Towards the Macroprudential Policy: Responsible
Lending Principles
What is the macroprudential policy?
Recently, macroprudential policy measures have been wide- ly discussed on the international level, i.e. measures aimed at limiting and mitigating systemic risk related to the operation of banks and other financial institutions, thereby seeking to avoid economic imbalances (“bubbles”) and excessive risk tak- ing28, resulting from the fact that some financial institutions
concentrate their liabilities. All these measures should help to prevent crises or at least to mitigate their potential conse- quences.
Basically, macroprudential policy is aimed at internalising ex- ternal consequences of the operation of financial institutions for the entire banking system and in that respect it differs from the supervisory policy, which is aiming to mitigate the risk of individual financial institutions. The success of macro- prudential policy depends on two aspects: first, the possibility to timely identify interrelations between financial institutions, risk concentration, rapid growth of the loan portfolio, etc.; second, the possibility to expediently apply adequate macro- prudential policy measures, e.g. require to hold larger capi- tal buffers, set risk concentration limits, a maximum loan to value ratio (hereinafter LTV) and a debt to income ratio (DTI). Macroprudential policy measures are not applied to an indi- vidual institution. They are applied to all market participants and, in that respect, they differ from the individual require- ments set for limiting financial institutions’ risk. Successful macroprudential policy cannot operate without coordinated supervisory, monetary and fiscal policies. It should be noted that sometimes macroprudential policy is not the most ef- fective tool to mitigate economic imbalances in the market. Often fiscal (tax) and/or monetary policy measures are more effective. Therefore, macroprudential policy requires cooper- ation and information exchange among public authorities, i.e. the central banks, supervisory authorities and the Ministries of Finance. Moreover, the activities of banks and other financial intermediaries have crossed state borders long ago. Therefore, international cooperation is necessary too.
The Bank of Lithuania seeks to ensure that financial market participants operate in a safe and stable environment and that their operation does not pose a threat to stability of the do- mestic economy and the financial system. From 2004 to 2010, the greatest impact on the economic cycle of the country was made by bank lending policy in the housing and real estate markets. During the recent steep economic growth, banks were applying liberal lending conditions – both in interest and non-interest terms29. The highest LTV ratio reached 100% dur-
ing the period of lending boom, whereas interest rate margins added to the variable interest rate indices were as low as 0.6 p. p. This enabled banks to attract new customers, who were not able to receive loans for house purchase before, since they did not have savings, whereas financial institutions assumed high risks, as after the fall of housing prices, increase in un-
28 For more information on the newest international initiatives, see Macroprudential
policy tools and frameworks. Financial Stability Board (2011).
29 For more information on interest and non-interest related lending conditions, see
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employment and the decrease of wages, such customers were the first who faced insolvency problems. For the banks, that resulted in additional losses incurred due to loan impairment, while for the households that meant heavier financial bur- den and a risk of loosing their dwelling. Moreover, the rapid growth of loans for house purchase boosted housing demand and as the construction works were lagging behind, housing prices were rapidly increasing and deviated from the value de- termined by fundamental factors30. A number of project de-
velopers, who launched their projects at the time of the price peak, suffered losses later on and banks had to take over the assets under construction and the unsold dwellings. Because of the increased demand for workers, wages in the construc- tion sector rose, this in turn prompted the migration of the labour force into that sector and boosted the price of labour in other sectors. Due to the above, the imbalances emerged in the economy, which resulted in the rapid economic growth from 2004 to 2007 and the consequent downturn from 2008 to 2009.
Therefore, excessive lending and the willingness of banks to assume inadequately assessed risk determined significant business cycle fluctuations. These fluctuations might be miti- gated in part by applying macroprudential policy measures (by introducing a maximum LTV ratio, higher capital require- ment for particular kinds of loans, etc.) and combining them with fiscal policy measures (real estate taxes and the cancella- tion of concessions for loans for house purchase, etc.). So far, a unified international practice as for what measures should be applied and when does not exist. However, individual coun- tries and international institutions make considerable efforts to entrench that practice31. The Financial Stability Board distin-
guished three methods, which the Member States use to regu- late mortgage market. They include: a) direct limitation, i.e. setting the maximum LTV and DTI ratios, and the prohibition to offer certain lending products; b) a method of supervisory incentives, which basically means a requirement to hold larger capital buffers for loans for house purchase; and c) responsi- ble lending practice and standards32. In order to avoid a new
real estate price bubble and concentration of excess loan risk in these sectors in the future, as well as to protect consum- ers who are less financially educated, the Bank of Lithuania has prepared draft responsible lending guidelines, which are a part of macroprudential policy toolkit.
What measures might be introduced to implement respon- sible bank lending to natural persons and to avoid the forma- tion of bubbles?
When granting loans to natural persons and households, the banks assess two key borrower’s indicators: whether dis- posable income of a borrower is sufficient to repay the loan and whether the pledged assets of a borrower will be suf- ficient to cover bank losses in case a borrower becomes insol- vent. In order to produce a quantitative assessment of these two indicators, first of all it is necessary to establish an accept- able level of indebtedness of households and then to calculate a DTI ratio and a LTV ratio, which are the key instruments in seeking to balance the financial system and ensure its sustain- able development.
30 For more information about the real estate market risk, see Financial Stability Review
(from 2005 to 2009).
31 The practice applied by countries is generalized by the Financial Stability Board,
International Monetary Fund, World Bank and Bank for International Settings.
32See. Thematic Review on Mortgage Underwriting and Origination Practices. Financial
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As the practice has shown, many households are not capa- ble of assessing adequately the risk of the liabilities undertak- en and realising the potential changes in interest rates or col- lateral value. Thus, the identification of the maximum values of the indicators mentioned above for the whole system could help to reduce the risks assumed, first of all, by the households themselves, as well as by banks.
DTI ratio reflects the share of income that the borrower has
to allocate for the regular payment of the loan (the sum of the principal and interest payments). Historically, in the countries that actively regulate the DTI ratio, this ratio was reduced in order to safeguard the solvency of debtors and enable them to hold more reserves of free funds for contingencies. Apart from the direct effect mentioned above, the system-wide lim- itation of the DTI ratio reduces credit risk and excess credit growth in the context of the prevailing concern over the ex- cessively high indebtedness of households or the growth in investment property prices. If this ratio is stable and does not depend on the economic cycle, the resulting effect material- ises more visibly during the time of economic downturn, as then it is expected that the income of the residents and their capability to properly discharge the undertaken financial li- abilities will decrease.
The requirement of the DTI ratio has a positive influence on the economy in two ways: first, along with the diminish- ing credit risk, the situation of the financial system improves; second, owing to the reduced share of the funds intended for the repayment of loans, households possess more dispos- able income, which can be consumed or saved. Moreover, the limitation of the DTI ratio in respect of loans for house pur- chase might provide incentives for households to rent a dwell- ing instead of acquiring it. Such a change in incentives, when other economic factors do not change (ceteris paribus), would increase housing rent prices and reduce their selling price. Looking from the macroprudential perspective, even under common consensus over socially optimal indebtedness level of households, it is quite complicated to define an effective DTI ratio. First, common agreement has to be reached as to the definition of a periodic instalment (periodic instalments of all loans of a person or a household should be evaluated, however, a comprehensive loan register is needed to attain this objective) and income (after-tax income of a person or a household should be evaluated, taking into consideration social benefits). Often a question arises as to how the income of persons working under a business certificate or engaged in individual activities should be assessed, since such income is often characterised by significant fluctuations and lower reliability of the quality of its declaration. Moreover, after assessing inelastic minimum living expenses of a household, the effective DTI ratio varies across different income groups, since, notwithstanding the person’s or household’s income level, a certain share of expenses is fixed (independently from the level of income, households seek to satisfy at least their fundamental needs, such as food, clothing, etc.). Therefore, it is often recommended to establish a lower DTI ratio for the persons or households receiving low income and a higher DTI ratio for the persons or households receiving higher income (in different countries, the maximum DTI ratio applied ranges from 40 % to 60 % of the total household income).
When analysing the relation between the DTI ratio and in- solvency in depth33, two types of households can be distin-
guished, the financial sustainability of which depends on the
33Analysis is based on the data of the Survey of households with housing loan 2011.
Chart 57. Changes of DTI ratio in Lithuania
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reserves of disposable income. Average DTI ratio of house- holds earning up to LTL 4,000 (47 % of respondents) accounts for 30 per cent and the probability of default reaches around 16 per cent. Average DTI ratio of households earning over LTL 4,000 (53 % of respondents) accounts for around 24 per cent and the probability of default reaches around 10 per cent.
When comparing insolvency levels of these groups, it could be noted that the default probability of the households earn- ing more is getting equal to the ratio of the households receiv- ing lower income, when the DTI ratio applied to the latter is around three times lower. When applying equal DTI ratio, the households earning more appear to have larger absolute re- serves of disposable income, therefore they can afford them- selves to take on additional obligations. However, one should take note of the fact that, according to the data of the house- hold survey of the Bank of Lithuania, an absolute debt of the households earning larger income comprises as much as two thirds of the loan for house purchase portfolio. It means that given a comparative LTV ratio between the households earn- ing low income and the households earning large income and after equalising the probability of their insolvency, the house- holds earning more pose a higher systemic risk than those which earn lower income.
In order to compare the systemic risk posed by the house- holds receiving lower income and the households receiving larger income (assuming that their LTV ratios might be com- pared), the probabilities of default should be inversely propor- tional to their shares of the loan for house purchase portfolio. To this end, according to the data of the household surveys of the Bank of Lithuania, the DTI ratio for the households with lower income should be about 75–90 per cent higher, com- pared to the DTI ratio of the households earning larger in- come.
Assuming that the present insolvency level of households is acceptable and aiming to offset a likely impact of a shock, we can state that the maximum admissible DTI ratio should be fixed at 35 per cent margin. Taking into account slightly higher limitations applied in the international practice, it is worth to consider a 35–40 per cent interval of the recommended maxi- mum DTI ratio.
Having in mind that the current average DTI ratio of the surveyed households is as low as 26.7 per cent, such a restric- tion would not be detrimental to the loan for house purchase market. Only the share from one fifth to one fourth of the surveyed households would have to reduce their liabilities.
The key objectives of the limitation of the LTV ratio are to increase responsibility of borrowers when they assume addi- tional financial liabilities, thus reducing potential risk to credi- tors due to higher recovery rate, and to reduce or avoid the formation of asset price bubbles. Economic researches prove that recessions coinciding with the burst of an asset price bubble last around four times longer, while the output in the country during this time is two to three times lower, compared to the recession, which does not coincide with the burst of an asset price bubble.
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Lower LTV ratio improves the financial capabilities of bor- rowers to repay a loan, while a larger share of the personal initial down-payment generates additional economic incen- tives to meet the undertaken liabilities. At the same time, it ensures greater financial stability and consumer protection, as it minimises the spill-over risk from the real estate market. This instrument limits excessive borrowing growth, resulting from the expectations that income will grow in the future, as well as the supply of loans for investing in real estate, which also exert high pressure on the property price growth. It has been estimated34 that the tightening of the LTV ratio by 10 p. p. de-
creases the real estate prices by 8–13 p. p.
At the same time, the limitation of the LTV ratio has a direct impact on the volumes of credit growth, since it limits the high- est possible amount of a loan and makes a link between it and the market value of the collateral. Also, in the case of a lower LTV ratio, a creditor has more opportunities not to incur loss- es, if the market value of pledged assets decreases. Experience of other countries and econometric researches prove that the limitation of LTV ratios together with other macroprudential policy measures is an effective way to mitigate the system- ic risk, arising from cyclicality of the real estate market. The policy of the LTV ratio limitation is pursued by such countries as Canada, Hong Kong, Norway, Sweden, Finland, etc., where the LTV ratio limit – taking account of the asset type, its value and the economic cycle phase – reached 50–95 per cent.
LTV ratio is a rather simple instrument preventing emer- gence of an asset bubble, limiting the flows of lending funds and prompting the borrowers to take a larger share of possi- ble losses and a higher degree of risk. It increases resilience of the banking system as it increases the lowest level of the value of pledged assets, at which the loan value will become higher than the collateral value, and induces the investors in real es- tate to evaluate the risk more conservatively, since the share of their ownership is increased. Moreover, when changing the LTV ratio on the basis of the economic cycle, this instrument helps to regulate the real estate market and reduces the likeli- hood of growing imbalances.
Data of the bank lending surveys conducted by the Bank of Lithuania indicates that LTV ratio applied by banks strongly fluctuated over the economic cycle. During the economic up- turn, both expectations of borrowers and willingness of cred- it institutions to lend more actively increased, whereas the average housing LTV ratio applied by some banks to newly granted loans reached 100 per cent in 2007. In addition to di- minishing possibilities and willingness of the borrowers to as- sume financial liabilities during the economic downturn, the bank risk assessment was getting stricter. The assessment of borrower risk became more demanding and cautious in 2009, while the highest average LTV ratio applied by banks to new loans dropped to 70–75 per cent. If economic cycle fluctua- tions are eliminated, it can be seen that the average LTV ratio was about 80 per cent and the highest LTV ratio applied by banks was about 88 per cent.
If new loans for house purchase with the LTV exceeding 300 per cent or loans unsecured by collateral were not granted in Lithuania since 2006 and the amount of loans with the LTV exceeding 85 per cent was reduced to the amount equal to the LTV of 85 per cent, the loan for house purchase portfolio could have been lower by about LTL 1.7 billion (or 8.6 %) in the first quarter of 2011. Taking into consideration an aver-
34Crowe C. W. at al. How to Deal with Real Estate Booms: Lessons from Country
Experiences, IMF Working Paper.
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age amount of a granted loan, the number of loans for house purchase granted from 2006 to 2008 would be smaller by 7–8 thousand, which would have determined a more moderate growth of real estate prices.