Boston Fed President Eric Rosengren spoke at the Asia-Pacific High Level Meeting on Banking Supervision in Bali, Indonesia; organized by the Basel Committee on Banking Supervision, the Financial Stability Institute, and the Executives’ Meeting of East Asia-Pacific Central Banks Working Group on Banking Supervision; and hosted by Bank Indonesia. Here are the top takeaways from his talk, with the full text and charts available here. 

Real estate’s role in past financial instability

Real estate has played an important role in past periods of financial instability, Boston Fed President Eric Rosengren said today at a conference on banking supervision.

Because many financial intermediaries lend to households and businesses with real estate as the collateral, recessions that are accompanied by significant declines in real estate valuations can lead to broader problems, Rosengren said.  

“In the United States the two most significant recent periods of financial instability were accompanied by declines in real estate values that impacted financial institutions and intensified the business cycle.” 

Not predicting problems; focusing on heading them off

Rosengren stressed that he was not predicting problems, but rather suggesting continued work to head them off.  He noted improvements since the financial crisis that have left financial institutions with better capitalization and liquidity, and resolution plans.  But he cautioned against overconfidence.

Noting that real estate holdings are widespread, and that the tools for handling valuation concerns are somewhat limited, Rosengren believes we must acknowledge that the commercial real estate sector “has the potential to amplify whatever problems may emerge when we at some point face an economic downturn.”  

“When large losses have occurred because of declines in real estate values, banks have historically shrunk their lending,” and “such a tightening of lending has several compounding effects.”

“I am not expecting such problems in the near term,” he stressed, “but would say that awareness, informed by data and analysis, is a first important step to continued actions that can head off unwelcome problems in the future.” 

Valuations, and growth in lending

Rosengren noted that commercial real estate capitalization rates are very low by historical standards, meaning that price increases have been outpacing growth in net operating income.  “This is occurring despite the gradual tightening of short-term interest rates and the issuance of real estate guidance by bank regulators.”

Rosengren also said that more-recent growth in lending has been quite significant.  “Over the past year, holdings of commercial mortgages by the banking sector have increased 8.9 percent, while bank holdings of multifamily mortgages have increased 12.0 percent,” he said. 

“This growth has occurred while bank supervisors have been cautioning about the potential risks emanating from the high valuations in some sectors of the real estate market.”