Wellington, June 8, 2017
In 2013, the Reserve Bank introduced macroprudential policy measures in the form of loanto-value ratio (LVR) restrictions to mitigate the risks to financial system stability posed by a growing proportion of residential mortgage loans with high LVRs (i.e. low deposit or low equity loans).
This increase in borrower leverage had gone hand-in-hand with significant increases in house prices, particularly in Auckland. The Reserve Bank’s concern was the possibility of a sharp fall in house prices, in adverse economic circumstances where some borrowers had trouble servicing loans.
Such an event had the potential to undermine bank asset quality given the limited equity held by some borrowers.
The Reserve Bank believes LVR restrictions have been effective in reducing the risk to financial system stability that can arise due to a build-up of highly-leveraged housing loans on bank balance sheets. However, LVRs relate mainly to one dimension of housing loan risk.
The other key component of risk relates to the borrower’s capacity to service a loan, one measure of which is the debt-to-income ratio (DTI). All else equal, high DTI ratios increase the probability of loan defaults in the event of a sharp rise in interest rates or a negative shock to borrowers’ incomes. As a rule, borrowers with high DTIs will have less ability to deal with these events than those who borrow at more moderate DTIs. Even if they avoid default, their actions (e.g. selling properties because they are having difficulty servicing their mortgage) can increase the risk and potential severity of a housing related economic crisis.
While the full macroprudential framework will be reviewed in 2018, the Reserve Bank has elected to consult the public prior to the review. This consultation concerns the potential value of a policy instrument that could be used to limit the extent to which banks are able to provide loans to borrowers that are a high multiple of the borrower’s income (a DTI limit). A number of other countries have introduced DTI limits in recent years, often in association with LVR restrictions.
In 2013, the Bank and the Minister of Finance agreed that direct, cyclical controls of this sort would not be imposed without the tool being listed in the Memorandum of Understanding on Macroprudential Policy (the MoU). Hence, cyclical DTI limits will only be possible in the future if an amended MoU is agreed.
The purpose of this consultation is for the Reserve Bank, Treasury and the Minister of Finance to gather feedback from the public on the prospect of including DTI limits in the Reserve Bank’s macroprudential toolkit. Throughout the remainder of the document we have listed a number of questions, but feedback can cover other relevant issues. Information provided will be used by the Reserve Bank and Treasury in discussing the potential amendment of the MoU with the Minister of Finance.
We present evidence (section 2) that a DTI limit would reduce credit growth during the upswing and reduce the risk of a significant rise in mortgage defaults during a subsequent severe economic downturn. A DTI limit could also reduce the severity of the decline in house prices and economic growth in that severe downturn (since fewer households would be forced to sharply constrain their consumption or sell their house, even if they avoided actual default). The strongest evidence that these channels could materially worsen an economic downturn tends to come from countries that have experienced a housing crisis in recent history (including the UK and Ireland).
The Reserve Bank believes that the use of DTI limits in appropriate circumstances would contribute to financial system resilience in several ways:
– By reducing household financial distress in adverse economic circumstances, including those involving a sharp fall in house prices;
by reducing the magnitude of the economic downturn, which would otherwise serve to weaken bank loan portfolios (including in sectors broader than just housing); and
– by helping to constrain the credit-asset price cycle in a manner that most other macroprudential tools would not, thereby assisting in alleviating the build-up in risk accompanying such cycles.
Significant intervention in the market
Wellington, June 8, 2017
I welcome the release of the Reserve Bank’s consultation document on the use of Debt to Income ratios for mortgage borrowers as an additional macro-prudential tool.
The document is a comprehensive summary of the pros and cons of adding Debt to Income ratios to the Reserve Bank’s toolkit of regulatory options
The use of Debt to Income ratio restrictions would be a significant intervention in the housing market, so it’s important that all interested parties have their say during this consultation period.
The Reserve Bank has been using Loan to Value ratio (LVR) restrictions since 2013, and they were re-calibrated in 2016.
The Reserve Bank’s analysis suggest that LVRs have helped moderate demand in the residential housing market, particularly in Auckland where prices have been flat to falling over last ten months.
The Reserve Bank has stated that even if DTIs were available now, they wouldn’t be using them currently. That gives us all time to consider their possible future use carefully.
The consultation runs for 10 weeks and closes on August 18, 2017.
The Reserve Bank’s consultation document is available here.