Finanstilsynet yesterday responded to the Ministry of Finance's letter dated 6 March 2015 concerning household credit growth.
In its letter the Ministry of Finance asked Finanstilsynet to consider "if it would now be appropriate to introduce measures at an aggregate level to dampen growth in house prices and credit growth in the Norwegian household sector, possibly accompanied by a draft version of regulatory changes." The ministry's approach was prompted by the fact that several years of strong growth in house prices and household debt have increased the risk that financial instability could trigger and intensify a setback in the Norwegian economy.
In its answering letter Finanstilsynet gives its assessment of the risk of financial instability and describes policy instruments able to contribute to financial stability and how such instruments have been applied in other countries.
The situation in the housing market has changed significantly since the guidelines were reviewed early last year. At that time house prices had fallen slightly. Thereafter, house prices again gathered momentum, and there is a danger that the rapid house price and debt growth will persist. Hence the basis for the authorities' assessment of measures has changed significantly over the course of the past year.
A weaker outlook and increased uncertainty about the Norwegian economy will in isolation contribute to dampening households' desire to borrow. However, there is a risk that the prospect of long-lasting low interest rates and easy access to credit will cause the strong growth in debt and house prices to persist. That would further increase households' debt burden and help to maintain demand for goods and services for a time, but such a development is not sustainable. The risk of a subsequent sharp setback and financial instability would thus increase.
Finanstilsynet considers that further measures need to be taken in its area of responsibility to help to dampen the risk of financial instability.
Despite certain counter-arguments, Finanstilsynet concludes that it would be most appropriate to establish requirements for lending practices in the form of regulations. This course of action is necessary in order to remove or strongly curb banks' scope to deviate from the standards for residential mortgage lending practices. In contrast to guidelines, regulations will provide a basis for tighter supervisory follow-up action, for example by allowing the imposition of corrective orders on banks that breach the regulations. The Ministry of Finance is the body empowered by law to adopt regulations governing banks' lending practices.
Finanstilsynet proposes regulations based on the authority's residential mortgage lending guidelines. The standards in the guidelines are formulated as requirements in the regulations. A tightening of banks' exercise of discretion is the most important contributor to tighter lending practices. The draft regulations also contain some tightening of reference values:
- The mortgage rate increase to be employed when stress testing a borrower's debt servicing capacity is raised by one percentage point, from 5 percentage points to 6 percentage points. In addition, in the case of fixed interest mortgages, a similar interest rate increase will be applied upon the expiry of the mortgage rate lock-in period. This represents a slight tightening and should be viewed in light of lower market interest rates, which may call for an increased safety margin to allow for an increase in mortgage rates. However, the most important tightening factor in testing a borrower's debt servicing capacity is a requirement that the borrower must pass the stress test, i.e. that a special prudential assessment cannot justify any deviation from the rule.
- The maximum loan-to-value ratio for repayment mortgages is retained at 85 per cent of property value. The opportunity for a higher loan-to-value ratio is retained subject to provision of satisfactory additional security in the form of a mortgage on other property. The maximum loan-to-value ratio is accordingly set at 85 per cent of the sum of property value and any additional security. However, a higher loan-to-value ratio cannot be justified on the basis of a special prudential assessment.
- The guidelines put the pledge of a personal guarantee (surety) for parts of a mortgage on an equal footing with security in other property as the basis for a loan-to-value ratio above 85 per cent. This is not included in the draft regulations.
- The maximum loan-to-value ratio for home equity credit lines is lowered from 70 per cent to 65 per cent, with no opportunity given for a higher loan-to-value ratio based on a special prudential assessment.
- As regards amortisation mortgages, an annual instalment payment of at least 2.5 per cent is required as from the first year, and applies to all mortgages with a loan-to-value ratio above 65 per cent. This matches the instalment requirement for a 40-year serial loan. Under the current guidelines, instalment repayments are the norm, albeit unquantified, as from the first instalment for all mortgages with a loan-to-value ratio above 70 per cent. In order to create consistency in the legislation, the instalment payment requirement is confined to loan-to-value ratios above the maximum ratio for home equity credit lines.
The draft regulations entail a clear-cut restriction on banks' exercise of discretion and will be the chief contributor to tighter mortgage lending practices. A tightening of mortgage lending practices by regulations that provide some, albeit clearly limited, flexibility will still enable tighter lending practices than are effectively entailed by the current guidelines.
Should the ministry need to consider models that provide somewhat more flexibility than Finanstilsynet's recommendation, Finanstilsynet considers this should be restricted to the requirement of a loan-to-value ratio for amortisation mortgages, such that banks are able to provide mortgages to borrowers with little capital but with excellent debt servicing capacity.
One possibility in this respect is to set a limit to the proportion of the total number of mortgages that can be granted with a loan-to-value ratio above 85 per cent of property value and additional security within a specified period. This limit could for example be set at 5 per cent of all mortgages granted in the course of a quarter. This type of regulation is known as a "speed limit" in countries where such limits are employed. The use of a "speed limit" allows some – controlled – flexibility. At the same time such a device entails more complex regulation, with increased reporting and control requirements.
Regulation of mortgage lending practices by means of regulations, as proposed by Finanstilsynet, is an intrusive measure and should not be a permanent policy instrument. Finanstilsynet emphasises that the regulations should be revoked, or adjusted, once market conditions call for this to be done.
This letter is accompanied by a consultation document including draft regulations (in Norwegian only).