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h the effects-oriented view.  This is necessary for real estate risk
management because it allows us to calculate the total market risk of a bank, which is a function of

its assets‘ volume and specific sensitivity to the real estate market.

2.  Evidence of the importance of real estate market risk for banks

The real estate market risk of financial institutions cannot be measured from information
generally available to the public.  Therefore indirect ways have to be found to assess its importance,
for instance by comparison to other types of market risk.
•  Several studies indicate that the systematic portion of total real estate risk is lower than that of

comparable risks, e.g., the stock market risk.

3. This finding alone doesn’t answer our question

  See, for instance, Capozza/Schwann (1990). This phenomenon can be explained by the extreme heterogeneity of the
real estate market, where—due to the immobility of the traded assets—each asset is unique and hence has its own
market which an overall market index cannot fully represent.
Profitability risk
Price risk
Credit risk
Collateral risk
Cash flows
Other (market)
prices
Credit-
worthiness
Value of the
collateral
Value of real
estate-related
assets
Real estate
market
Other influences
Direct real estate market riskbecause we don’t know how much of the total risk banks can diversify away and how much risk
remains after using hedging instruments.
•  Other studies show a significant correlation between the systemic risk in the financial services

industry and the real estate market.

4

 It can be concluded that one of the major reasons for most
prominent banking crises of the last two decades were real estate crises, which is a strong
indication for the importance of the real estate market risk on the macro level.
•  On the level of the individual banking firm, there is also plenty of evidence for the strong

influence that fluctuations of the real estate market have on the performance of mortgage loans.

5

Yet again, those studies provide no measure for the importance of real estate market risk.
For that, we have to use methods from capital market research, such as factor models based on the
Arbitrage Pricing Theory (APT).  In the past, bank stock returns were mostly explained by two-

factor models with a market factor and an interest-rate factor.

6

 Some researchers have tried to refine
this method by adding a third factor, e.g., foreign currencies, inflation or real estate.  The basic form
of such a model is:
Rit = ß0 + ß1 RMt + ß2 It + ß3 RRt + eit
where Rit represents the return on a portfolio of bank stocks i in period t, RM is the stock
market return, It stands for the interest rate, RR is the real estate market return, eit is an error term,
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