Macroprudential lessons for the Bank of England

Last year, Andy Haldane, the Bank of England’s new chief economist, described macroprudential policy as the “new kid on the block and perhaps even the next big thing”. However, he admitted that knowledge of the effect of these policies was limited. “Macroprudential policy is roughly where monetary policy was in the ’40s,” he said. “If I were being charitable, that would be the 1940s, rather than the 1840s.”

This presents a dilemma for the Financial Policy Committee (FPC), which is in charge of maintaining financial stability. On the one hand, the Bank of England’s Governor, Mark Carney, and the other FPC members have at their disposal the most powerful toolkit the central bank has ever had to rein in mortgage lending. It could force borrowers to find bigger deposits, or make banks hold more capital against mortgage lending. On the other, the Bank is venturing into uncharted waters, which suggests it will err on the side of caution. After all, it doesn’t want to derail the recovery.

Carney has already hinted at the policies the FPC could activate this week. Recently, he suggested that the Bank could impose a new “affordability test” to assess the ability of borrowers to cope with much higher mortgage payments when interest rates rise. Others believe the FPC will activate one of its dramatic tools and cap the amount people can borrow as a multiple of their income. What is clear is that the status quo has become unacceptable. So what next?

For Olsen, who advises the government on macroprudential policy, the focus has always been about hardwiring prudence into the banks.

“The primary objective of monetary policy is to stabilise prices. Monetary policy is, to some extent, the first line of defence to stabilise the economy when you have variations and fluctuations in business cycles or when you have fluctuations in the activity level. The purpose of introducing capital requirements or the counter-cyclical buffer is to make banks more robust and resilient to major shocks which hopefully do not occur as frequently as more ordinary business cycles.”

Olsen says his advice to Carney would be to implement measures swiftly but permanently. “It’s about time to have stricter curbs, stricter regulations of banks. And countries should seek the necessary measures to build up bank buffers as quickly as possible once their economy can sustain them.”

Macroprudential tools can have powerful effects. Odd Nymark, the chief executive of Eiendomsmegler1, Norway’s biggest mortgage lender, describes the effects of raising risk weights on mortgages as worse than the impact of the financial crisis on Norway. “It stopped the financing between selling and buying because banks suddenly said you can borrow the money, but you need to wait until you’ve sold the house you have, because we will not give you the full financing,” he says. “Suddenly 50pc of the market that usually would have bought a property said 'we can’t buy it now’, which meant we had a huge build-up of property for sale.”

The impact on Norway’s mortgage market was clear, but does that mean similar measures in Britain would have the same effect? After all, Norway is a much larger country than Britain, but has a much smaller population. The influx of overseas cash for properties at the top end of the market, which has pushed up prices in London, is also absent.

However, in many other ways, Norway is the perfect example of where Britain could get to if credit growth continues to rise. Norwegian households, like British ones, have quite a lot of debt. Norway’s household debt-to-income (DTI) ratio is around 200pc, compared with the UK average of around 140pc. Norwegians also have the same desire to own a home as Britons. It’s true that they tend to save more, but prices have been going up sharply. The OECD warned in 2013 that Norway, Canada, Sweden and New Zealand risked a “price correction” because “houses appear overvalued but prices are still rising”.

Of course, Norway is not the only country that has tried to rein in mortgage lending and stop house prices from getting out of control.

A paper published by the International Monetary Fund (IMF) in 2013 assessed the impact of macroprudential policies on 46 countries. By far the most common measure was a cap on the amount people could borrow as a multiple of the value of the home. Half the countries had imposed LTV ratios, compared with 30pc with a loan-to-income (LTI) cap.

A study conducted by academics Kenneth Kuttner and Ilhyock Shim last year went even further. They found that tightening LTI ratios had by far the greatest impact on credit growth, which decelerated by between 4 to 7 percentage points in the year after LTI limits were introduced. “Evidence indicates that reductions in the maximum LTV do less to slow credit growth than lowering the maximum DTI ratio does,” they noted. “This may be because, during housing booms, rising prices increase the amount that can be borrowed, partially or wholly offsetting any tightening of the LTV ratio.”

Lord Turner, the former chairman of the Financial Services Authority who sat on the interim FPC in 2012, agrees that LTI caps are more effective than LTV limits. “The trouble with LTV is it can be a bit circular. You impose an LTV limit and the price can go up, and then somebody can borrow more money via a mortgage on the price that’s gone up,” he says. “One of the problems we have in our economy is the way in which we borrow money against the value of an asset which goes up, which appears to make more borrowing justified. LTI targets the real thing, which is: can people repay the debt out of their income?”

Caps like these also have consequences. People could try to dodge the rules by taking out unsecured debt on top of their mortgage to “top-up” their loan.

Martin Andersson, the head of Sweden’s financial regulator, which also introduced a series of measures to cool the housing market, including an 85pc LTV cap and higher risk weights, says the evidence suggests very few people have done this. “Before the new rules, more than a third of households had a mortgage of over 85pc LTV,” he says. “After we introduced the LTV it was only 10pc of households that actually took an additional loan besides their mortgage when they bought the house.”

Mortgage lenders have also described LTV and LTI caps as “crude”. Paul Smee, the director general of the Council of Mortgage Lenders, argues that limits would lock people out of the market and make it difficult for them to move. Nymark also says rule changes had a big impact on first-time buyers. “When that market stops, that triggers a domino effect on the rest of the market.”

Many Norwegians have coped with the LTV caps by going to the bank of mum and dad. “Many are helped by their parents to fill up some of the necessary equity capital. We know that is happening to a large extent,” says Olsen. He adds: “There are some remaining who is not in that position. They could have problems.”

While he admits that this raises inequality issues, Olsen maintains that such a cap is needed to maintain financial stability. “I think this could be an argument for reaching a sensible level but which is permanent so that for every generation they are quite aware of this requirement when they go to the bank.”

The issue of inequality quickly takes macroprudential policy into deep political territory. As Lord Turner explains, this was one of the reasons why the interim FPC decided against asking the Government for powers of direction on mortgage caps. “The majority [of FPC members] said let’s not run before we can walk, we really haven’t used macroprudential powers in the past, let’s keep it a small number, focus on counter-cyclical capital requirements and then we can build up measures over time,” he says. “But there was also a school of thought that said this would be very political, and the committee will be seen to be imposing a LTV limit or LTI limit, and, when it does, suddenly somebody won’t be able to get a mortgage who was previously able to get one, and that will politicise it.”

LTV caps have already been used as a vote winner in Norway. Erna Solberg, the country’s current prime minister, gained power last year partly thanks to her commitment to review Norway’s 85pc cap. The so-called “egenkapitalkrav på 15” was deeply unpopular with younger voters.

There is evidence that macroprudential measures only work when policymakers take a tough stance. Kuttner and Shim’s study found that increasing risk weights or reserve and liquidity requirements had “little or no detectable effect on the housing market.

“Measures aimed at controlling credit supply are therefore likely to be ineffective,” they concluded. Analysts at Deutsche Bank agree. The bank calculated that if the FPC lifted the minimum capital weight on UK home loans from 15pc of their value to 20pc, it would cost Lloyds Banking Group, Britain’s largest provider home loans, about £1bn in extra capital and a further £1.45bn for the country’s other major banks. However, the bank believes However, the bank believes “a step of this kind to trap modest amounts of additional capital in the system” would offer “little benefit to stability and little change in practice”.

And, while tougher capital requirements slowed down the market in Norway, banks have bounced back this year, with bumper profits for 2013 helping the sector to cope with the tough new rules. Nymark says it’s pretty much back to business as usual now. “Pre-crisis, it used to take us around 20 days to complete a sale once a house went on the market. When the capital requirements were introduced, this went up to around 35 days. Now it’s back to about 27,” he says.

For this reason, some policymakers believe that a tough package of measures is needed to cool the market and keep it stable. Adam Posen, a former member of the Bank of England’s Monetary Policy Committee, is one of them. “The big message from other countries, including China, Hong Kong, Australia and Spain, is that you have to lean against a housing boom very hard to make it work and really stop it. So it can be successful, but they’re going to have to be pretty aggressive.

Posen says an LTV cap of 80pc, or even 75pc, is necessary to cool the market. “By American standards or British standards, that’s quite large, but by European standards, that just brings the UK back into the middle of the pack.”

But what about the notion that Britain is obsessed with owning property and that an Englishman’s home is his castle? Posen’s reply is blunt: “We need a housing policy, not a home ownership policy.

“There used to be a British obsession with the lash, and that was a bad idea as well. It’s not the job of public policy to worry about people’s dreams. It’s the job of public policy to worry about the stability of the system and the fairness of the system.”

Posen goes a step further and says the FPC should write to the Government this week to urge them to use fiscal policy to help cool the market. “I would ask them to introduce a tax targeting either foreign investors, investors who buy properties above a certain price limit, or investors who don’t keep their flats or houses occupied,” he says.

While controversial, Kuttner and Shim described housing-related taxes as “the only policy tool with a discernable impact on house price appreciation, while a speech this month by Min Zhu, the deputy managing director of the IMF, argued that taxes were the only way to deter housing demand from overseas buyers. “Evidence shows that this fiscal tool did reduce demand from foreigners who were outside of the LTV and DTI regulatory perimeters,” he said.

Others, like Andersson, prefer a swift but more measured approach. “This is uncertain territory, and faced with that truth you can have three approaches. You can say this is uncertain, this is untested so we don’t want to do anything. I think that’s bad policy because it creates problems now or means you run into problems later.

“And then you can say that now is the time for tough measures, and try to fix the problem once and for all. This is potentially very risky. Some people think that we can reduce LTVs very quickly or, as they have done in the Netherlands, introduce rules from one day to the next that mortgages should be paid down completely in 30 years. These types of measures are very dramatic and risk creating the very problem you’re trying so hard to avoid. It might be more sensible to use different tools on the demand side and on the supply side, evaluate the effect and then try to move on later on.”

But, as the banks have pointed out, the Mortgage Market Review (MMR), which was designed to stop people from taking on unaffordable mortgages, was only introduced in April. Surely it should be given time to bed down?

Andersson responds: “When we first introduced the LTV ratios, no one thought that we did the right thing because all the experts and media thought that we were creating a problem that didn’t exist. But after six months, taking the vibrant discussion in the media into account where we showed the analysis and took the debate, a lot of people thought that we should do more, because this was now seen as a serious problem. We’ve seen that the discussion changed the ballgame and actually made household indebtedness an issue that everyone needs to take seriously. That was actually one of the big achievements, to get the problem on the agenda, and what we need to do is continue to work on these different measures to make sure we change people’s behaviour.”

Andersson advises Carney to start addressing the problems early. “The sooner you start, the less hard you need to be on the measures you take and then you can always follow up to take other measures. The process is equal parts art and science [but] don’t wait until you feel you need to take more draconian steps because that will only hurt the economy.”

He also says openness will remain important. “No one is saying that you need to die debt-free [but] the public debate is extremely important.” This perhaps, will be one of the most important things for the FPC to remember when forming policy. The committee has much to learn from Scandinavia, where policymakers were extremely candid about their thinking. Nymark, the CEO of Norway’s second-biggest bank, turned up unannounced during my visit to an open house viewing in Oslo; a sign that public debate really matters in Norway.

As Smee puts it: “The FPC are, at the moment, a more invisible body and it would be better if they were more upfront about seeking opinion. They should be an open body that seeks input. At the moment, they’re rather a shadowy body.”

Macroprudential policy may still be in its infancy but, as most people agree, openness and transparency will be the key to understanding its impact on the market. Carney and co please take note.

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