have had a significant role in the excessive risk taking of banks and, consequently, on the development of the financial crisis (e.g., Basel Committee on Banking Supervision, 2010; Board of Governors of the Federal Reserve System, 2010a,b; OECD, 2010). Therefore, it is of paramount importance to empirically address the potential implications of corporate governance on bank performance in the midst of the recent crisis. It is widely acknowledged that the most important factor in the variability of bank performance and the risk of failure is loan losses (e.g., English, 2002). Given that bank performance was severely affected by real estate loan problems and declining property prices during the market turmoil, we examine the influence of corporate governance on real estate loan losses, and furthermore, on different types of real estate loans (residential, commercial, and construction and land development loans). If strong corporate governance constrains inordinate risk taking in real estate lending, we should observe a negative relationship between real estate loan losses and the strength of governance mechanisms amidst the financial crisis.

We focus on the real estate lending behavior of banks for three main reasons. First, it is important to empirically analyze the association between corporate governance on real estate lending around the financial crisis because excessive risk taking in real estate lending is often considered among the main factors contributing to the development of the crisis (Guynn, 2010). Second, real estate loans are by far the largest loan category in the loan portfolios of most banks. For large U.S. bank holding companies, real estate loans accounted for approximately 60% of total loans and for about 45% of total assets during the crisis. Third, although the financial crisis had a strong adverse impact on all loan categories, the increase in real estate loan losses was substantially higher than the increase in other types of loans. While losses on consumer loans and commercial and industrial loans increased by 160% and 659%, respectively, from 2007 to 2009, the real estate loan losses of large banks surged by 1,122% in the midst of the turmoil.1 Therefore, it can be argued, at least ex post, that banks with larger real estate loan portfolios were associated with higher risk.2 This argument about higher risks involved with real estate lending is also consistent with the empirical findings of Blasko and Sinkey (2006), who document that banks holding a vast proportion of their total assets in real estate loans are riskier and have higher probabilities of insolvency. …

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