The consequences of cyclical lending and the need for a new prudent framework.

I remember in the mid-to-late 1980s, when I was a relatively young, newly qualified valuation surveyor in London, I was constantly asking my peers, “why are the banks lending so much on commercial property? Surely, they know that there will be a recession around the corner?”

I never received a good answer to this inquisition; indeed, I rarely received a courteous response. Everyone was caught up in the boom, lending was strong and everybody from the banks to the agents to the developers in the property food chain were feeding well on strong bonuses and commissions. But then, in 1987, everything changed; prices crashed, and the banks started to bemoan losses and defaults and they were reeling in the shock that property values could fall and fall so much. I remember thinking at that point that banks didn’t understand market value (MV), and they erroneously thought that it was a magical figure that could and would never fall from the figure given at the loan’s commencement.

Bank Lending – a pro-cyclical pattern

I also remember working with the British Banking Association in the early 1990s when I made the radical suggestion that the loan-to-value (LTV) ratios were too high in property booms, and, conversely, too low in recessions. If you use the analogy of the peaks and troughs of a property cycle being equivalent to high mountains and low valleys, then the risk of being hurt if you fell was substantially higher at the top of the mountain than in the car park before or after the climb. Yet, the LTV criteria of banks – if you pardon my English – was “arse about face”; it allowed for more risk of prices falling in the downturns than in the up markets. Banks would lend at more preferential rates in booms based on higher LTVs (for commercial property up to 90% of MV) and at higher interest rates on lower LTVs (maybe as low as 40%) in the lows.

Later, I moved into academia. As an observer, I asked the same questions again in 1995 before the smaller crash of 1996/97 and, once again, in the late noughties before the onset of the financial economic crash (FEC) of 2008. It was constant déjà vu and the banks continued to lend too much in the booms as their LTVs were benchmarked on current market pricing as indicated by MV.