Exposure to Local Housing Markets and Bank Performance

Abstract

We uncover a robust positive relationship between a bank’s share of retained mortgages and subsequent bank performance. This relation is time-varying and depends on the business cycle. During crises, when house prices decline and delinquencies increase, high-retained-share banks report higher profitability than other banks. The relation is reversed during expansion periods when house prices rise and delinquencies are typically low. We provide evidence that banks’ internalization of fire sale externalities acts as a main channel with important real effects: high-retained-share banks originate higher loan volumes at more favorable terms and indirectly affect the performance of banks active in the same region. Further evidence confirms that this channel is different from alternative explanations based on market power, relationship effects, diversification, or informational benefits.

Keywords: Fire sales, bank profitability, bank concentration, resilience

JEL Classification: G21, G32; L13, R31