Real Estate Prices and Bank Stability

Real estate prices frequently deviate from their fundamental value due to rigid supply, heterogenous goods, and various market imperfections. This has two contrasting effects on the stability of banks as major financiers of real estate investment. On the one hand, higher prices increase the value of collateral and net wealth of home-owners, which reduces the likelihood of credit defaults and can potentially enhance soundness of banks. On the other hand, persistent deviations from fundamentals may foster adverse selection of increasingly risky creditors by banks seeking to expand their loan portfolios, making them more prone to distress. We test these competing hypotheses using unique data on real estate markets and banks in Germany. Our results support the notion that deviation of house prices from their fundamental value contributes to bank distress.We did not find significant association between house price changes and bank distress. Our findings suggest the importance of accounting for the developments in fundamental value of real estate prices when evaluating their impact on bank stability