UK: The Financial Policy Committee: The Time To Repair The Roof Is When The Sun Is Shining

Last Updated: 27 June 2014
Article by David Strachan

Most Read Contributor in UK, August 2017

The Bank of England's Financial Policy Committee (FPC) met this Tuesday, 17 June. We will have to wait until 26 June when its latest Financial Stability Report is published before we know what conclusions it reached, but at least one of the topics on its agenda is clear – the housing market. The question being asked is what, if any, action the FPC will take to check what to many appears as the emergence of an asset price bubble in the UK's residential property market, or at least that part of it centred around London and the south east of England. That the issue has risen to the top of the FPC's agenda has been well signalled over the past several months. How though might it respond; what factors will it consider; and what are the potential implications for mortgage lenders?

The background

The fact that the FPC is asking this question at all is evidence of just how much thinking has evolved about how to deal with risks to financial stability. In the period before the onset of the global financial crisis, the debate would have been about whether and when to raise interest rates. Any talk of using 'macroprudential tools' would have been regarded as eccentric and unorthodox at best and faintly dangerous at worst. Now the orthodoxy has changed and the FPC finds itself empowered with a range of such tools. For example, it could introduce a counter-cyclical capital buffer (CCB), raising capital requirements across the board; higher capital requirements for either all, or a subset of, residential mortgages; or even loan-to-value (LTV) or loan-to-income (LTI) caps to constrain how much people can borrow.

The speeches which the Governor of the Bank of England and the Chancellor gave at the Mansion House on 12 June are an essential part of the background, highlighting that the housing market has moved right to the top of the agenda. In addition to the Chancellor's announcement that he would be giving the Bank new powers in relation to mortgages, enabling the FPC to direct banks to impose caps on LTVs and LTIs as well as to limit the proportion of high LTV/LTI mortgages each bank can lend, there were some important pointers to both HM Treasury's and the Bank's thinking on the housing market.

The Chancellor made it clear that, in his view, the housing market does not pose an immediate threat to financial stability, but that it could in the future "especially if we don't learn the lessons of the past". This led to the conclusion that "...we act now to insure ourselves against problems before they materialise".

Some considerations regarding the use of macroprudential tools

The FPC will be weighing up a number of factors in deciding what - if any - action to take. We are clearly in untested waters, both for policymakers and for the mortgage lenders subject to the policy. As FPC member Richard Sharp recently pointed out there is currently a "lack of definitive empirical evidence on the impact of many of the tools available to the macroprudential bodies".

The Governor clarified in his Mansion House speech that the Bank does not target house price inflation but is concerned by indebtedness, particularly "systemic risks arising from unsustainable levels of debt, leverage or credit growth". And he repeated his view that, in the current conjuncture, monetary policy is the last line of defence against financial instability. Ultimately the Bank and FPC are concerned about the resilience of financial institutions and the stability of the economy.

A number of the possible macroprudential tools that the FPC might consider are intended to affect the flow of new mortgage lending, by operating on either the marginal cost of new lending or restricting the supply (e.g. if LTV or LTI caps are used). These tools are intended to link more immediately to limiting further rises in household indebtedness. In this respect one of the key questions for the FPC is how lenders will adjust their mortgage offerings in response to the use of these tools. There is a further question as to the price elasticity of borrowers' demand for mortgages. Some borrowers may be relatively indifferent to small increases in the price of a mortgage – especially set against the effect of higher interest rates, which are expected to increase during the horizon over which any macroprudential tool might be applied.

Some of the macroprudential tools are blunt – the CCB increases capital requirements across-the-board, for SME and corporate loans as well as for mortgages. Others have a better fit in relation to the underlying risks, but that potentially comes at the cost of other risks – the former Governor of the Bank of England, for example, was cautious about the Bank assuming powers to limit LTV and LTI because of sensitivity about using them.

In some cases, such as the sectoral capital requirement (SCR), the CCB and, in future, LTV and LTI limits, the FPC can impose the measure directly, while for others it will have to rely on a recommendation, with which the recipient will have to "comply or explain". In theory, this makes some tools more immediately and directly applicable than others, although in practice we would expect the PRA and FCA to 'comply' rather than 'explain'.  

Some tools will bind all banks operating in the UK, while others will depend on the home supervisors of banks with branches in the UK adopting the UK's approach and there is a risk of 'leakage' (incomplete coverage) if they do not. There is also the prospect of leakage outside the mortgage lending sector, eg if borrowers could obtain unsecured finance to 'top up' their loan above any FPC-imposed LTV or LTI cap. None of the tools has been used in recent times in the UK, although some have been tried elsewhere. And, finally, if one of the goals of the FPC is to influence people's expectations, the clarity with which these tools can be communicated is an important consideration.

It is important to distinguish between the existing stock of mortgages and the flow of new mortgage lending and between tools that affect the resilience of financial institutions and the level of indebtedness (although these latter two considerations are clearly linked). The current stock of UK residential mortgages is around £1.2 trillion. UK banks either are or will be subject to a Bank led stress test which will require them to assess the impact of a 35% fall in house prices on their existing mortgage book and, depending on the outcome, possibly hold more capital against these assets. The stress test scenario also provides for a sharp increase in interest rates, with gilt yields peaking just below 6%. The stress test may well be the right macroprudential tool to deal with risks from the existing stock of mortgage loans. It will undoubtedly give the Bank strong evidence of just how resilient the UK banking system is to a severe shock.

The Macroprudential policy tools affecting mortgage lending table examines a range of tools that the FPC might deploy in relation to the UK housing market and how the various considerations set out apply to each. The analysis identifies some of the challenges and choices facing the FPC.

What are the implications for mortgage lenders?

If the FPC has decided to take action, the first question for mortgage lenders will be a strategic one – how to respond to the chosen policy measure in terms of the price or the quantity of mortgages offered.  If capital requirements are increased, how will this feed through to the pricing of mortgages and how are both borrowers and competitors likely to respond? The strategic choices may be fewer, and easier, if a tool is used which applies equally to all mortgage lenders, such as an LTV or LTI cap. However, lenders that focus on the higher LTI/LTV end of the market may need to consider a potentially more material impact of the caps on their business models. The range of stakeholders interested in the outcome of this and the impact is long: shareholders, analysts, customers and policymakers.

A second challenge may arise around the operational implementation of LTV and LTI caps. While lenders already consider LTV as a key variable in their lending decisions, and capture it in their systems, this is less commonly the case with LTI. Putting a cap on LTI in place is therefore more likely to require system changes.

A third issue concerns the extent to which the costs to lenders of higher capital charges (as opposed to interest rates) are passed on to customers. Given the FCA's concerns about the fair treatment of existing customers, we would expect lenders to be particularly vigilant in this regard.

Those banks comfortable that these factors can be managed should still reflect on the risk implications of any measures that are taken. Whilst macroprudential policy will be used before monetary policy to tackle this particular problem, monetary policy will quite possibly be tightened over the same horizon, presenting a dual risk to mortgage lending through valuations and affordability.

We will find out shortly what the FPC decided at its last meeting. The answer may be "no change", at least for now. The UK authorities have already taken several steps, including prudential stress testing, tougher FCA affordability criteria and the ending of capital relief for new mortgage lending. The Bank reports tentative signs that the FCA changes on affordability may be having an effect. The stress tests are still work in progress. There are risks of moving ahead with new measures before the efficacy of the others have been tested. On the other hand, the FPC may well see merits in taking out an insurance policy, while the sun is still shining.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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