Consultation – Revising and retaining the regulation on requirements for new residential mortgage loans
Norges Bank's letter of 21 October 2016 to the Ministry of Finance
Norges Bank refers to the consultation letter of 8 September 2016 in which the Ministry of Finance invites comment on the proposal by Finanstilsynet (Financial Supervisory Authority of Norway) to retain and tighten the current regulation on requirements for new residential mortgage loans.
Norwegian household debt has continued to grow faster than income following the financial crisis. From spring 2008 to the present, house prices to disposable income per capita have risen 15 percent. Over the past six months, house price inflation has risen sharply, particularly in southeastern Norway. Against the background of low lending rates, house price inflation has accelerated and household debt has increased at a faster pace than household income.
There is an interaction between house prices and credit. High house price inflation may lead to increased household borrowing. Households as a whole have considerable equity, but it is dominated by housing wealth. A fall in house prices may engender a heavy burden on highly leveraged households, and as a result many will have to reduce consumption. This may amplify a downturn in the Norwegian economy and increase banks’ losses on commercial loans. Downturns that occur in the wake of periods of rapid debt accumulation are usually deeper and more prolonged than other downturns.
Residential construction has picked up in recent years, but for long periods the increase in the number of dwellings did not keep pace with population growth. The authorities have implemented a number of measures to facilitate residential construction, and housing taxation has been increased somewhat.
Capital requirements for Norwegian banks have been increased considerably in recent years. General capital requirements have been raised, the countercyclical capital buffer has been turned on and higher risk weights for residential mortgages have been imposed on banks. This has made banks more resilient to future loan losses. Higher capital requirements may dampen credit growth and house price inflation if banks increase their margins to build capital. However, banks can to some extent adjust to higher capital requirements by tightening corporate lending.
Requirements for banks’ credit standards have a direct effect on household borrowing and may make vulnerable households more resilient. Such requirements seek to counteract the failure of individual borrowers and banks to take fully into account the fact that the economy gradually becomes more vulnerable as household debt ratios rise. At the same time, such regulations can weaken banks’ incentives to take independent responsibility for assessing risk. Standardised requirements may have undesirable consequences in individual cases and restrict some lending that is associated with low risk. Regulation of credit markets must weigh efficient credit markets against limiting the build-up of risk in the financial system. This regulation should also take into account the possibility that market participants may seek to circumvent the requirements. New risk may arise if credit is extended via new and unregulated channels.
Effects of the current regulation and possible effects of Finanstilsynet’s new proposal
Accelerating house price inflation and the continued rise in household debt ratios may suggest that the effects of the regulation so far on developments in house prices and total credit have been limited. Nevertheless, there are signs of somewhat tighter bank credit standards and some decline in borrowing at particularly high loan-to-value (LTV) ratios. Norges Bank gave an account of developments in house prices, credit and bank credit standards in a letter to Finanstilsynet of 17 August 2016 in connection with Finanstilsynet’s assessment of the regulation on requirements for new residential mortgage loans.
In its consultation document, Finanstilsynet proposes retaining and tightening the regulation:
- The requirement for a maximum LTV ratio of 85 percent after deductions for any additional security on other real property is maintained.
- The maximum LTV ratio for home equity lines of credit is reduced from 70 to 60 percent.
- Principal payment requirement for loans with an LTV ratio above 60 percent, a tightening compared with the current limit, which is 70 percent.
- The test of the borrower’s debt-servicing capacity in the event of a 5 percentage point rise in interest rates is to be supplemented with a requirement that total debt may not exceed five times gross income, a loan-to-income (LTI) requirement.
- The provisions allowing banks to deviate from the requirements relating to debt-servicing capacity, LTV ratios and principal payments are to be removed, alternatively set at a maximum of 4 percent of new loans (by amount) during a quarter. Currently this flexibility quota or “speed limit” is set at 10 percent of new loans.
Finanstilsynet has also considered the possibility of utilising regional requirements, but finds that such requirements are not appropriate.
Norges Bank has analysed the effect of requirements for credit standards and the new proposed regulation on the basis of data for household income, debt and housing wealth based on tax assessment data and data from the Ambita Land Registry for the period 2009-2014.
An upper limit on LTV ratios was introduced in guidelines in 2010 and tightened in 2011. The analyses show that the changes to the guidelines have had some effect on the LTV ratios for younger first-time home buyers. At the same time, the data show a substantial share of first-time home buyers with LTV ratios higher than the upper limit both before and after the changes to the guidelines. This may reflect the fact that 2/3 of the loans that breach the LTV requirement are secured on additional collateral.
Analyses of the probability that young persons buy their first home, suggest that the introduction and tightening of the guidelines has not had a significant impact on the ability of this group to buy a home.
Tax assessment data for household income, debt and housing wealth for 2014 can provide information on the share of borrowing that would have been affected by the requirements in the proposed regulation if they had been in force in 2014. The data suggest that the LTV requirement is the requirement with the greatest impact on borrowing. The analyses indicate that debt growth in 2014 would have been substantially reduced if borrowing had been limited by strictly applying the overall requirements. The result is broadly the same as in a similar analysis of tax assessment data for 2013 (cf. consultation response of 4 May 2015).
While there is considerable overlap between the requirement for a borrower’s capacity to service debt in the event of a 5 percentage point interest rate increase and a maximum LTI ratio of five times gross income, these requirements still affect various income groups differently. For higher-income borrowers, an LTI requirement would be more restrictive. For a household with two children and a total income of approximately NOK 750 000, the two requirements imply the same maximum borrowing limit. In 2014, the requirement for the capacity to service debt in the event of a 5 percentage point interest rate increase would have restricted more of the households that borrowed than the proposed LTI requirement. According to Finanstilsynet’s consultation document and residential mortgage lending survey, in August 2015 there were more new loans that would have breached the LTI requirement than the requirement to service debt in the event of a 5 percentage point interest rate increase.
Finanstilsynet’s estimates show that 6.7 percent of new loans were in breach of the overall requirements in the current regulation in 2016 Q2, but this share varies somewhat across banks. The regulation currently sets a flexibility quota of 10 percent of new loans that are allowed to breach one or more of the requirements in the regulation. Several banks have reported that they give priority to first-time home buyers in their flexibility quotas.
Norges Bank’s assessment
Norges Bank supported Finanstilsynet’s guidelines for prudent residential mortgage lending in 2010 and 2011 and in 2015 supported the introduction of a regulation on requirements for new residential mortgage loans. In its consultation response from May 2015, Norges Bank emphasised that the aim of maintaining efficient credit markets pointed towards providing flexibility for banks, for example by permitting banks to approve a certain proportion of above-limit mortgages. Norges Bank recommended that the share of mortgages with a higher LTV ratio than 85 percent could be restricted to 5-10 percent.
Norges Bank supports the proposal to retain the regulation on requirements for new residential mortgage loans. Norges Bank is of the opinion that requirements for prudent lending should be regarded as a permanent structural measure.
In Norges Bank’s opinion, it is essential that households have sufficient equity to cope with a fall in house prices. Finanstilsynet is not proposing changes to the maximum LTV ratio for repayment loans, but is proposing to tighten the maximum LTV ratio for home equity lines of credit and interest-only loans from 70 percent to 60 percent. This change may help to ensure that households have sufficient equity to cope with a fall in house prices and may have a dampening effect on total credit growth. On the other hand, a tighter requirement for principal payment entails somewhat greater restrictions on the allocation of household savings. Norges Bank supports Finanstilsynet’s proposal to tighten the LTV ratio for home equity lines of credit and interest-only loans.
Finanstilsynet points out that a supplementary requirement for a maximum LTI ratio may provide added assurance that banks’ assessments of debt-servicing capacity are not stretched too far. The current requirement to be able to service debt in the event of a 5 percentage point interest rate increase primarily restricts the borrowing of low-income households. An LTI requirement will restrict middle- and higher-income borrowers to a greater extent. An LTI requirement may also affect persons who invest in the housing market on a larger scale. On the other hand, the introduction of an LTI requirement will make regulation of credit standards more complex. Nevertheless, following an overall assessment, Norges Bank is of the opinion that the LTI requirement may be an appropriate supplement to the debt-servicing capacity requirement. One member of Norges Bank’s Executive Board does not support this assessment.
Norges Bank is of the opinion that banks should have room for discretion in applying the regulation. In its consultation response of 4 May 2015, Norges Bank recommended the introduction of a flexibility quota or “speed limit” of 5-10 percent. In its letter to Finanstilsynet of 17 August 2016, Norges Bank pointed out that “a speed limit in the lower portion of the interval that Norges Bank outlined in its consultation response may have some dampening effect on borrowing”. It was emphasised that this adjustment would still provide banks with flexibility, while banks are required to restrict the proportion of loans especially at risk to a somewhat greater extent than currently. At the same time, it was explicitly stated that setting the speed limit at zero could have unintended efficiency and distribution effects. An excessively strict speed limit may also increase the incentives to circumvent the regulation in some other manner. Norges Bank further specified in the letter of 17 August that “any adjustment of the speed limit must be viewed in the light of the regulation’s other requirements”. Introduction of an LTI requirement and further limitations on interest-only periods will contribute to some tightening of the overall requirements. Nevertheless, Norges Bank is of the opinion that the speed limit can be reduced to the lower portion of the interval of 5-10 percent of total loan volume.
As a whole, the proposed tightening measures will likely have some dampening effect on total borrowing.
- In a letter of 24 June, Finanstilsynet requested that Norges Bank provide an “[..] assessment of house price inflation and the growth of Norwegian household debt and of how the Regulation on requirements for new residential mortgage loans has affected these developments.”
- Analyses are discussed in the Annex to this letter
- Finanstilsynet’s 2015 residential mortgage lending survey 2015
- The estimates are subject to considerable uncertainty. For example, additional collateral is not included in the estimates of LTV ratios. In addition, estimated market values of dwellings are used that probably underestimate actual market values so that the LTV ratio is overestimated.
- The analyses were based on Finanstilsynet’s proposal to quantify the requirements. The proposal was somewhat more restrictive than what was approved, but these differences have little bearing on the results of the analyses. Finanstilsynet proposed implementing the requirements in a regulation, originally without a speed limit. The analyses are discussed in detail in the attachment to Norges Bank’s consultation response of 4 May 2015.
- It is assumed an interest rate of 2.5 percent.