How Global Rules Can Make Property Crises a Bank Problem

(Bloomberg) -- Property was behind the last big financial crisis, and if the fallout from Brexit worsens, it may be behind the next.

No wonder: real estate is an outsized part of banks' books, whether through mortgage loans or as collateral for other lending. So any blow to values can hurt the financial system -- and now, investors can blame it on regulators.

Basel III, the set of banking rules created after the 2008 crisis to bulletproof the system against another major blow-up, may in a cruel twist have increased banks' sensitivity to property. A regulation, now being revised, allowed banks to reduce the capital they set aside for loans to risky borrowers as long as there was real estate attached to the deal.

Standard risk weighting for loans backed by residential property

35%

Under those rules, large banks need to hold about 11.5 cents for every dollar they lend. How you measure that dollar depends on the risk weighting assigned to the borrower. Against a loan to, say, the U.S. government, considered risk-free, the bank may not have to set aside a penny. In lending to a small enterprise, the institution might need to reserve 17.25 cents of capital for every dollar. If, however, there is a property pledge attached to that loan, the amount may drop to 4 cents. This is why banks like real estate as collateral.

Shifts in property prices thus can have a disproportionate impact on the banking system. And while the panic that led seven open-ended property funds in the U.K. to halt redemptions doesn't mean prices are about to collapse there, if they did, banks in London could be at risk.

Take Barclays: Since 2010, the share of its loans that are backed by real estate went from 27.2 percent to 35 percent of the bank's internal ratings-based credit exposure. Meanwhile those secured by mortgages, which used to form 10 percent of its loans, dropped to 8.9 percent. As of Dec. 31, the bank had 156 billion pounds ($201.7 billion) of loans with property attached, and only 13.9 billion pounds lent as mortgages.  

Mortgages have been shrinking since the financial crisis because of the "application of more stringent residential mortgage requirements to buy-to-let mortgage applicants, ensuring better lending decisions," as Barclays said in its annual report. Yet altogether, 44 percent of Barclays's loans had some form of property attached.

Barclays is just one example here of a pattern repeated across the world. Property has always been favored collateral, because in most places it's easy to take over if the borrower can't repay. By making it cheaper for banks to lend against real estate, global regulators have institutionalized that choice and deepened the potential impact of property prices on the financial system. 

This reliance also may exacerbate credit cycles. In a recession, property prices drop, dragging down the value of bank collateral and forcing lenders to retrench, which then aggravates the economic downturn. If the prices of London homes and offices really drop, as the market has been signaling, this could happen in the U.K. 

As global regulators review the rules they set in the heat of the crisis, those rules need to evolve so that an asset doesn't turn into a liability.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story: Christopher Langner in Singapore at clangner@bloomberg.net.

To contact the editor responsible for this story: Paul Sillitoe at psillitoe@bloomberg.net.