But the two phenomena are correlated in a remarkable number of instances ranging over a wide variety of institutional arrangements, in both advanced industrial nations and emerging economies. The consequences for the real economy depend on the role of banks in the country's financial system. In the United states, where banks hold only about 23 percent of total assets, most borrowers can find substitutes for bank loans, and the effect on the general level of economic activity is relatively slight. This paper develops an explanation of how real estate cycles and banking crises may be related and why they occur. It first reviews the determinants of real estate prices and asks why the real estate market is so vulnerable to sustained positive deviations from long-run equilibrium prices, defined as prices that are sustainable indefinitely in the absense of any additional shocks to the market.
Special emphasis is placed on the role played by the banking system.
Increases in the prices of real estate may increase the economic value of bank capital to the extent that banks own real estate. Such increases will also increase the value of loans collateralized by real estate and may lead to a decline in the perceived risk of real estate lending. For all of these reasons, an increase in the price of real estate may increase the supply of credit to the real estate industry, which in turn, is likely to lead to further increases in the price of real estate. Bank behavior may also play an important role in exacerbating the collapse 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.