Macro-prudential regulation: have we got the balance right?
Published: 21 April 2017 | Author: Bob Pannell
It is nearly three years since the Bank of England’s financial policy committee (FPC) intervened to slow the future trajectory of the UK housing market.
Arguably, it has been more successful than it had originally hoped. Whereas its consultation paper consultation paper in June 2014 referred to a central scenario in which house purchase approvals would now be averaging 270,000 each quarter, the latest three-month total is only 205,000.
The Bank acknowledged, in last November’s Financial Stability Report, that we had seen material changes to interest rate expectations since mid-2014. The CML and other industry players have suggested that this creates scope for the FPC to ease back on its requirement that affordability should be assessed on the basis that interest rates could be 3% higher during the first five years of the mortgage.
The FPC, however, struck a different tone and signalled that it should “hardwire” its current requirements in order to help build greater resilience for borrowers.
Although there is a technical discussion to be had about the “normal” rate of interest to which the UK might ultimately revert, we do not propose to work through that here. It is perfectly legitimate for the Bank to view current conditions as exceptional, and so to downplay current interest rate signals.
But there is nothing inherently wrong with an alternative judgement that interest rate expectations reflect key macro-economic developments and are relevant to the sustainability of mortgage debt. If that turns out to be true, then the Bank’s stance would be unnecessarily restrictive and potentially adverse for housing activity levels and UK households.
Our concerns about the hardening stance of the FPC are magnified because we do not share the Bank’s assessment that its policies have had little adverse impact on the housing market to date.
Although counterfactual analysis is not straightforward, we think it is more plausible than not that the Bank’s measures have contributed to lower levels of house purchase activity and made it harder to transact for older borrowers and for households with single incomes.
According to the Bank’s original modelling in the June 2014 consultation paper, buying a house with a mortgage would go ahead if it passed the FPC’s affordability test or the mortgage only had to be reduced by up to 10% to do so.
This is probably true for some first-time buyers. But it does not ring true for those thinking about moving house. In these circumstances, transactions are often aspirational in nature and households may enjoy a range of options, including recourse to the rental market or simply staying put (perhaps choosing to extend or improve their current home).
Chart 1: House purchase activity, four-quarter moving totals
Intriguingly, house-moving activity represents the one major sector, where we have seen almost no recovery post-crisis. This makes movers interesting to look at. Lots of factors will be at play here but it is possible, as we shall see, that macro-prudential policy has been part of the mix over recent years.
If we look more closely at mover activity, we see, for example, that higher loan-to-income (LTI) activity is becoming much more concentrated in the hands of younger borrowers, and also in households with two incomes.
To the extent that its rules may be exacerbating these developments, the FPC may be limiting credit risks at the expense of shrinking overall activity and contributing to a less diverse cohort of borrowers. This may, in turn, be adding to market illiquidity and concentration risks.
Chart 2: Movers, use of higher LTIs by age
Note: Figures show % of lending in the age bracket at an LTI ration of 4.5% or higher
Development of macro-prudential policy
At its heart, macro-prudential decision-making is about market judgements and trade-offs.
When macro-prudential policy was being developed in the UK, the Bank was rightly wary of the huge public interest in housing markets. It insisted on having a political mandate to intervene and, when parliament first granted such powers, the Bank acknowledged the need to monitor market developments closely, to engage with stakeholders and to communicate policy changes effectively.
When the FPC acted in June 2014, the CML and much of the mortgage industry saw the measures as sensible, proportionate and market-sensitive, and that they would define a sustainable growth trajectory for the housing market.
As we mentioned earlier, market activity levels since then have been disappointing, despite numerous government interventions to support first-time buyers and new build activity.
The changing environment
The interest rate environment has changed materially and parliament has granted the Bank directive powers to act in the residential and buy-to-let markets. We have also seen a number of interventions targeted at buy-to-let lending, including various tax changes and micro-prudential interventions by the Prudential Regulation Authority.
Given so many changes, we are pleased to see that the Bank has committed to undertake a review of its housing powers this year. In our view, this affords the Bank an overdue opportunity to re-engage with the CML, mortgage lenders and other industry stakeholders, and to re-invigorate public debate about future macro-prudential policy direction and associated trade-offs.
We continue to believe that macro-prudential policy could be re-calibrated, especially around affordability tests, in a manner that would deliver a modestly stronger and broader mix of activity, without undermining financial stability.
We would encourage the Bank to update and expand the housing and mortgage metrics that it monitors and publishes, to aid stakeholder understanding and challenge. Such challenge can only strengthen acceptance of its judgement-based policy actions.