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Systemic Risk from Real Estate and Macro-prudential Regulation

Banking regulation failed to prevent the crisis that started in the summer of 2007. One reason is that it was based on a micro-prudential approach. This involved regulating the risk taken by individual banks. The idea was that if the risk taken by each individual bank was limited then the risk in the financial system as a whole would be limited as well. The problem is that this approach ignores systemic risk. This is the risk faced by the financial system as a whole.

Systemic risk is a complex phenomenon and our understanding of it is still limited. However, there are at least four types of systemic risk. The first is banking panics. These are self-fulfilling multiple equilibria as modeled by Bryant (1980) and Diamond and Dybvig (1983). The work of Friedman and Schwartz (1963) suggested that this was the most important systemic risk. The second is asset price falls that lead to banking crises. There can be many reasons for asset price falls, including business cycle downturns as emphasized by Gorton (1988), the bursting of real estate bubbles, and sovereign default.

The last two appear to be particularly important in the current crisis. The third type of systemic risk is contagion in the banking system (Allen and Gale (2000a)) or in the payments system (Freixas, Parigi, and Rochet (2000)) that can lead to the collapse of the financial system. The fourth is foreign exchange mismatches in the banking system. These appear to have been at the heart of the 1997 Asian financial crisis.

Herring and Wachter (1999), Reinhart and Rogoff (2009), and Crowe, Dell'Ariccia, Igan, and Rabanal (2011) have provided evidence that the most important source of systemic risk is the collapse of real estate prices. This has been true both historically and in the current crisis. Our focus is on this type of systemic risk and how it can be countered using macro-prudential policies. Section 2 considers the importance of real estate booms and busts for financial crises, including the current one. Four features are focused on in this context. The first is the positive serial correlation of real estate prices, the second is the regional variation in real estate prices, the third is the role of low interest rates in setting off booms, and the fourth is the availability of credit.

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Systemic Risk from Real Estate and Macro-prudential Regulation