We explore the relationship between the real estate cycle and profitability of European banks. From 2010 to 2018, the divergent real estate dynamics across European countries explain nearly one fourth of the profitability gap between banks established in countries with a sluggish real estate market and those located in the other countries.
As a counterfactual exercise, we estimate that the average ROE of Italian banks in 2010-18 would have been about 1.6 percentage points higher if real estate prices in Italy had grown on average at the same pace as the median European country.
Finally, we find that banks established in countries that have been experiencing a sustained upswing in the real estate sector have not increased their capital position in response to the potential overheating of their domestic real estate sector.
