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It is a timely thought. As the UK government concludes its deliberations about whether or not Royal Bank of Scotland should be broken up into a good and bad bank, some of the UK’s top commercial property experts will on Tuesday publish a report on how real estate finance should be regulated in future.
Timely, because one of the big bad bits of RBS that could do with going into that putative bad bank is its vast commercial property book. At the last count, RBS had £59bn of exposure to commercial property, 39 per cent of which was non-performing, with a similar proportion already in the group’s “internal bad bank”, coyly dubbed its non-core division.
If any bank is an illustration of the dangers of misguided commercial property lending, it is RBS. It was excessive risk-taking in this area, as much as the bank’s infamous acquisition of ABN Amro, that triggered its failure five years ago.
As A Vision for Real Estate Finance in the UK – from the Real Estate Finance Group – highlights, poor commercial real estate can invariably “cause or prolong” a financial crisis. The recent crisis has been no exception. The natural consequence of the 45 per cent collapse in UK commercial property prices between mid-2007 and early 2009 has been a pro-cyclical evaporation of financing capacity.
Not only have banks been “significantly hindered” in their ability to lend, the report says; the damage has been compounded by “over-regulation”.
It is hardly surprising that an industry panel, comprising bankers, real estate developers and other property experts should publish a report that criticises the regulatory response to a crisis.
But the tome – now sitting on the desk of Andy Haldane, the Bank of England’s director of financial stability – is clearly being taken seriously by regulators.
There are plenty of sensible recommendations in the REFG report. There should be mandatory qualifications for property lenders. There should be a diversity of credit supply as in the US; insurers, for example, could be encouraged to compete with banks. And a central database should be created of all £250bn of the UK’s commercial real estate exposures to restore trust in the industry and help reignite the European commercial mortgage-backed securities market.
One of the group’s ideas – on regulatory capital requirements – is particularly trenchant, and goes to the heart of the industry’s broken supply-demand dynamic: how much capital must banks hold against their lending.
As in other areas of their response to the financial crisis, UK regulators have gone their own way in determining banks’ capital requirements in commercial real estate – and have ended up being tougher.
This year the Prudential Regulation Authority introduced so-called “slotting” rules that forced banks to stop using their own clever, often over-optimistic, models to judge the risk of a commercial property asset, and instead put each loan into one of four “slots” with standardised capital risk weightings.
The problem, property experts argue, is that such a simplistic approach constrains credit supply at a vital juncture, in turn compounding property price falls across the UK. “Over-regulation is likely to persist precisely during the period when it is least required,” says the REFG.
So far, so self-servingly predictable. But here’s where the group’s argument breaks with the expected. “A return to lighter touch regulation [is likely to] coincide with the return of over-exuberance to the market,” the report adds. Its answer – that regulators should judge the capital requirement of a real estate loan relative to the “long-term sustainable” value of the underlying property rather than its potentially volatile point-in-time value – smacks of fudging. Asset price manipulation with the aim of prettifying bank balance sheets is unhealthy. But the group, which believes market values must also be transparent alongside smoothed “sustainable” valuations, insists the approach would be a benign way to smooth peaks and troughs in bank capital requirements and thus in credit supply.
The idea takes its cue from Germany – not from the country’s regulatory capital system, but from the valuation method used to underpin resilient Pfandbrief mortgage securities market.
The REFG panel admits that ideas suitable for one country’s real estate market may not be transferable elsewhere. But policy makers in Spain and Ireland, as well as those in some of the frothier parts of Asia, would do well to weigh the group’s ideas nonetheless. Pre-empting problems is easier than setting up all those bad banks and non-core units.
Patrick Jenkins is the Financial Times’s banking editor
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