Bank publishes checklist of six key measures
Published: 5 December 2013 | Author: Bernard Clarke
In setting out what it sees as potential risks to the financial system, the Bank of England's Financial Stability Report provided clear guidance to the lending industry on those features of the market that the authorities will monitor closely. The Report identified six key indicators that the Bank will continue to scrutinise, and which might be a guide as to what could trigger intervention in the market:
- Changes in house price inflation, relative to indicators of affordability and sustainability. UK house prices have gathered momentum since the June Report, the Bank says, with the rate of price growth rising at an annual rate of 6.8% by October. Market recovery has also broadened, with prices now rising in nearly all regions and with surveys indicating that prices are expected to rise further in the coming period.
Measures of valuation remain below the levels reached in 2007, the Bank acknowledges, but some metrics – including house price to income and house price to rent – are above historical averages. Household income gearing is at a lower level, but this directly reflects the impact of exceptionally and historically low interest rates. As the Bank says: "If UK house prices were to rise materially or interest rates increase, these valuation measures would look more stretched."
Activity in the housing market is also increasing, the Bank says, but remains at a low level. This year, the number of UK property transactions will – for the first time in five years – exceed one million. But the long-term average number of UK transactions is around 1.5 million.
- Growth in the "tail" of heavily-indebted borrowers. Household debt-to income ratios have fallen since the financial crisis but they remain at historically high levels, with some households and firms being particularly vulnerable. Around one-fifth of total mortgage debt is now held by households whose debts are at least five times greater than their incomes.
- Exposure of lenders to highly-indebted households. One consequence of the high proportion of heavily-indebted households is that there could be sharp adjustments to household spending in response to higher interest rates or falling house prices.
That could lead to weaker economic activity and rising unemployment, with consequences for the exposure and profitability of lenders, according to the Bank’s analysis. Estimates of past losses associated with housing corrections would be significantly larger, the Bank says, once indirect losses, and losses from non-mortgage debts, are taken into account.
- Underwriting standards in the residential mortgage market. The Bank acknowledges that underwriting standards today are materially stronger than before the crisis. But the Bank says: "Past experience reveals that mortgage lending standards have deteriorated as house prices have risen, amplifying losses in the downturn."
- Underwriting standards on construction and commercial real estate loans. The Bank highlights the potential vulnerability of lenders to losses on loans to sectors linked to the housing market, like construction and commercial real estate. Risks could be magnified, it says, should a downturn in the housing market coincide with a similar movement in the commercial property market.
- Reliance by lenders on short-term wholesale funding. The Bank says it will be alert to the potential for imbalances arising from the way in which an expansion in mortgage lending is funded. One risk is that lending becomes inadequately capitalised relative to potential losses in a market downturn. Another is that lenders respond to a funding gap by resorting to short-term funding options, the failure of which contributed to the financial crisis. The Bank warns against vulnerability to a run on such sources of funding.
The Bank will also monitor carefully the way in which these indicators are inter-related, and may therefore have wider consequences. With some signs of lending now being provided at higher loan-to-income ratios and for longer terms, the Bank says it is concerned that any deterioration in underwriting standards could increase threats to financial stability, especially if interest rates were to rise from their current low levels.
The Report also says that rising house prices – and any subsequent falls – need not in themselves pose a threat to financial stability. "It is the interaction of developments in the housing market with a range of factors, including household indebtedness and leverage in the banking sector, which gives rise to financial stability risks," it says.