Five years after introducing new affordability tests designed to limit the number of higher loan-to-income mortgages, the Bank of England has concluded this has helped prevent a potential increase in highly-indebted households.
However, the bank has concluded that while its policy may have been effective, the “vulnerability from indebtedness has not changed markedly since 2014.”
These comments were by Sir John Cunliffe, the deputy governor for financial stability, at a speech to the Bank of Portugal in Lisbon.
Cunliffe, who is a member of both the Monetary Policy Committee and Financial Policy Committee, said it was important to assess the effectiveness of these borrower-based measures, which were designed to ensure financial stability.
Cunliffe explained that highly-indebted households tended to cut back more in periods of economic contraction, potentially magnifying the effects of a downturn. And there were concerns in 2014, that there were potential problems building in the housing market.
Cunliffe says: “In the five years after the financial crisis, housing market activity and house price growth was very subdued.
“But by 2013 both price growth and mortgage transactions began to pick up rapidly.
“In 2014 in the UK, house prices grew by 9 per cent in the year to quarter one – twice as fast as incomes. Mortgage approvals had risen from around 50,000 per month in June 2012 to over 70,000 in January 2014.
“And, very importantly, the share of those mortgages at high loan-to-income ratios was rising. The aggregate debt to income ratio for UK households had fallen from its crisis peak but remained high relative to historical averages and international comparators.”
In response to these potential risks the Financial Policy Committee of the Bank of England introduced two measures. The first was a loan to income ‘flow limit’ that limited the proportion of mortgages with LTI ratios of 4.5 or higher to 15 per cent of new mortgages.
The second was an affordability test for borrowers. This test had recently been implemented in the UK by the Financial Conduct Authority as a consumer protection measure. But the FPC recommended that the test should be recalibrated, and recommended lenders also assess affordability of mortgages in the event of interest rates rising by 3 percentage points.
Cunliffe says that as a result of these measures the highly indebted “tail” of borrowers has become a little smaller over since 2015. But at the same time, the average debt level of the mass of the distribution has increased.
He adds: “We can therefore I think conclude that the vulnerability from indebtedness has not changed markedly since 2014 – the increase in vulnerability that the FPC sought to prevent happening has not happened.”
Cunliffe adds that assessing what could have happened if the BoE had not introduced these policies, or if the macro environment had been different, is more difficult.
At the time the BoE was forecasting that activity in the mortgage market would continue. If this had been the case, or if the market had followed its subsequent path but without these BoE measures, then Cunliffe concludes there would be more highly indebted households, and the impact of debt on consumption would be larger than it is today.
He explains: “House prices and mortgage activity have been relatively subdued over the past five years – with house price and income growth slightly lower than the central forecast prior to the introduction of [these measures] in 2014, and markedly fewer housing transactions than we were expecting.
“So the policy impact – both costs and benefits – have been relatively small to date. What would mortgage indebtedness look like if the policy hadn’t been there?
“Results suggest that in those circumstances the tail of highly indebted households would be slightly larger than it currently is. And, were a downturn to hit, that the impact of debt on consumption would be a little larger than today.”
Cunliffe concludes that the effect of these policies going forward will depend on future house price growth, relative to income. If it remains subdued effects will remain fairly limited, but if it increases – to pre-crisis levels – then these policies will have a more marked effect.
He adds: “There is a separate but related question about the extent to which the relatively subdued evolution of house prices and transactions between 2014 and 2019 was due to the FPC’s policy, including a general signalling effect on indebtedness.”
However, he concludes that general economic developments — for example, weaker than forecast economic growth, the post referendum inflation squeeze on incomes, and general Brexit uncertainty— and housing policies beyond the central bank (such as changes to buy-to-let tax treatment) have probably played the bigger role.
He says: “Putting all of this together, I would conclude that the rationale for the FPC’s action remains sound in the light of subsequent evidence and that the action itself was effective at preventing further build up in the tail of more indebted households, and more importantly that it continues to function as an insurance policy.”