Structural changes in financial markets and in various segments of the financial services industry, especially the savings and loans, have presented opportunities and threats to commercial banks.

Many bankers have reacted by shifting their portfolios toward real estate lending. Risk-based capital requirements and reform of federal deposit insurance have provided additional incentives for banks to specialize in real estate lending.

We have investigated the on- and off-balance-sheet activities and performance of commercial banks that have a concentration in real estate lending, which we define as 40% or more of total loan assets secured by real estate in a particular year. The test period was 1989 through 1996, and banks not specializing in real estate lending were used as a control group.

The key results show that the number of real-estate-lending banks increased from 1,724 at yearend 1989 to 2,835 at yearend 1996, an annual growth of 7.4%. This is especially noteworthy given the substantial consolidation in the banking industry, which led to a decrease of 6.8% a year in the number of banks in our control group.

Most real estate banks are "community banks" with assets between $10 million and $500 million. Organizational structure does not seem to have a major effect on whether or not a bank specializes in real estate lending, as roughly similar proportions occur across the most common organizational forms of banking.

A safety index based on return on assets, capital, and the standard deviation of return on assets shows that long-term players in real estate are no riskier than more diversified lenders.

However, banks with concentrations in real estate lending in only one, two, or three of our eight sample years-what we call short-term players- have lower returns on assets, higher variability of ROA, and slightly less equity capital, resulting in a lower safety index on average.

The safety or risk index has great intuitive appeal, because it combines three fundamental measures of bank performance. The third measure, variability of ROA, addresses overall risk in finance and is a key component of valuing common stock.

The higher a bank's safety index, the less risky it is. Short-term real estate banks with hit-or-miss tactics have not been as successful as other banks. In contrast, long-term real estate banks have been safer than both their inconsistent cousins and more diversified banks.

Though long-term real estate banks and nonreal estate banks had almost identical average ROAs over the years 1989 to 1996, non-real-estate banks had much more volatile earnings and, to offset that riskiness, held more equity capital per dollar of assets.

During our test period, which was characterized by decreasing inflation and nominal interest rates, real estate banks demonstrated their economic viability. Nevertheless, like the S&Ls of old, they take on too much interest rate risk. Though they use some floating-rate loans to manage their exposure to interest rate risk, most do not use interest rate derivatives.

Moreover, real estate banks make, on average, 64% to 75% of their real estate loans (secured by one- to four-family residential properties) as fixed-rate contracts. Funding these longer-duration assets with shorter- duration deposits does not bode well for the next upswing in the interest rate cycle.

Given the availability and refinement of tools for managing interest rate risk, it is puzzling why so many real estate banks behave like predestined S&L zombies. On the other hand, given the lack of effective regulatory incentives from either risk-based capital requirements or variable-rate pricing of deposit insurance, the puzzle seems less complex.

Finally, since most real estate banks, like most community banks, face little market discipline, they can be viewed as simply responding to the lack of incentive-compatible contracts for managing interest rate risk.

Recent increases in the number of real estate banks and weaknesses in their aggregate hedging should generate concerns about the potential effects of unexpected increases in interest rates on the banking industry.

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