This is the BSA's response to the consultation published on 30 October by HM Treasury (HMT) into granting the Financial Policy Committee (FPC) powers of direction over Loan to Value (LTV) and Debt to Income (DTI) in respect of owner occupied mortgages.
The BSA recognises the need for the FPC as a macro-prudential body to survey and address risks to the UK financial system. In addition, the FPC should be empowered to have targeted tools at its disposal to take action to avoid future financial crises.
But we are concerned about the extent to which the outlined limitations of both DTI and LTV will overlay the sound underwriting principles already laid down for mortgage lending under the Mortgage Market Review (MMR) in April this year.
An individual borrower’s debt and income is already taken into account when assessing whether a borrower can afford a specific loan and any arbitrary cap on the amount borrowers can take on board will have political repercussions as specific groups of borrowers find themselves unable to get on the housing ladder.
As part of our response to the Prudential Regulation Authority (PRA) and Financial Conduct Authority’s (FCA) consultation on the Loan to Income cap that was introduced in October this year, the BSA had argued that a volume cap be introduced to bring out of scope smaller lenders. A volume De minimis threshold was introduced but at just 300 mortgages per year it was too low to bring out of scope any BSA members. If a similar De minimis threshold and allowance was introduced for DTI and LTV caps it could severely limit first-time buyers’ access to finance. Instead we would like to either see a volume De minimis of 3,000 mortgages per year or a value De minimis of £200m per year. Either would provide greater flexibility and ensure smaller lenders are not unfairly penalised.
Considerations of proportionality are especially important as building societies would be particularly affected by LTV or DTI limits because they are required by law to hold at least 75% of their assets in loans secured on residential property. Other lenders do not have the same legislative constraint, so building societies would find it relatively more difficult to divert their funds to alternative uses.
There are also considerations as to how any cap would be enforced. The existing Product Sales Data (PSD) framework has been used to monitor the current LTI cap, which we welcome. However any amendments made to it will add additional costs to firms and will need to be taken into account when a full cost benefit analysis has been made.
The FPC also needs to ensure that it fully consults with the market participants who will have to implement its measures on how its new powers of direction will work in practice so that any disruption is kept to a minimum.
Finally, to ensure that neither of the tools become a permanent feature of the mortgage market, we believe that each tool should apply for a maximum time limit, such as 18 months. During this period the FPC may change the limit or the proportion of lending that is allowed, but the automatic 18 month expiry would mean that a more formal and thorough review of the need for the limit would take place.
While it’s right that the FPC has the right tools for the job, they should be used only in defence rather than as a means to over-engineer the UK’s mortgage market.
Below we address the questions in the consultation document.
Do respondents agree that the FPC should be granted a power of direction over DTI?
While the general principle of capping the overall indebtedness of borrowers is a worthy aim in principle, we have concerns regarding the practicalities of implementing it. Both the Government and FPC view the macro-prudential tools as the first line of defence against risks to financial stability and cite international evidence that more than two thirds of systemic banking crises were preceded by boom bust cycles in the housing market.
But as the consultation acknowledges, lenders already take into account borrowers’ existing liabilities and that informs part of their existing processes when deciding how much to lend. This has been further embedded by the introduction of the MMR. As with the current LTI cap, a DTI cap would introduce another arbitrary limit when weighing up who to lend to.
Borrowers who currently are eligible for a mortgage could potentially find themselves unable to get one due to the amount of debt they have built up. Government and Local Authority-backed schemes would be exempt from any cap under the consultation but this raises additional concerns about the permanence of these types of programmes.
A key concern here is the financial cost this could result in to implement. The consultation does not state how the limits would be monitored. The PSD returns produced by lenders are already being used by regulators to monitor the LTI cap. On the basis that this continues to be used, regulators would require modifications to capture the information requirements necessary for a DTI cap and naturally would result in significant additional financial costs to implement. Lenders are still in the process of conducting comprehensive systems developments to implement the PSD changes brought in by the MMR, which are to be implemented from January 2015. While using the existing PSD system is clearly the lesser evil of requiring a whole new system to monitor these macro-prudential tools, nonetheless each modification carries significant cost to firms.
Careful definitions would be required to ensure that assets to be used as part of the deposit are not included in any assessment.
It is also worth pointing out that not all credit can be found on credit searches because not all financial institutions share all of their information. Therefore, it may not be possible to establish the full extent of a consumer’s indebtedness, especially if the consumer also chooses not to disclose the debt on the application form.
Another concern is that the cap would only ensure borrowers’ debt is manageable up to the point at which they get a mortgage. It would do nothing to stop borrowers overleveraging themselves the moment they get the mortgage.
Both DTI and LTV limits could result in risks being shifted to other areas, rather than being reduced. In particular, they could result in more unsecured lending, or activity shifting to other sectors, particularly unregulated ones. The use of a DTI rather than LTI should help to mitigate some of the use of unsecured lending. However, the FPC should ensure that the list of indicators it publishes with its Policy Statement cover some of the most likely areas where activity might shift to, in order to assess the effectiveness of DTI or LTV limits.
DTI and LTV limits will result in some individual borrowers being excluded or having to pay more to borrow at high LTV or DTI ratios, even if they are able to repay these loans and pose no threat to financial stability.
Other borrowers who may be affected by the implementation of these limits are those existing borrowers who, because of house price falls, may have very high LTV loans, or even be in negative equity, and may not be able to refinance or move home because of the limits applied to the market.
Do respondents agree that the FPC should be granted powers of direction over LTV?
As with a DTI cap, the general principle of LTV limits would be a major intervention in the UK’s mortgage market.
While international examples are referred to in HMT’s consultation, the only specific link made is to a report on Hong Kong’s mortgage system where a 70% LTV cap has been in place since 1991, with access to 90% LTV loans only made available via a mortgage insurance scheme.
HMT’s consultation stipulates that any macro-prudential limitations to mortgage finance would exclude Government and Local Authority backed mortgage schemes. As a result Government backed schemes could quickly become the only, or at least the primary, means by which first-time buyers have access to a mortgage.
The report on Hong Kong’s mortgage market concludes that potential liquidity constraints “should not be used as a compelling reason for not adopting an LTV policy to contain the systemic risk associated with property price shocks”.
But if this type of permanent limit was applied to the UK both the Government and FPC would need to be more transparent to both the industry and country about permanently tying the country to Government-backed programmes that aid demand. For example, while the Government has extended Help to Buy equity loan until 2020, Help to Buy mortgage guarantee, which was launched at the beginning of 2013, is due to end in January 2017. So along with the FPC’s powers of direction, it would also need to ensure that existing and future Government and Local Authority schemes can accommodate the vast majority of first-time buyer lending.
If Government schemes become the only means by which higher LTV lending was available there would be financial consequences for UK taxpayers if property values fell at some point in the future.
And this type of cap would cause material damage to smaller building societies as for some the fixed costs of accessing the Government schemes have made them uneconomic. Instead many have sourced their own mortgage indemnity guarantees from insurers to allow them to lend at higher LTVs. This type of lending would not be excluded and would leave smaller mutuals at a direct commercial disadvantage.
These limits would also pose a particular problem for shared ownership loans, where the borrower acquires a proportion of the property and pays rent to the Housing Association or Registered Social Landlord on the remaining interest of the property. With the combined loan often at high LTVs, LTV limits would effectively close this section of the market, excluding a substantial number of first-time buyers.
Do respondents agree with the proposed scope of mortgages to which the DTI and LTV limits could be applied?
With the conditions of both limits potentially meaning that Government or Local Authority backed mortgages end up being the only means by which first-time buyers can get a mortgage. The lesson of Hong Kong’s mortgage market is that while some stability is achievable where limits are introduced, stimulus packages become an essential part of the market to widen home ownership socially. The introduction of both Help to Buy schemes was based around them not becoming permanent parts of the market.
Both limitations will have a restrictive effect for those looking to buy their first home. As a result the political case for permanently having Government backed schemes to ensure house purchase remains achievable for first-time buyer would need to be made.
What are respondents’ views on the proposed definition of ‘debt’ for the purposes of the DTI tool?
The Government proposes to adopt the following definition of debt: “The borrower’s outstanding debt on owner-occupied mortgages (both first and second charge loans) plus the amount of credit extended under the new mortgage to which the flow limit applies
“Amounts outstanding on personal loans, overdraft facilities, credit cards and other types of secured and unsecured borrowing.” Non-contractual personal debts would be outside the scope.
We view this as a sensible definition and it fits in with how our members currently calculate debt.
What are respondents’ views on how (if at all) a borrower’s assets should be taken into account in calculating that borrower’s DTI ratio?
The Government is also consulting on to what extent a borrower’s savings and other assets should be offset against their debt. It argues that if this is not taken into account this could potentially have “a prejudicial impact” on anyone who has simultaneously built up assets and debt. While this may make it fairer for some borrowers, such an assessment also risks further complicating and lengthening the time it takes to assess borrowers for a mortgage.
Do respondents agree with the proposed definition of ‘income’ for the purposes of DTI?
The intention is to define a borrower’s gross income as the sum of the individual’s main income plus any income derived from the likes of overtime or other sources. However the FPC will be able to use its judgement to determine whether any direction should specify more precisely what types of income should be included, based on what is “appropriate and proportionate” to managing risks at a particular time.
Any change to what income was deemed acceptable for lenders to calculate affordability would have cost implications both in terms of training staff and amending IT systems.
What are respondents’ views on the appropriate treatment of existing buy-to-let mortgage debt, and income derived from rental yields (after cost) on buy-to-let properties?
If the income generated from the loans can be proven then it should be viewed as income. For professional landlords, this will be their income stream and any cap or rules should acknowledge this. But the question highlights the difficulties of applying any form of regulation to the buy-to-let market.
The FPC has recommended to the Government that it be given powers to limit both the LTV and interest coverage ratios of buy-to-let mortgages as well. However, the Government intends to separately consult on this in 2015. That specific review will aim to build an evidence based model of the buy-to-let housing market may carry risks to financial stability.
Our main concern here is that any move to apply residential mortgage caps to the buy-to-let market will be tantamount to regulation by stealth. It seems wrong to apply wider limitations on this sector when the case for regulation has still not been made.
Since The Turner Review in 2009 there has been considerable appetite to regulate the buy-to-let market from both regulators and Governments. In the 2010 HMT consultation into Mortgage Regulation the Government was initially supportive of extending Financial Services Authority (as it was then) regulation to buy-to-let. But it was ultimately swayed by concerns about what impact it would have on the UK’s PRS and given its importance, pledged to “reconsider the scope and form of the regulation to address these issues”. And four years on HMT specifically stated in its recent response to the European Mortgage Credit Directive that it had “not been persuaded of the case for introducing regulation in this area”.
In the FPC’s September statement on the extension of its macro-prudential tools it provided a brief analysis of the effects the buy-to-let market has had on the UK’s housing market. In a similar way that high frequency traders can exaggerate the peaks and troughs of equities markets, the FPC argued the scale and nature of buy-to-let activity in the UK makes it a “significant potential amplifier of housing and credit cycles” on the basis that any increase in buy-to-let lending in an upswing adds further pressure to house prices. This prompts owner-occupiers to take on bigger loans “thereby increasing overall risks to financial stability”.
This clearly warrants further analysis and investigation in the prospective 2015 consultation paper on the buy-to-let sector.
But PRS remains strategically important to the UK’s housing needs and any consultation into the extension of the FPC’s powers to the buy-to-let market needs to be mindful of this fact.
Do respondents agree that the FPC should be able to apply DTI and LTV limits to a proportion of new mortgages calculated on either a value or volumes basis? If not, please explain on which basis the tools should apply and why.
The prudential and conduct regulators are responsible for risks at individual firms, whereas the FPC’s primary objective relates to identifying and reducing systemic risks. Therefore, its powers of direction should be applied in a way that is sufficient to address system-wide threats, and they do not have to have complete coverage. We therefore support the use of De minimis thresholds in making sure its powers are used in a proportionate way.
The PRA and FCA introduced a volume limit as well as a value limit with the introduction of its LTI cap at the beginning of October. This principally was aimed at bringing out of scope lenders/private banks providing fewer than 300 large loans per year to high net worth borrowers.
As part of our response to the LTI consultation, the BSA had argued that a volume cap be introduced to bring out of scope smaller lenders. At just 300, the volume mortgage De minimis threshold was too low to bring out of scope any BSA members. If a similar De minimis threshold and allowance was introduced for DTI and LTV caps it could potentially severely limit first-time buyers’ access to finance.
The introduction of wider and more intensive DTI and LTI caps particularly risks starving groups like first-time buyers of finance. It also risks over burdening Government schemes with lending rendered impossible by any other means.
With many members focussed on regional lending, there would be a benefit to introducing a volume De minimis threshold of 3,000 mortgages per year or a value De minimis threshold of £200m to ensure that small to medium sized societies are not unfairly restricted by any future cap.
Considerations of proportionality are especially important as building societies would be particularly affected by LTV or DTI limits because they are required by law to hold at least 75% of their assets in loans secured on residential property. Other lenders do not have the same legislative constraint, so building societies would find it relatively more difficult to divert their funds to alternative uses, so instead may be incentivised to make more risky loans in other segments of the housing market, counter to the FPC’s likely intention when implementing these tools. And those lenders which originate and then securitise mortgages in order to sell on to overseas investors would not be affected by having to hold higher capital against high LTV or LTI loans.
Do respondents agree with the Government’s proposed approach in relation to remortgages and further advances on existing mortgages?
If additional caps are deemed necessary then this seems a sensible exclusion to make.
What views do respondents have regarding the potential impact of the Government’s proposals?
In terms of what the implications could have on the housing market, the consultation makes the point that while the new tools can be far more targeted than interest rate rises in addressing risks to financial stability, use of the tools could constrain household access to credit and have specific distributional consequences.
In the FPC’s statement on housing market powers of direction that was published at the beginning of October, it pointed out that the distributional impact of a DTI or LTV cap based on the value of loans “may have more impact on mutuals and private banks that have a more sporadic pattern of lending” than other lenders. We would caution the FPC to take heed of its own advice.
The FPC also has a statutory obligation to exercise its functions with regards to the principle of proportionality. Whatever caps are introduced need to be sufficiently proportional to ensure that smaller institutions are not unfairly penalised.
Many medium to smaller mutuals are providing vital finance to their local communities and a compromise has to be found between protecting the UK from systemic threats but not to the extent that it stifles competition and overall demand.
It also needs to ensure that it doesn’t impact the overall competitiveness of the UK’s wider housing market and the increased provision of housing.
Do respondents agree with the Government’s proposed approach in relation to procedural requirements?
The Government is proposing that while it may need to act quickly in the deployment of the tools, once applied the following conditions would apply:
The PRA and FCA must carry out a consultation and cost-benefit analysis.
Any change or recalibration would not require a consultation but would still require a cost-benefit analysis.
While this seems a pragmatic approach, regular reviews of the effectiveness of any limit imposed should also be a part of this process.
In addition, just as the FPC is required to provide justification on why it judges it necessary to take action, it should also be required to outline what economic conditions would allow it to retire macro-prudential tools in the future once the threat that has led to their deployment has receded.
The consultation paper, in paragraph 4.7, alludes to the FPC using these limits somewhat counter-cyclically, as the FPC could loosen regulatory requirements in a downturn. But to loosen these limits would seem to imply that the standard state of affairs would be to have limits in place, which we would find concerning.
To prevent either of the tools becoming a permanent feature of the mortgage market, we believe that each tool should apply for a maximum time limit, such as 18 months. During this period the FPC may change the limit or the proportion of lending that is allowed, but the automatic 18 month expiry would mean that a more formal and thorough review of the need for the limit would take place.
The Building Societies Association represents all 44 UK building societies. Building societies have total assets of over £330 billion and together with their subsidiaries, hold residential mortgages of over £240 billion, 19% of the total outstanding in the UK. They hold over £240 billion of retail deposits, accounting for 19% of all such deposits in the UK. Building societies account for about 28% of all cash ISA balances. They employ approximately 39,000 full and part-time staff and operate through approximately 1,550 branches.