The Micromechanism of Risk Formation in China Real Estate
Financial Market
LI Xiuting, GAO Peng, DONG Jichang
(Management School of Graduate University of Chinese Academy of Sciences)
Abstract: House price in China has increased at a historically fast pace since 2010. Real estate is a very important sector of the economy, as well as a major factor in the acquisition of wealth. The fluctuations in housing markets draw the attention of both government and consumers. And they have paid great concern about the accumulating arises of risk. It’s commonly accepted by most
researchers that the behaviors of interest groups in market mainly account for housing price fluctuation and the risk accompanying. The aim of this paper is to uncover the dynamic of housing price and risk formation in China real estate financial market, from the microscopic perspective.
Keywords Real estate finance; Market risk; Micromechanism; Bayes game; Dynamic game
1 Introduction
Since 2010, the central government has issued a series of polies that directly influence the supply and demand of housing market, so as to curb the excessive growth of real estate prices. On one hand, it tries to increase the supply of commercial residential buildings by regulating land hoarding, housing vacancy and other illegal acts, as well as by promoting the constructin of low-income housing. On the other hand, strict differentiation credit policy, or “purchase
restrictions” are implemented, so as to conctrol sepculation behaviors and encourage rational housing consumption in the market. These policies do affect the market as expected, but to a very limited degree. The housing price still keeps go up with a high growth rate, so does the rent. The affordability of housing has become a heated social inssue in China. As pointed out by some scholars, like Yi Xianlong (2005), there are different interest groups in who are strategic dealing with each other for their own sake and affecting the development of the market. Under the profound background of transition economy and society transformation in China, the relationship among differenct socail stratification has become more complicated and increasing interest confilcts arise. The healthy development of the real estate market play crucial role in the overall macroeconomic perfomance and national livelihood, as well as the harmonious development of society. It’s significant to study the relationship among different interest groups and analyze the microscopic formation of risk in the real estate market, and accordingly to deal with interest conflicts and coordination of the groups.
2 Lieterature Review
As for the formation of financial risk, there are various opinions held by different academic schools, which can also explain the formation of real estate financial market risk. For example, Monetarism, formulated by Milton Friedma, argues that variation in the money supply has major influences on national output in the short run and the price level over longer periods (Andersen,
1968) and that inappopriate monetary policy is the main cause of financial risks (Frideman, 1982).
Real estate industry is capital-intensive industry, the money supply and cost of capital is directly related to its development and prosperity. And Eunkyung？1998，found that monetary policy has
great impact on the variation of real estate price. Financial instability hypothesis (FIH), proposed by Hyman Minsky (1974), claimed that a fundamental characteristic of our economy is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles. In prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, speculation arises, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. Kindleberge (1985) developed Minsky’s theory and thought that financial crisis broke out due to
irrational behaviors, which could be explained as demonstration effect and bandwagon effect. Herring？1998，attributed the real estate bubbles to the short-sighted investors with limited information. He found that the intensive bank loan provided led to boom of real estate market, which in turn brew bank crisis. Robert J. Shiller (2008) argued that the social transmission of irrational exuberance is one of the most critical factors that triggered a speculative boom. Stiglitz？1981，claimed that asymetric information is the major cause of financial risk. In his opinion, commercial bank and depositor involve in a principai-agent relationship, and adverse selection and moral hazard may arise because the two parties don’t have the completely consistent interest
and incentives, which would reduce the efficiency of the market mechanism and affect the efficient allocation of capital, and then lead to a financial risk. Lu Yajuan (2006) put that the main reasons for the overbuilding of real estate, soaring housing price and the failure of macro-control included the negtive externalities of regional development caused by administrative division, information asymmetry .etc. Research group of Baoding branch of Cenral Bank (2007) conculded the main risk factors existing in China’s real estate financial market, including the imperfect
financing system, the lack of institutional arrangements, excessive dependence on bank credit, poor awareness of risk of financial institutions and so on. Lu Yuelan (2007) pointed out that there are two major problems, that is, the unreasonable investment of real estate credit and the imperfect external envrioment, would affect the development of China’real estate finance. Zhou Houming
(2008) summed up that the formation of real estate financial risk results from two major factors, the lack of risk sharing mechanism and effective control of post-loan risk. Shen Yanbin proposed that the boom of current real estate market indicated market risk. There are financial risk for high-liability enterprises, moral hazard for consumers and operational risk in bank loans and great credit risk in land development loans.
Several domestic scholars have tried to analyze the real estate market using game theory. Yang Jianrong and Sun Binyi (2004) established a three-party dynamic game model with incomplete information and concluded that policies have been determining the basic direction of China's real estate market. Han Zhenguo and Wang Li (2006) using game theory demenstrated it’s
the individuals’ rational behaviors that resulted in the arising, transmission, and burst of bubbles in the real estate market. Wang Ning and Tan Zhanglu (2006) studied the formation of housing price in China’s real estate market and found that the developers would always develop and sell property at a high price. Chen Geng and Fan Yun (2006) pointed out that the real estate market is a typical asymmetric information market. The pricing of commercial real estate and consumers’
decision-making constitutes a dynamic game with incomplete information.The developers could take their information advantage to influence consumers’decisions and push up the real estate
price. He Yuanbin (2006) thought that the price game between consumers and speculative investors are one of the factors contributing to the high housing price in China. Fan Qiaoyan (2009) analyzed strategies chioces of different players in China’s real estate market and warned that the
government should take immediate measures to prevent the financial risk.
The previous literature on the financial risk, financial crisis provides foundation and reference for the relevant research in the field of real estate market. Most scholars agreed that the development of domestic real estate market is the game results of all the interest groups (Peng Fangping and Fang Qiyun, 2003; Wang Jun, 2005; Chao Laichun and Xia Jing, 2006; Zhang Qiangwei and Xu Jian, 2007; Huai Jianjun, 2008). And some studies are made on the market risk in real estate market using game theory, but little was made specifically on the fincancial risk in the market. This paper tries to analyze the microscopic mechanism of risk formation in China’s real estate market based on game theory. Related studies are concluded in the section 2. Key market players are identified in section 3, and a bayes game model depicting the borrowing behaviors in the real estate financial market is constructed and anzlyzed in section 4. Finally, policy suggestions are provided as conclusion in section 5.
2 Players in the Housing Market
2.1 Government
As policy makers, the central government's main objective is to maintain sustained, steady and healthy development and ensure welfare of people, with the resposibilities of ensuring the smooth house price and housing affordability. When there is excessive volatility in the market, and house prices rise too fast, the central government would timely implement of policy intervention to maintain market stability.
Local governments play dual roles in the real estate market, as the executor of the central government’s policies and regulator of local market, with main objective of local GDP’s rapid
growth. Local officials consider tend to consider their achievements during the tenure. Real estate industry has a number of upstream and downstream industries, and the rapid growth of real estate market can bring a lot financial and tax revenue to the local government and quickly pull the rapid development of the local GDP. As statistics show, land transfer in Beijing, Shanghai and Guangzhou respectively accounted for 45.8%, 41.1% and 69.6% of local fiscal revenue in 2009. Therefore the local governments have great tendency of power rent-seeking and allying with real estate developers, taking incentive policies to maximum extent and restrictive policies to minimum extent. Besides, different local governments compete for talents and capital, so they would attract developers and investors with supportive policies.
2.2 Developer
Real estate developer is always the core and dominant player in the market, with the information advantage both in the borrowing and purchasing game. Real estate is a typical capital-intensive industry which has great dependence on bank loans. It’s estimated that about 80% of the real
estate investment funds, directly or indirectly, comes from commercial banks’loans (Xu Jianbin,
2003). However, mortagage loan is one of the new contributors to the banks’ revenue growth, as
high-quality asset, so banks compete for the mortagage product to enlarge market share, which
makes real estate lending business gradually transit from a seller to a buyer's market, where the developers hold dominant position.Compared with the home buyers, the developers also take dominant positon during the transaction process, for they are not desperate to sell houses to withdraw the money. They also have not incentives to reduce the selling price. The boom of real estate market in 2009 has help the real estate enterprises hold a stable cash chain and health balance sheet, which ensure their dominant position in the game.
2.3 Commercial bank
Under the current situation of real estate market, the commercial banks face hard decisions. On the one hand, the banks themselves are vulnerable to resist financial risks and the shock of financial crisis, and so they hold the same interest sought as the financial regulatory authorities, which is to approporiately controll the scale and quality of loans and loan, in order to reduce credit risk exporsure. On the other hand, investment in the real estate market has a relatively fast and stable return, and the housing loans, mortage loans have always been the core of high-quality and profitable assets of banks. Therefore, banks tend to expand the scale of the mortgage, and houses prices keep rising. Statistics show that personal housing mortgage loans of China's commercial banks have rise from RMB 332.9 billion yuan in 2003 to RMB 3.13 trillion yuan at the end of 2007, with an average annual rate of about 75%.
2.4 Home buyer
Throughout the game, the buyers try to maximize their utility by pays as little as possible to buy the property desired. Home buyers’ strategies are to wait and see, or purchase the property
immediately. They make decisions according to their needs, the expectation of market, as well as the strategy of real estate developers. Based on different kinds of demand, home buyers can be divided into two kinds which are investment-oriented buyes and consumption-oriented buyes, based on diffirent needs. And the consumption-oriented buys can further been divided into first-home buyers and improving-home buyers, the former of whom have more desire to home ownership. According to a survey, home buyers hold more confidence about the effects of real estate policies implemented. As the data show, the fraction of buyers who’re very confident about the effects of policies in the first quarter account for 36.1% of the whole respondents, a increase of 23.7% than in the first quarter of 2010, which indicates that buyers hold good expectation about the market. More buyers may choose to wait for another proper time to buy. But, on the other hand, the soaring rent make the buyes bear greater cost of not owning a home, which may put them in a disadvantage position during the transaction game with real estate developers.
3 Model
Based on definition of the Basel Committee on Banking Supervision (1975) and American economist Crockett (1997), this study defines the real estate financial risks as possibility of loss of banks’ credit fund under the background of "uncertainty or incomplete information” in which
there are excessive real estate speculations and abnormal fluctuationsof housing prices. And credit risks are not taken into consideration, that is, the borrowers would pay back the loan on time as long as they can. In the following parts, a Bayesian game model with two players is constructed
under the assumption that the policies keep stable. Further, the governement is introduced into the model to research its influence on the game equlibrium.
3.1 Borrowing game under given regulation
When the government is not considered, the key market players include the banks as the money lenders, and the real estate developers and buyers, both as money borrowers. The current prosperity of the real estate market can be divided into two possibilities, namely rational exuberance (R), and irrational exuberance (F) as Zhou Jingkui (2005). The real estate developers know much more about the industry, the market and the properties for sale than home buyers, who are thus easily affected by the strategy of develpoers and tend to follow the strategy. Therefore, this study assumes that developers and home buyers hold the same behavioral tendencies, and both of them are attributed as borrower in the market so as to simply the analysis. Borrowers take the first move in the game.
Then banks can accurately judge the market status with incomplete information. If the market is in a period of rational exuberance, the banks should compete for the high-quality asset and lend more monery to the borrowers for maximized profits. Conversely, if the market is in a period of irrational exuberance, which is more vulnerable to shocks, the banks should better to control the loan scale to reduce the risk exposure. However, as the real estate bubble would burst at a time of uncertainty, and the bank's own actions would also affect the time and manner the bursting, which makes the bank difficult to take appropriate action. In this research, the banks are assumed as Bayesian rational, who hold a priori of the market, and then modify the prior judgement according to the actions taken by the borrower and make final decision.
If the borrowers expected that the boom the market is rational with much potential to
Isustainable flourishing, they would make rational investment (). If the market is expected in the r
period of irrational exuberance, the borrowers have two strategies, namely, rational investment I(), to promote stable operation of the market, and access to the industry average profit, and r
Iirrational speculation (), which incurs the prevalence of market speculation, to get more f
speculative gains exposing to greater risk.
The banks hold a prior judgement about the maket status, which determines the market is in
！the period of rational exuberance at the probability of, and irrational exuberance at the r
！probability of .A the banks are Bayesian rational, they would modify their prior judgment f
(！,！)accordind to the first move of the borrowers, and the posterior probablity is: RF
！m，P(I/F)P(F)，ff！Prob{F/I}？？？~Ff！！P(I)m;~ffr;1； ：！P(I/R)，P(R)fr~ ！！1-？？？RF~P(I)m！;！ffr；
If the banks are risk averse, they would reduce the financial support to the market when they
conclud the market is in the period of irrational exuberance. On the contrary, if the boome of market is judged as rational, the banks would choose to increase the financial support to get a larger market share. When the market runs smoothly, the bank can infer that the market is in the period of rational exuberance, and the dominant strategy for them is to increase financial support. When the market is volatile, the banks can not accurately judge the market status, and then they make decisions according to posterior judgement.
Then the game tree is drawn based on all the assumptions:
Fig 1Borrowing game tree under incomplete information
As for banks, when the markt runs stably and the borrowers invest rationaly, they can get a profit of U by increasing the financial support, and a profit of Uby reducing the financial b1b2
support. But if the borrowers make irrational investment, they can get a profit of U by increasing b3
the financial support, and a profit of Uby reducing the financial support. The banks can get more b4
profit by increasing financial support in the rational exuberance market, so U> U>U> U. If b1b3b2b4
the market is infered as irrational exuberance and the borrowers make rational investment, the bankers can get a profit of U by increasing the financial support, and a profit of Uby reducing b5b6
the financial support. If the borrowers invest irrationally, the bankers can get a profit of U by b7
increasing the financial support, and a profit of Uby reducing the financial support. In the b8
irrational exuberrance market, the speculation prevails and the banks’ increasing financial support
itself is a speculative behavior, which may put the bubble busting. Under this situation, the banks
face much risks and get less profits, so U> U>U> U. Compared with the irrational b6b8b7b5
exuberrance market, the banks bear less risks in the rational market and so can get more profits, so U>U. Then the profits of banks’s with different actions satisfy the condition that is U> b4b6b1
U>U> U> U> U> U> U. b3b2b4b6b8b7b5
As for the borrowers, when the market is in the peiod of ratianl exuberrance, if they make rational investment and get much financial support, they can get the most profit of U. If little l1
financial support is provided, the borrowers get a profit of U. If they make speculation, and get l2
much financial support, they get a profit of U. f little financial support is provided, the borrowers l3
get a profit of U.When the market is in the period of irrational exuberrance and much financial l4
support is provided, the borrowers can get a profit of U. If little financial support is provided, the l5
borrowers get a profit of U. If the banks make speculation, and much financial support is l6
provided, they can get a profit of U. If little financial support is provided, the borrowers get a l7
profit of U. Generally speaking, the borrowers expose to less risk in the rational exuberrance l8
market, and then can get more profit, thus U>U>U> U.In the period of irrational exuberance, l1l3l2l4
speculative borrowers try to create the illusion of rational exuberance to get much financial
support from the banks, and then the ultimate profit Uwould be greater than the rational l7
investment income U. If little financial support is provided, then the borrowers would face the l5
risk of capital chain disruption, in which the least profit of Uis got, thus U> U> U >U. If l8 l7l5l6l8
much financial support is provided, the borrowers bear less risk, and the profits of Uand U got l1 l3
accordingly would be greater than those of Uand U, namely, U> U！U> U, likewise, U> U, l5 l7l1l5l3l7l2l6
U> U. When the borrowers make speculation in the market that is in the period of rational l4l8
excuberrance, and little financial support is provided, they get more profit than that in irrational
excuberrance, thus U>U. Finally, the profits of borrowers with different actions satisfy the l4l6
condition that is U> U> U> U>U> U> U> U. l1l3l7l5l2l4l6l8
3.2 Solution and Equilibrium
mnWe assume that the strategies of real estate developer and bank are and respectively.
m . The borrower chooses rational investment with probability, and the m；[ 0, 1 ]n；[ 0, 1 ]
nbank chooses increasing financial support with probability. The payoff matrix is as follows:
Fig 2: Payoff matrix in irrational exuberance
Fig 3: Payoff matrix in rational exuberance
Under complete information, both players know the state of the market. When the market state
is rational exuberance, and then U> U！U> U！U> U！U> U;so the Nash equilibrium l1l3l2l4b1b2b3b4
strategy is (rational investment, increasing financial support). When the market is irrational exuberance, and then U> U！U> U！U> U！U> U, the Nash equilibrium strategy is l7l5l6l8b6b5b7b8
(rational investment, decreasing financial support).
Under incomplete information, the borrower has information advantage. Assume that the
borrowers assess the market is in irrational exuberance, and then move first to raise price with
mU(m,n)probability. The expected payoff is. When the borrower’s action is observed, the l
U(m,n,I)bank will get an expected payoff, if it assesses the market state is in rational bf
exuberance. The expressions are as follows:
U(,)？m;(1；m)[nU;(1；n)]mnUU，ll6l7l8？2， ： U(m,n,I)？n[(1；)U;];(1；n)[(1；);)]！！U！U！UbfRb5Rb1Rb6Rb2；
Taking the first-order partial derivative of equation (2):
(U，l？U；[nU;(1；n)U]？U；U;n(U；U)l6l7l8l6l8l8l7~(m~(Ul~？(1；m)(U；U)，0l7l8~(n~ ：！！ ;3；(Urbf~？-？02！！(m(m;)~rf
~！(Ubr~UUUU？U；;(-;-U)b5b6b1b2b6b5~(nm！;！fr；
m The borrower’s expected payoff of choosing rational investment with probabilityis
nnnproportional to the bank’s strategy, and its marginal payoff is also proportional to. Greater
will increase the probability of financial support, and the borrower will obtain higher payoff by
nspeculating. Otherwise, Lowerwill decrease the probability of bank’s financial support, and the borrower cannot obtain huge speculative payoff.
(U(Ubl？0？0m,nLetandyield the critical strategy (): 11(n(m
U；U，l6l8n？1~U-Ull8~7 ;4； ：！U；Ub1b2r~m？，1~U-U！b6b5f；
n？n If the borrower expects the bank will choose the strategy, no matter what strategy, the 1
n，nborrower will maximize its expected profit. If the borrower expects the bank’s strategy is, 1
(Ul，0and so, he will tend to get high speculative payoff by choosing the strategy. And m？0(m
(Uln？n？0if the borrower expects the bank’s strategy is, and so, it is unlikely to get bank 1(m
support by speculation. He will choose the rational investment, and his strategy is. m？1
m？m Similarly, if the bank expects the borrower will choose the strategy, it will obtain the 1
m？mmaximal expected payoff. If the bank expects the borrower’s strategy is, and so1
(Ub，0, the bank will maximize its expected payoff when. In this case, it is less likely to n？1(n
speculate for the borrower in the period of irrational exuberance. If the borrower’s speculative
behavior is observed, the banks will think the market is in irrational exuberance, and tend to
m，mprovide high financial support. And if the bank expects the borrower’s strategy is, and so1
(Ub？0, the bank will maximize its expected payoff when. In this case, the borrower will n？0(n
choose more speculative behavior, and the market may be in a period of irrational exuberance. The bank's dominant strategy is to reduce financial support, so. n？0
From the above analysis, the borrower and the bank both make their priori beliefs about market using their available information. The borrower moves first, his decision is based on the bank’s
critical strategy. In fact, the critical strategyis the borrower’s tolerable psychological nn11
expectation, and is determined by the borrower's payoffs under various options. And then the bank will modify its priori belief according to the borrower’s behavior, and make its decision based on
mmthe borrower’s critical strategy. The critical strategyis the bank’s tolerable psychological 11
expectation, and is jointly determined by the bank's payoffs under various options and its priori
(！,！)beliefs. Finally, the game will reach its perfect Bayesian Nash equilibrium, and the rf
equilibrium strategy is:
**，m；argmaxU(m,n)~l ？5， ：**~n；argmaxU(m,n,I)bf；
！？1 If the bank expects market is in irrational exuberance, and that, thus it will reduce f
financial support to restraint market speculation to some extent. If the bank estimates the market optimistically, a greaterwill increase the likelihood to enlarge financial support. The borrower ！r
will get sufficient money, the market speculation will become prevailing, and ultimately the real estate bubble will be formed.
3.3 Impact of regulation on the equilibrium
If the regulation is given, the equilibrium strategy of debit-credit game in real estate market is
****{m；argmaxU(m,n),n；argmaxU(m,n,h)}. The borrower and bank make their lb
decisions according to the critical strategies () of each other. The borrower’s critical m,n11
！UU；b1b2rstrategyis jointly determined by the bank's payoffs under various options m？，1U-U！b6b5f
(！,！)and its priori beliefs about market. If the borrower expects market is in rational rf
exuberance, and makes rational investment, the greater differential payoff of borrower obtained from between increasing and reducing financial support, it is more likely for the borrower to do rational investment. And if the borrower expects market is in irrational exuberance, and chooses rational investment, the greater differential payoff of borrower obtained from between increasing and reducing financial support, it is less likely for the borrower to do rational investment. If the bank expects market is more likely in irrational exuberance, the borrower is more likely to do irrational speculation.
U；U6l8l The bank’s critical strategyis determined by the borrower's payoffs with n？1U-Ull87
various options. If the bank expects market is in irrational exuberance and reduces the financial support to the borrowers, the greater differential payoff of borrower obtained from between rational investment and speculation, it’s more likely for the bank to increase financial support. If
the borrower makes speculation, the greater differential payoff of borrower obtained from between increasing and reducing financial support, it’s less likely for the bank to increase financial support.
Since 2010, a series of policies have been implemented, designed to make direct influence on the supply and demand of real estate market, which affects the payoffs of key players in the
market. For example, the land polices require the developers pay at least 20% of land price as auction bond, 50% of the land price in one month. The developers who keep idle lands would be punished by forzening the asset. The policies also require the local government ensure more than 70% of lands should be supplied to indemnificatory housing construction. The banks are required not lend money to some developers. These policies if put in place, can directly affect the market supply. On one hand, they make the banks more prudent to provide financial support to real estate market, and reduce the speculation of developes and investment-oriented home buyers through constrained funding sources. On the other hand, they increse the costs and reduce the profits of speculation by more strict capital qulification and raising the penalty. Taking “New 10
requirements” as an another example, it expicitly requires banks to implement strictly differential credit policy, suspend the mortagage laor to home buyers who purchase the third or more property, and raise the downpayment and interest rate of the loan purchasing the second property. In addition, there have been 14 large and medium cities introducing different versions of the “restriction order” to the local real estate markets. The policy increses the constraints of
speculative home buyers, and reduce corresponding speculative profits, which imposes great pressure to the speculation in the market and affects the market expectation to some extent.
To sum up, the regulatory authorities, through the implementation of regulatory policies, can on the one hand, change the payoffs of market players, especially those of developer's who are in a dominant position in the game, so as to guide the sound development of the market. On the other hand, it plays the role of policy direction to guide the market's rational expectations, and increase the cost of speculation, urges the banks and other financial institutions to strengthen credit management and risk control, to keep the market healthy and stable.
4 Policy Suggestions
The fluctions of real estate market affects the lives of hundreds of millions of peope. And the real estate industry is closely related to financial industry which makes the fluctions of real estate market can easily transfer to the financial markets, and lead to financial risks. If the house prices keep rising at such a rapid speed, more risks would be accumulated, and the bubble would come to bursting finally. In this regard, the major concern of regulatory authorities is to adjust the payoffs of the market players, balanct their positions in the game, so as to guide rational market expectations and keep the market develop healtily and stably.
Firstly, weaken the position of real estate developers. Reasonably adjust the credit structure and control credit scale of real estate market. Encourage diverstification of financing channels for real estate enterprises and reduce their capital dependence on bank financing.
Secondly, strengthen the real estate credit risk management and reduct the commercial banks’
exposure to risks. Urge the banks to reasonably determine appropriate scale and proportion of real estate loans considering of their own financial situation, risk tolerance and development prospects of real estate market.
Thirdly, reduce the game costs of consumption-oriented home buyers. Implement the strictly differentiated credit policy and increase the financial support to consumption-oriented home buyers. Meantime, constrain the financial support to speculative home buyers. Continue to strengthen the supply of indemnificatory housing, especially the construction of public rental housing. Critically review the applicants’ qualifications for indeminificatory housing.
Fourthly, improve the executation of local government, and establish a reasonable policy evaluation system. The central government should broadly participate in the rule making process of local policies, urging local governments to introduce feasible implementation plan timely and supervising the implementation of local policies. Policy evaluation system should be established as soon as possible. The implementation effects of policies should be included in the evaluation of performance of local governors.