Do Banks Drive House Prices? How Money Markets Shape the Housing Market

Takeaway: New mortgage lending drives house prices up by injecting fresh purchasing power into the market, while loan repayments push prices down by destroying money, revealing that bank balance sheets actively steer real estate cycles.

---

Key Points

• Credit Creation Lifts Prices: A boost in new mortgage originations acts as a temporary injection of fresh purchasing power that creates a lasting upward shift in house prices.

• Credit Destruction Cools Prices: Paying down mortgage principal extinguishes bank deposits and depresses home prices about as strongly as new lending increases them.

• Quantities Matter More Than Interest Rates: Central bank interest rates affect housing primarily through the volume of credit banks create and destroy, rather than through a direct interest-rate effect on homebuyer demand.

---

Why is housing so expensive? Why do home prices spike rapidly during economic expansions and cool off when borrowing slows down? Standard explanations often point to population growth, construction costs, interest rates, or supply shortages.

While those factors matter, they overlook a fundamental feature of modern banking: commercial banks do not simply lend out pre-existing savings, they create new money when they issue loans.

When a bank approves a mortgage, it creates a new deposit electronically, injecting fresh purchasing power directly into the housing market. Conversely, when a borrower repays mortgage principal, that money is extinguished from the economy.

Most economic studies measure mortgage credit using net total debt (the "stock" of credit). However, netting these numbers together conceals the continuous tug-of-war between credit creation and credit destruction.

Research

Economists Wasay Majid and Michael Rehm set out to answer a central question: Do banks actively drive housing cycles through credit supply, or do they merely accommodate homebuyer demand driven by income growth and market expectations?

To test this, the authors used quarterly economic and financial data from New Zealand spanning 1998 to 2025. New Zealand offers an ideal setting for this research because its banking system is dominated by four standard commercial banks without a large "shadow banking" sector.

Using structural statistical models (SVARs) alongside historical regulatory changes in loan-to-value (LVR) rules, the researchers isolated how independent shocks to new lending and principal repayments separately affected national house prices over time.

Findings

The researchers found that bank lending actively drives housing dynamics rather than passively following them. An unexpected increase in new mortgage lending (credit creation) causes an immediate and persistent rise in house prices. Interestingly, while a new lending surge itself decays within a few quarters, the higher house prices endure. This occurs because initial sales at higher prices set new benchmark appraisals for subsequent property listings, locking in a durable shift in the overall price level.

Crucially, the study provides direct empirical evidence on the "destruction" side of bank balance sheets. A rise in the ratio of principal repayments relative to new lending (credit destruction) lowers house prices by roughly 3%—a response remarkably symmetrical to the positive effect of new lending.

Moreover, when controlling for household income growth, credit supply remained the dominant driver of real estate valuations, accounting for more than half of house price variations. Direct interest rate shocks accounted for less than 10% of house price variance, demonstrating that central bank decisions reach real estate primarily by expanding or contracting bank balance sheets.

Limitations and Context

These findings should be read with a few caveats in mind. The study focuses on New Zealand, a small open economy; the exact policy magnitudes may differ in countries with distinct financial structures, such as the United States, where non-bank lenders play a larger role.

Additionally, detailed data isolating genuine principal repayments from refinancing only became available from 2017 onward, meaning the credit destruction channel is estimated over a shorter time frame.

Why It Matters

If house prices are heavily dictated by the balance between credit creation and destruction, housing affordability cannot be managed through interest rate adjustments alone. For policymakers, this highlights the necessity of "macroprudential" tools—such as loan-to-value (LVR) limits and bank capital requirements—that directly regulate how much credit banks can create. For homebuyers and businesses, it suggests that real estate trends depend less on general economic growth and more on the credit taps controlled by commercial banks.

Learn More

• Paper Title: Credit Creation, Credit Destruction and House Prices

• Authors: Wasay Majid and Michael Rehm

• Journal / Source: Preprint (SSRN / University of Auckland Business School)

• Publication Year: 2025

• URL: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=7216036

Econ Today Explains

Economic Concept: Endogenous Money Creation

Endogenous money creation is the principle that commercial banks create new money out of thin air whenever they issue a loan, rather than acting as mere intermediaries that pass existing savings from depositors to borrowers.

When a customer takes out a $500,000 mortgage, the bank does not transfer funds from another account; instead, it expands its balance sheet by recording the loan as an asset and simultaneous buyer deposits as a liability. This adds $500,000 of new purchasing power into the economy. Conversely, as borrowers repay loan principal, those deposits are erased, shrinking the money supply. Understanding endogenous money helps explain why bank lending behavior can independently trigger asset booms and busts.

This article was written by AI but reviewed by a real human.