Reference is made to the consultation letter of 17 March 2015 from the Ministry of Finance regarding residential mortgage lending requirements. The Ministry requests comments on the proposal drawn up by Finanstilsynet (Financial Supervisory Authority of Norway) to implement the current guidelines on prudent residential mortgage lending practices as regulatory requirements and to tighten some of the standards in the guidelines.

Household debt growth in Norway increased substantially in the 2000s, across all age groups. House prices rose considerably in the same period. Debt growth has slowed since the financial crisis, but household debt has continued to grow more rapidly than household income. Although total household equity is high in Norway, it is dominated by housing wealth. If house prices fall, some household equity will be eroded. This may weigh particularly heavy on younger households with high debt. Many households will have to tighten their consumption if house prices fall, income declines or borrowing rates rise. This could amplify a downturn in the Norwegian economy and increase bank losses on lending to the corporate sector.

Experience shows that household debt and house prices often rise rapidly in the years preceding a financial crisis. Downturns in the wake of periods of rapid debt accumulation are often deeper and more protracted than other downturns. When lending rates remain low for a prolonged period, there is a risk of a renewed surge in debt growth and house prices.

Developments in house prices and household debt are closely linked to structural factors in the housing market. Population growth has led to underlying strong growth in demand for housing. The increase in the housing supply has for a period not kept pace with population growth. Measures to facilitate housing construction could increase housing supply flexibility. Tighter taxation rules for residential property (cf., for example, NOU 2014:13) could have a dampening effect on prices and lead to a more efficient distribution of household saving in the long term.

Capital requirements for Norwegian banks have been strengthened considerably in recent years. More capital increases banks' resilience to future loan losses. Higher capital requirements may also contribute to curbing house price inflation and credit growth if banks increase margins in order to build capital. Banks can also adjust to higher capital requirements by reducing lending to the corporate sector.

Requirements imposed on banks' lending practices have a more direct effect on household borrowing. Such measures can be justified as individual borrowers and banks do not fully take into account the gradual increase in the economy's vulnerability to shocks as household debt burdens rise. Limiting the share of borrowing that stretches the boundaries of prudent lending practices could curb borrowing in good times when credit demand is high. This will strengthen the resilience of households and banks. On the other hand, imposing strict requirements on lending practices will interfere with the scope for judgement in banks' credit provision. If the requirements restrict banks' opportunities for lending to creditworthy customers, the efficiency of credit markets could be impaired. Credit market regulation must weigh the aim of maintaining efficient credit markets against the aim of mitigating the build-up of risk in the financial system. Regulation should also take into account the possibility that market participants may seek to circumvent the requirements, for example by providing credit through new channels that may involve higher risk.

Lower oil prices and a lower level of activity in the petroleum sector have dampened prospects for the Norwegian economy. In assessing measures that could have a tightening effect, the aim of preventing a further build-up of vulnerability must also be weighed against the aim of avoiding the possibility that tightening lending could trigger a downturn in the Norwegian economy.

Possible effects of Finanstilsynet's proposal

Finanstilsynet's proposal is to implement regulatory requirements for prudential residential mortgage lending practices. The proposal comprises three main elements:

1. Borrowers' debt-servicing capacity must be tested to ascertain whether they can meet an interest rate increase of 6 percentage points, up from 5 percentage points in the existing guidelines, and still have sufficient funds to cover normal living expenses. Divergence from the rule based on a special prudential assessment must no longer be permitted.
2. Loan-to-value (LTV) ratios must not be higher than 85 percent of the value of the dwelling and any additional real property pledged as collateral. The maximum LTV ratio of 85 percent in the existing guidelines is retained, but the proposed regulation introduces tighter conditions whereby the possibility of extending a mortgage that exceeds the LTV limit on the basis of a special prudential assessment or debt guarantee is no longer permitted. The maximum LTV ratio for home equity lines of credit is reduced from 70 to 65 percent.
3. An annual principal repayment of at least 2.5 percent is required for all mortgages with an LTV of more than 65 percent. Under the current guidelines, this requirement is not quantified.

Finanstilsynet's annual mortgage survey covers around 90 percent of approved mortgages in the Norwegian banking sector over a specified period of time. In the 2014 survey, five percent of mortgages were in breach of the debt-servicing requirements under the guidelines. The share of mortgages with an LTV ratio of more than 85 percent was 19 percent. If additional collateral is taken into account, the share decreases to 10 percent. The share of interest-only mortgages was 14 percent.

Norges Bank has analysed data on household income, debt and housing wealth based on tax assessment data for 2013.[1] Tax assessment data can provide information about the number of households that would have been affected by the proposed regulatory requirements if these requirements had applied in 2013.

About one in three of home-owning households that increased their debt in 2013 would have breached the overall requirements in Finanstilsynet's proposal. If borrowing by these households is limited to comply with the requirements, tax assessment data indicate that household debt growth in 2013 would have been reduced by half. Of the measures proposed, setting a maximum LTV ratio of 85 percent would have had the strongest impact. One in four households in the data breaches this limit.

The estimates are subject to considerable uncertainty. The effect would have been stronger if, instead of borrowing up to the new limits, many households had not increased their debt. On the other hand, additional collateral is not taken into account in the analysis. Furthermore, some of the increase in debt may be the result of non-mortgage borrowing, and the value of some dwellings may have been underestimated.

Overall, Finanstilsynet's mortgage survey and the analysis of tax assessment data indicate that Finanstilsynet's proposal will restrain borrowing for many households.

Restricting the supply of credit could dampen house price inflation and lead to lower growth in housing investment and consumption. The interaction between credit and house prices could amplify the effects.

Norges Bank's assessment of the proposed regulation

Norges Bank has previously supported Finanstilsynet's guidelines for prudent mortgage lending practices.

Norges Bank supports a maximum LTV ratio of 85 percent under normal circumstances. An LTV limit provides a safety margin for borrowers and banks and could strengthen financial stability. Low interest rates make it easier to service large mortgages, and the share of high LTV lending may increase as a result.

Norges Bank agrees that mortgages with an LTV ratio of more than 65 percent should be subject to an annual principal repayment of 2.5 percent as a norm. Principal repayments will over time contribute to reducing mortgages with high LTV ratios. However, the temporary approval of interest-only periods should also be possible, for example in the event of a short-term deterioration in the borrower's financial situation.

Norges Bank agrees that borrowers' debt-servicing capacity should be tested against a 6 percentage point interest rate increase. When interest rates are low, the test should be based on a higher increase. Debt-servicing capacity grows in pace with income. Income is normally more stable than house prices. A limit on debt-servicing ratios could thus act as an automatic stabiliser when house prices rise.

In Norges Bank's view, prudent mortgage lending requirements should be regarded as a permanent structural measure and should not be changed frequently. The authorities should not have the ambition of fine-tuning developments in house prices and credit.

Norges Bank's view is that prudent mortgage lending standards should as a rule be issued as guidelines. Implementing the guidelines as regulatory requirements constitutes a government intervention. Implementing the guidelines as regulatory requirements could raise a number of questions regarding delimitation and interpretation, giving rise to impractical microregulation. The aim of maintaining efficient credit markets points towards providing flexibility for banks. This emphasises banks' own responsibility for prudent lending practices.

Flexibility can be provided in various ways, for example by including mortgage lending limits in guidelines or providing for banks to approve a certain proportion of above-limit mortgages in a regulation. Such quotas for above-limit mortgages are increasingly being employed in other countries, such as the UK and New Zealand, and are often referred to as speed limits.

A maximum LTV ratio is a standardised requirement based on a property's market value that may be appropriately implemented in the form of a regulation. Regulation is, in the opinion of Norges Bank, less appropriate for quantified standards for principal repayment and debt-servicing capacity.

Norges Bank recommends that a maximum LTV ratio of 85 percent be implemented as a regulatory requirement with flexibility through a speed limit. The share of mortgages a bank may extend at a higher LTV ratio should be restricted to 5-10 percent of the number of new mortgages extended each quarter.[2]

Norges Bank recommends that the proposed stricter standards regarding principal repayments for mortgages with high LTV ratios and regarding debt-servicing capacity should be issued in the form of guidelines.

Yours sincerely,

Øystein Olsen
Governor

Ida Wolden Bache
Executive Director

Footnotes:

1. Norges Bank’s analyses of the possible effects of Finanstilsynet’s proposal are presented in more detail in the attachment to this letter.
2. A speed limit on the number of new mortgages that breach the LTV limit could lead to an increase in the volume of above-limit lending in NOK. In addition to the number of mortgages, the authorities should also monitor developments in the volume of lending within the flexibility provided by the speed limit.