Comparing banking in the 1950s to today, we find giant changes that surely would have astonished the bankers of that earlier time. What’s the biggest and most important one?
You might nominate the shrinkage in the total number of U.S. banks from over 13,200 in 1955 to only about 5,300 now—a 60% reduction. Or you might say the rise of interstate banking, or digital technology going from zero to ubiquitous, or the growth of financial derivatives into hundreds of trillions of dollars, or even air conditioning making banking facilities a lot more pleasant.
You might point out that the whole banking industry’s total assets were only $209 billion in 1955, less than one-tenth the assets of today’s JPMorgan Chase, compared to $15 trillion now. Or that total banking system equity was $15 billion, less than 1% of the $1.7 trillion it is now. Of course, there have been six decades of inflation and economic growth. The nominal GDP of the U.S. was $426 billion in 1955, compared with $17.9 trillion in 2015. So banking assets were 49% of GDP in 1955, compared to 83% of GDP now.
But I propose that the biggest banking change during the last 60 years is none of these. It is instead the dramatic shift to real estate finance and thus real estate risk, as the dominant factor in the balance sheet of the entire banking system. It is the evolution of the banking system from being principally business banks to being principally real estate banks.
In 1955, commercial and industrial loans were 40% of total banking loans and real estate loans only 25%. The great banking transition set in after 1984. The share of C&I loans kept falling, down to about 20% of total loans, while real estate loans rose to about 50%, with a bubble-induced peak of 60% in 2009. In this remarkable long-term shift, the share of real estate loans doubled, while the share of commercial and industrial loans dropped in half. The lines crossed in 1987, three decades ago, and never met again, despite the real estate lending busts of the early 1990s and of 2007-2009.
The long-term transition to concentration in real estate would have greatly surprised the authors of the original National Banking Act of 1864, which prohibited national banks from making any real estate loans at all. This was loosened slightly 1913 by the Federal Reserve Act and significantly in 1927 by the McFadden Act – in time for the ill-fated real estate boom of the late 1920s.
The real estate concentration is even more pronounced for smaller banks. For the 4,700 banks with assets of less than $1 billion, real estate loans are 75% of all loans, about the same as their bubble-era peak of 76%.
Moreover, in another dramatic change from the 1950s, the securities portfolio of the banking system has also become heavily concentrated in real estate risk. Real estate securities reached 74% of total banking system securities at the height of the housing bubble. They have since moderated, to 60%, but that is still high.
In terms of both their lending and securities portfolios, we find that commercial banks have become basically real estate banks.
Needless to say, this matters a lot for understanding the riskiness of the banking system. The assets underlying real estate loans and securities are by definition illiquid. The prices of these assets are volatile and subject to enthusiastic run-ups and panicked, unexpected drops. When highly leveraged on bank balance sheets, real estate over banking’s long history has been the most reliable and recurring source of busts and panics.
A good example is the frequency of commercial bank failures in 2007-2012 relative to their increasing ratio of real estate loans to total loans at the outset of the crisis in December 2007. From the first quartile, in which real estate loans are less than 57% of loans, to the third quartile, in which they are over 72%, the frequency of failure triples, and failures are nine times as great for the highest ratio quartile as for the lowest. In the fourth quartile, real estate loans exceeded 83% of loans, and the failure rate is over 13%, which represents 60% of all the failures in the aftermath of the bubble. The 50% of banks with the highest real estate loan ratios accounted for 82% of the failures.
Central to the riskiness of leveraged real estate is the risk of real estate prices falling rapidly from high levels—and right now those prices are again very high. The Comptroller of the Currency's current "Risk Perspective" cites rapid growth in commercial real estate loans, "accompanied by weaker underwriting standards" and "concentration risk."
The predominance of real estate finance in banking’s aggregate banking balance sheet makes that risk far more important to the stability of the banking system than the bankers of the 1950s could ever have imagined.
Alex J. Pollock is a distinguished senior fellow at the R Street Institute in Washington, DC. He entered international banking in 1969 and was president and CEO of the Federal Home Loan Bank of Chicago 1991-2004.