In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Macroprudential Policy: Lessons From Advanced Economies1

The UK is experiencing a rapid increase in house prices, particularly in London, and greater numbers of new mortgages with high loan-to-income ratios could represent risks to financial stability. Macroprudential policy is the first line of defense against those risks. Empirical evidence from a sample of advanced economies suggests that caps on debt-to-income (DTI) and on loan-to-value (LTV) ratios are potent tools to dampen mortgage credit growth and to mitigate financial stability risks. The effectiveness of these tools is enhanced when they are used simultaneously with additional macroprudential measures. In addition, countries tend to implement macroprudential policies gradually, possibly as a result of the uncertainty of the transmission mechanism of those policies.

A. Macroprudential Policy and Financial Stability Risks

1. High loan-to-income mortgages are rising in the UK, resulting in an increase in financial stability risks. Although mortgage lending is growing at a slow pace and financial risks have not materialized yet, the loan-to-income ratio of first-time buyers and of those households living in London have been increasing in the last 12 months. If this trend continues, banks’ and households’ balance sheets will become more vulnerable to income, interest rate, and house price shocks.

Figure 1.
Figure 1.

Loan-to-Income Ratio

Citation: IMF Staff Country Reports 2014, 234; 10.5089/9781498304337.002.A003

Sources: Haver Analytics; ONS; RICS; and IMF Staff Calculations.

2. Macroprudential policy is the best tool for addressing financial stability risks associated with the housing market. By introducing financial regulations, such as caps on loan-to-value (LTV) and debt-to-income (DTI) ratios of mortgage loans, macroprudential policies can mitigate systemic risks in the financial system. By adopting macroprudential policies, government authorities not only are able to reduce the supply of mortgages and dampen credit growth, but can also reduce the leverage ratio of marginal borrowers and improve the resilience of the financial system to negative shocks.

3. Macroprudential policies are becoming more common among advanced economies. Macroprudential policies are being used intensively in advanced economies, in particular since 2004.2 Caps on LTV/DTI ratios are the most common macroprudential measures used to address financial stability risks. Other measures, such as changes in the property taxes and risk weights (RW) of banks assets, have also gained popularity but are used less intensively than caps on LTV/DTI ratios (See Figure 2 and Appendix 2).

Figure 2.
Figure 2.

Number of Macroprudential Policy Measures in Advanced Economies.

Citation: IMF Staff Country Reports 2014, 234; 10.5089/9781498304337.002.A003

Sources: BIS; and IMF staff estimates.

4. This note analyzes the recent experience of macroprudential policies in advanced economies and draws some policy lessons for the UK. Using the macroprudential policy actions database from the BIS (2013), we analyze quantitatively and qualitatively the implementation of macroprudential policies in advanced economies.3 There are three main results: (i) the use of caps on the DTI ratio is the most effective tool to reduce mortgage credit growth and contain financial stability risks;4 (ii) the impact of macroprudential measures is maximized when several instruments are used simultaneously; and (iii) macroprudential measures are typically implemented in a gradual fashion, possibly as a result of implementation lags and uncertainty about the transmission mechanism of these policies. These results suggest that the recent cap on high loan-to-income ratio mortgages recommended by the Financial Policy Committee (FPC) is appropriate for addressing financial risks. 5 Going forward, it is likely that the factors that lead to a gradual implementation of macroprudential policy measures in other advanced economies also hold in the UK. A gradual approach would call for an early adoption of macroprudential policies, so UK authorities would have the flexibility to properly calibrate these policies over the cycle.

B. International Evidence on the Effectiveness of Macroprudential Policies

The Effectiveness of Macroprudential Policy in Advanced Economies

5. The effectiveness of macroprudential policy tools is quantified through an event study analysis. We quantify the impact of macroprudential policies as the difference between: (i) the growth rate of mortgage credit and house prices 6 months after the introduction of a macroprudential measure; and (ii) the growth rate of the same variables 6 months before the measure. The difference in growth rates quantifies the slowdown (or acceleration) in credit and house prices after the implementation of macroprudential policies. The empirical evidence shows that macroprudential policies have quantitatively important effects on mortgage credit and house prices.6

6. Macroprudential policies, in particular caps on DTI ratios, are highly effective in containing financial risks stemming from the housing market. The empirical evidence from a sample of advanced economies shows that credit and house price growth rates decline after a tightening of macroprudential policies (Figure 3). The most effective instrument to contain credit growth is a cap on DTI ratio, which reduces nominal mortgage credit growth by 1.4 percent and house price inflation by 1.8 percent. A cap on the LTV ratio is also effective, since it reduces credit growth by 0.8 percent and house price inflation by 1.9 percent. The most effective tool for reducing house price inflation is tax policy, an instrument widely used in Asian economies. On average, house price inflation is reduced by almost 4 percent after the implementation of tax measures. Other measures such as changes in risk weights and provisioning have a limited impact on mortgage credit and house prices.

Figure 3.
Figure 3.

Impact of Macroprudential Tools on Mortgage Credit and House Prices

Citation: IMF Staff Country Reports 2014, 234; 10.5089/9781498304337.002.A003

Source: IMF staff estimates.

7. The effect of macroprudential policy is maximized when several instruments are used simultaneously. In the sample of advanced economies macroprudential policies are typically implemented in a gradual fashion. Furthermore, over time as macroprudential policies are widely tested, authorities tend to use several macroprudential tools simultaneously.7 The empirical evidence shows that macroprudential policy is much more powerful when several instruments are used at the same time (Figure 4). While, on average, a single instrument can reduce mortgage credit growth by 0.4 percentage points, the combined effect is 5 times more powerful, and several instruments combined are capable of reducing mortgage credit growth by 2 percentage points. For instance Hong Kong used four different macroprudential tools in the first quarter of 2013, resulting in a reduction in house price inflation and credit growth of 11 and 3 percent, respectively.

Figure 4.
Figure 4.

Impact of Individual and Combined Macroprudential Policies

Citation: IMF Staff Country Reports 2014, 234; 10.5089/9781498304337.002.A003

Source: IMF staff estimates.

8. Other studies also find similar effects of macroprudential tools in dampening credit growth and house price inflation. Kuttner and Shim (2013) find that caps on the DTI have the maximum effect on containing credit growth, while tax measures are effective at reducing house price inflation. Krznar and Morsink (2014) find that in Canada a cap on the LTV ratio is a powerful tool for reducing mortgage credit growth. In addition, in a cross-country econometric estimation, they find that changes in risk weights and caps on DTI ratios are effective at containing credit growth. In Asia, there is evidence that caps on LTV ratios and taxes on housing transactions have a strong impact on credit growth, house price inflation, and bank leverage (REO, 2014).

B. Case Studies of Macroprudential Policies in Advanced Economies.

9. We analyze the implementation of macroprudential policies in Korea, Canada, and New Zealand. From each case study we draw some lessons for the UK: (i) macroprudential policies are effective at containing regional housing booms; (ii) macroprudential policy measures are implemented gradually; and (iii) the macroprudential policy toolkit should include instruments that target directly mortgage credit flows (i.e., caps on LTV and DTI ratios that directly affect the supply of mortgage credit). Next, we analyze in detail the experiences in Korea, Canada, and New Zealand.

Korea: The role of regional macroprudential policies

10. Korea experienced pronounced housing cycles in the early 2000s. In the aftermath of the Asian crisis Korea experienced two major housing cycles. The first one in the 2001–05 period, and the second one during 2005–13. By 2002 house prices were growing at 18 percent in the country, and 32 percent in the prestigious Gangnam districts. Moreover, household credit was growing at an annual rate of 36 percent.

11. In response to high house price inflation in specific markets, government authorities introduced regional macroprudential measures in 2003. In response to house price inflation in the prime areas in Seoul, the government adopted macroprudential policies tailored specifically to “speculative zones”. A geographical area was designed a speculative zone, if the following criteria were satisfied:

  • Monthly nominal house price index increase of 30 percent more than the CPI inflation rate during the previous month.

  • Either (i) The average house price inflation in the previous two months increase 30 percent more than the national house price inflation in the previous two months; or (ii) the average monthly house price inflation over the previous year was higher than the average monthly national house price inflation over the previous three years.

12. Empirical evidence suggests that regional macroprudential policies were effective, but it required frequent adjustments. In May 2003 the authorities reduced the LTV threshold on mortgage loans with a maturity of less than three years from 60 to 50 percent. In October 2003 the LTV restrictions on mortgage loans with a maturity shorter than 10 years and properties located in speculative zones were reduced even further to 40 percent. After this measure was adopted, real house prices declined by 5 percent. In June 2005, once the house prices started increasing again, the government reduced the LTV to 40 percent on properties priced above 600 million won. Moreover, in August 2005 the government increased the capital gains tax for homeowner with three or more properties in the speculative zones. Data on house prices and mortgage credit indicate that these policies were effective at stabilizing the housing and mortgage market (Chang, 2010 and Miller, 2013). Furthermore, the policy was effective at curbing expectations on house price increases and discouraging speculative incentives (Igan and Kang, 2011).

Canada: The role of mortgage insurance and gradual implementation of macroprudential policies

13. Canada’s housing boom was a major risk to financial stability. House prices, residential mortgage credit, and consumer credit (including Home Equity Lines of Credit or HELOCs) all grew rapidly in the 2000s. Most indicators of house price valuation, such as the house price to income ratio and the house prices to rent ratio, increased sharply (IMF, 2014). Household debt as a share of disposable income rose from about 110 percent in 2000 to 165 percent in 2013. Mortgages and consumer loans secured by real estate (mostly HELOCs) are estimated to account for 80 percent of household debt and to represent the single largest exposure for Canadian banks (about 35 percent of their assets).

14. The Canadian authorities have exceptional power to affect housing finance through government-backed mortgage insurance. Specifically, the combination of the requirement that most lenders have insurance for high loan-to-value (LTV) mortgage loans and the central role of the government in providing such insurance gives the government great power to influence housing finance. In other words, the rules governing mortgage insurance are de facto important macroprudential tools. In addition, the authorities can also influence credit and house price growth through microprudential measures, such as prudential guidelines on mortgage lending, and structural measures, such as the oversight of the government-owned Canadian Mortgage and Housing Corporation (CMHC).

15. The tightening of mortgage insurance in Canada along with other macroprudential tools was most effective after several rounds of combined measures. Krznar and Morsink (2014) find that the initial macroprudential measures were not effective in limiting mortgage credit growth. However, after the implementation of three further rounds of mortgage insurance tightening (2010, 2011 and 2012) and successive increases in LTV and DTI caps, there was a slowdown in mortgage credit and house price growth.

New Zealand: The need of a comprehensive macroprudential toolkit

16. New Zealand adopted a macroprudential policy framework in 2013 to address systemic financial risks. New Zealand has a history of boom and bust cycles in the housing market. In the pre-crisis period, house prices were growing at double digits. By the end of 2012, house prices in New Zealand were growing at an annual rate of 7 percent while mortgage credit was expanding at 4 percent per year. The rate of mortgage credit growth appeared to be low compared to previous housing booms as a result of high debt repayments. However, new mortgage loans were growing in excess of 30 percent, similar to pre-crisis rates. In this context the Reserve Bank adopted a new macroprudential policy framework in May 2013 to deal with financial vulnerabilities arising in the housing market.

17. The macroprudential toolkit of the Reserve Bank of New Zealand included four instruments. The instruments were: (i) countercyclical capital buffer (CCB); (ii) sectoral capital requirements (SCR); (iii) adjustments to the minimum core funding ratio (CFR); and (iv) restrictions on high LTVs. The first two instruments are designed to build capital buffers against negative shocks. The third instrument builds resilience in the financial system against liquidity shocks by ensuring a stable source of funding. Only the fourth instrument, a cap on LTVs, has a more direct effect of reducing the risk of mortgage loans and the supply of credit.

18. In October 2013 the Reserve Bank imposed caps on the proportion of new loans with high LTV ratios. The Bank limited the share of high LTV loans (80 percent or higher) to 10 percent of the new mortgage lending.8 As opposed to outright LTV caps, a partial limit on LTV loans provides banks with some flexibility to manage the risk of their mortgage portfolio. In order to reduce incentives for regulatory arbitrage, the measure was announced to be temporary, and there was a commitment to remove the cap once the housing market stabilized.9

19. The cap on high LTV loans was effective at containing financial risks. As a result of implementing the cap on loan-to-value ratios, the share of high LTV loans declined from 25 percent of new mortgage lending in September 2013, to 5.6 percent at the end of March 2014. In addition, national house sales dropped by 23 percent between September 2013 and March 2014 across regions (RBNZ, 2014). Although the policy achieved the objective of reducing the risk exposure of banks, constant monitoring is required to prevent regulatory arbitrage. An assessment on the impact of this macroprudential policy is published twice a year in the Financial Stability Report.

C. Policy Implications for the UK

20. The experience of macroprudential policies in other advanced economies provide three important policy lessons which could have implications for the UK:

  • Macroprudential policies have been implemented gradually. The experience from Canada and other advanced economies shows that macroprudential policies are implemented in a gradual fashion. Since there is uncertainty about the transmission mechanism and possibly some implementation lags, macroprudential policy measures are enacted in several rounds. Under a gradual approach, the authorities have time to assess the impact of macroprudential measures and, if necessary, they can recalibrate the policies accordingly. Large and discrete changes of macroprudential policy could disrupt the financial system, have a negative effect on economic activity and lead to financial disintermediation.

  • Macroprudential policies that rely on caps on LTV/DTI ratios to deal with risks in the housing market have been shown to be successful. The experience from New Zealand shows that the macroprudential authority should rely on caps on LTV/DTI ratios to deal with financial stability risks arising from the housing market. The Reserve Bank of New Zealand had some macroprudential instruments in common with the FPC, namely countercyclical capital buffer (CCB) and sectoral capital requirement (SCR). However, the first macroprudential instrument used by the Reserve Bank was a cap on the proportion of high loan-to-value mortgage lending. The Reserve Bank of New Zealand chose that instrument since it was considered the most targeted and effective at mitigating risks from the housing market (Spencer, 2013).

  • Regional macroprudential policies can be effective in containing financial risks. House price dynamics in the UK are not uniform across regions. While house price inflation in London has reached the same levels as in the pre-crisis period (19 percent), in the rest of the country it still remains at single digits (7 percent). In this context, there are merits of implementing macroprudential policies targeted at specific regions following the Korean example. By introducing limits on high LTV and DTI mortgages issued in London, the macroprudential authority could directly address the source of systemic financial risk. However, as the Korean experience suggests, several rounds of regional macroprudential policies are required to mitigate financial risks.

D. Concluding Remarks

21. Cross-country evidence indicates that macroprudential policies are effective at containing risks from the housing market. Macroprudential policy is becoming an increasingly important tool in advanced economies, in particular, in countries that experience rapid surge in house prices. Relying on an event study analysis, we find that the caps on high DTI and LTV ratios are highly effective at reducing both mortgage credit growth and house price inflation. Moreover, the effectiveness of macroprudential policies is maximized when several tools are used simultaneously. However, as a result of the uncertainty about the lags and effectiveness of the transmission mechanism, authorities in advanced economies implement macroprudential policies gradually.

22. The cap on high loan-to-income mortgages in the UK is a step in the right direction. The FPC has recently recommended a cap on mortgages with high loan-to-income ratios which is due to take effect from October 1, 2014. The new macroprudential policy measure states that no more than 15 percent of new mortgages could have a loan-to-income ratio of 4.5 or higher. As the experience in the Reserve Bank of New Zealand indicates, this new macroprudential tool could be extremely powerful at reducing the households’ leverage ratio. In addition, evidence from other advanced economies suggests that this macroprudential measure could be adjusted gradually over the business cycle.

Appendix 1. Event Study Analysis

1. The event study analysis relied on the BIS (2013) database of macroprudential policy actions. The database, compiled by Shim et al. (2013) from the BIS, describes in detail the macroprudential policies implemented in advanced and emerging economies since 1990. From this database we obtained the list of macroprudential policy actions for a sample of seven advanced economies: Australia, Canada, Hong Kong, Korea, New Zealand, Singapore, and Sweden. In addition, for each country we obtained data on mortgage credit in domestic currency and a house price index from Haver Analytics. These two variables were used as an input to estimate the impact of macroprudential policies.

2. The impact of each macroprudential policy tool was calculated as follows:

  • For each macroprudential policy measure in each country we computed the slowdown of mortgage credit and house price growth. This is calculated as the difference between the growth rate of the variable of interest 6 months after and 6 months before the measure was implemented. For instance, if mortgage credit grew by 12 percent 6 months before a macroprudential measure was implemented and grew by 9 percent 6 months after the implementation, the estimated impact was -3 percent (9–12 percent).

  • For each macroprudential tool (in each country) we calculated the simple average of the impact of the correspondent macroprudential policy measure. For instance, Singapore adopted four measures under the category of LTV caps. The effect of LTV caps in Singapore is calculated as the simple average of the impact of these four measures.

  • The final impact presented in figures 3 and 4 was calculated as the simple average of the effect of macroprudential tools across countries. For instance, the average impact of caps on LTV ratios is calculated as the simple average of the effect in each country.

  • We followed the same steps to estimate the effects of combined and individual macroprudential policies.

Appendix 2. Macroprudential Measures to Deal with Housing Booms in Advanced Economies

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Source: Krznar and Morsink (2014) and Shim et al. (2013).

References

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1

Prepared by Ruy Lama (EUR) and Mohamed Norat (MCM).

2

We analyze a sample of 7 advanced economies: Australia, Canada, Hong Kong, Korea, New Zealand, Singapore, and Sweden. Many of these countries have important financial centers and their experience with macroprudential policies can provide valuable lessons for the UK.

3

The classification of macroprudential policy measures follows the work of Shim et al. (2013) and Krznar and Morsink (2014).

4

Caps on LTV ratios also have an important impact on credit growth, but they are not as effective as caps on DTI.

6

Data on house prices and mortgage credit was obtained from Haver Analytics for the 1997–2013 period.

7

Most of the simultaneous macroprudential measures were adopted after 2008. Before 2008, countries had a tendency to implement individual macroprudential measures.

8

New mortgage lending was defined for a window of six months.

9

However, there was no formal definition of stability in the housing market.

United Kingdom: Selected Issues
Author: International Monetary Fund. European Dept.