An Investigation of Regulatory Changes and Real Estate Credit in Episodes of Financial Instability

Abstract

The deregulation and internationalization of domestic banking industries in many countries since the 1970s led to significant episodes of financial instability in many domestic banking systems, including Sweden, Australia, the USA, and most recently, the Asian Financial Crisis of 1997-1998. These episodes have stimulated many researchers and policymakers alike to search for reasons for such episodes. One of the main issues pointed out by many is the problem of asset quality on banks' balance sheets. This paper goes one step further to examine the reason why banks take on excessive risks and the role of real estate plays in such behavior. Information asymmetry is seen as one important explanation for banks' over-reliance on real estate as collateral for many loans. As will be shown in the case studies, change in banks' lending behavior is often triggered by a series of deregulation or regulatory changes of financial systems that brings about intensified competition. This often leads to aggressive asset growth and often is accompanied by deteriorating credit criteria. By looking at the case studies of Sweden, Japan, Australia and Thailand, this paper explores the relationship between deregulation of financial intermediaries and the subsequent behavior exhibited by banks in these markets. In particular, we are interested in how banks' behavior lead to an expansion of credit to real estate as an asset class, and how these collective decisions destabilize banking systems will also be discussed.