UK: The Financial Policy Committee (FPC) Puts The UK's Houses In Order

Last Updated: 9 December 2013
Article by Deloitte LLP

Most Read Contributor in UK, August 2017

The housing market topped the list of concerns of the Bank of England's Financial Policy Committee (FPC) in its latest assessment of the prospects for financial stability in the UK.  The FPC fired a salvo of initiatives that together should ensure the financial system remains resilient as housing market activity continues to pick up.  What stood out though was the suggestion the Committee might in future introduce a new macro prudential tool based on the affordability of mortgages.  This would open up a new front in banking supervision, adding complexity to the regulatory framework for mortgage lending, changing the nature of the affordability assessment and potentially affecting the dynamics of the mortgage market itself.

In the latest issue of its bi-annual Financial Stability Report, published last Thursday, the FPC said that if risks warranted, it would consider making recommendations on, for example, maximum loan to value (LTV) ratios, loan to income (LTI) ratios, or mortgage terms.  The FPC already monitors these indicators as part of its on-going conjunctural risk assessment; this new tool would mean recommending explicit limits that the Prudential Regulation Authority (PRA) or the Financial Conduct Authority (FCA) should apply on a "comply or explain" basis.

This is a significant development.  Back in 2011 when the Bank of England considered what possible directive macro prudential policy tools might be used, its analysis included LTV and LTI restrictions, set either as a hard limit on the extension of mortgage credit beyond a particular threshold, or the requirement for banks to hold proportionately more capital if a threshold was breached.  A key benefit of these tools highlighted was the ability to directly limit higher risk lending (as opposed to relying on other tools that target aggregate lending, such as the countercyclical capital buffer, or sectoral capital requirements). Another was that the tools could be applied to all banks including branches.  That is a significant advantage over, for example, sectoral capital requirements, which can only be applied to UK-headquartered banks and subsidiaries of overseas banks operating in the UK.

The Bank of England also saw a flaw though: it would be difficult to calibrate the trade-off between financial stability benefits, economic activity and societal preferences for home ownership.  That flaw is particularly significant set against the Bank of England's long history of being apolitical.  The potential problems are clear.  For example, LTV limits could have the effect of making access to a mortgage more difficult for certain groups of borrowers, or of skewing home ownership to wealthier households (with higher capital).  The FPC must have satisfied itself though that, at least in principle, the narrow line between these competing factors can be navigated.

Restrictions based on affordability could have several implications for banks.  Caps could prove to be blunt tools, reducing discretion for banks to assess individual circumstances, and therefore reducing access to credit as well as limiting potentially profitable opportunities for lending.  As there is now the threat of the FPC imposing restrictions, for example in times of rapidly increasing house prices, it may be necessary for banks to apply restrictions in all scenarios.

The measures could, perversely, increase risk.  For example, facing limits on LTV or LTI ratios borrowers might seek other (unsecured) sources of credit to make up the difference between the available mortgage and the cost of a property.  Limits on mortgage terms might constrain banks in dealing with borrowers unable to make payments, forcing them to crystallise default rather than restructure a mortgage.  And in all likelihood, these restrictions would alter the dynamic of buyers and sellers in the housing market, subsequently affecting prices and possibly increasing the risk of sharper price adjustments when the trigger points for restrictions to be imposed are met. 

That said, these measures would not be wholly novel.  An LTI ratio cap would complement other affordability criteria, although depending on its calibration it might prove a harder 'stop' for stretched (prospective) borrowers than testing against stressed interest rates.  Caps could even improve on other tools.  The IMF recently pointed out that caps on LTV and LTI ratios could provide a backstop in situations where higher sectoral risk weights were less effective because of banks holding capital well above minimum regulatory requirements.  

The FPC noted there are already other measures in train to lean against risks that may arise from the UK housing market, including higher capital requirements and the PRA's stress testing initiative.  Underwriting standards are also being tightened (as part of the FCA's Mortgage Market Review (MMR)).  And the FPC said that in future it might make recommendations to the PRA or FCA to ensure standards remain robust, for example, by making a recommendation on the appropriate interest rate stress test to use in an affordability assessment. In addition, the PRA will now not extend the temporary regulatory capital off-set for new household lending, which was introduced alongside the Bank of England's Funding for Lending Scheme (FLS) and is due to end on 31 December 2013.  The Bank of England is also changing the terms of FLS, to re-focus incentives towards business lending.

The macro prudential tool of imposing restrictions on mortgage affordability is not likely to be introduced in the near future whatever the outlook for the housing market.  However, that it is being considered underscores the increasing importance of banks monitoring macro prudential policy announcements and making monitoring the macro financial conjuncture a regular part of the Board agenda.

Simon Brennan – Senior Manager, Deloitte EMEA Centre for Regulatory Strategy
Simon is a Senior Manager in the EMEA Centre for Regulatory Strategy, specialising in prudential regulation for banks. Simon joined Deloitte after 11 years at the Bank of England, where he worked in a number of areas covering macro and micro prudential policy, and financial institution risk assessment. LinkedIn.

Kai Kohlberger – Senior Manager, Deloitte EMEA Centre for Regulatory Strategy
Kai is a Senior Manager in the EMEA Centre for Regulatory Strategy, covering cross-sectoral issues in banking and capital markets. Before joining Deloitte, Kai worked for the UK Financial Services Authority (FSA), the European Commission and the European Central Bank (ECB). LinkedIn

For more information on the EMEA Centre for Regulatory Strategy, please visit: www.Deloitte.co.uk/centre

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