Impact of Real Estate Loan Default Shocks on the Banking Sector: Evidence from China

Large-scale real estate loan defaults have frequently occurred in China in recent years. This study proposes a model to describe the risk contagion process within the banking system under such loan default shocks. The model incorporates both interbank debt default contagion and asset liquidity contagion arising from fire sales of bank assets. Using data from listed banks in China, numerical experiments systematically examine the impact of different real estate loan default scenarios on banking system stability. The results show that: (i) although the banking system is resilient to small-scale shocks, it becomes vulnerable to large-scale shocks stemming from real estate loan defaults. Preventing major shocks in key banks is crucial for maintaining financial stability. (ii) Developing asset sale strategies for illiquid assets from a system-wide perspective can mitigate the negative impact of loan defaults on the banking system. (iii) Adjustments to monetary policy, such as changes to banks' statutory leverage ratios and the price sensitivity of illiquid assets, can enhance banks' ability to withstand loan defaults. These findings offer valuable insights for policymakers in developing effective response strategies to reduce the impact of real estate loan defaults on the banking system.