The impact of commercial real estate secured lending on financial stability

Since the Global Financial Crisis (GFC), lending secured on commercial real estate (CRE) is one aspect of the financial system which, virtually ignored previously, has come under increasing scrutiny.

In the UK, The Independent Commission on Banking’s review of the GFC identified the failure of the financial system to weather a major CRE market downturn in 2007 as a major cause of the subsequent stress on that system. Although this review failed to address CRE lending in its proposed reforms, the Bank of England (BoE) was alive to the issues, as was the industry.

During 2013 and 2014, a “Cross-Industry RE Finance Group” produced “A Vision for Real Estate Finance in the UK”. One of the major aspects of this vision was the need to reform the valuation process of CRE assets for secured lending purposes. Crosby and Hughes (2011) had already published work on bank lending valuations and illustrated how a different cash-flow modelling approach to valuation would have identified the impending downturn in CRE prices in 2005, two years earlier than the eventual crash. Normally, bank lending valuation does not attempt to do anything more than identify or verify the current correct exchange price and this valuation figure does not provide any further advice concerning the ability of the asset to act as security for the whole period of the loan.

Crosby and Hughes (2011) informed the final vision report in 2014. From 2014 to the present and Professor Crosby played a leading role in shaping the approach of both industry and Government to subsequent reform of the bank lending valuation process. Firstly, following on from the Vision Report, he acted as a lead author of the 2017 industry report developing different forms of valuation modelling and back-testing those models to see if they identified the downturn. The back-testing extended to previous CRE market downturns and crucial findings included the nature of different downturns, which explained why certain models picked up some elements of the downturns, but not all.

Secondly, he acted as consultant to the BoE and helped develop its modelling of CRE markets and the model’s use in stress testing the UK financial system. This work is cited in its Financial Stability Reports and has been discussed with the International Monetary Fund, which is developing its own responses to global CRE financial stability issues.

Thirdly, in 2019-2020, Professor Crosby and Dr Devaney, in collaboration with Cambridge University, undertook further BoE-supported and industry-funded research developing the long-term valuation and market analysis modelling of the UK market. In 2020, the BoE stated that it intends to use the more sophisticated modelling recommended in that report in its stress testing and financial stability modelling of CRE lending markets.

Finally, Reading has been instrumental in guiding the valuers’ response to the development of long-term valuation approaches. Professor Crosby was lead author of the Royal Institution of Chartered Surveyors (RICS) professional guidance on bank lending valuations for the UK and Europe. He has since taken on lead authorship of advice in 2021 to the EU on their potential adoption within their Credit Requirements Regulations of a new definition of prudent valuation, included in the Bank for International Settlements’ Basel III accord. This advice was steered by the three major global and European valuation standard setters (the International Valuation Standards Council, The European Group of Valuers’ Associations and the Royal Institution of Chartered Surveyors), with the aim of providing a conceptual and practical framework for any adoption of long-term valuation approaches across Europe.

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