Box A: The potential role of a macro-prudential debt-to-income policy
Borrowers with elevated DTI ratios are vulnerable to a period of reduced income or higher interest rates and can present a risk to the banking system and wider economy. This box discusses the possible role that a limit on high-DTI loans or a similar serviceability restriction could play in mitigating these risks, and how it would complement other macroprudential tools.
The potential role of DTI policies
The Reserve Bank focuses its regulation on areas where financial institutions’ incentives differ significantly from the public interest.1 A macro-prudential DTI policy would enable the Reserve Bank to limit the degree to which banks can reduce mortgage lending standards during periods of rising housing market risks, in order to protect financial system soundness. This may be desirable in some periods as (i) banks are not incentivised to adequately take account of the impact their lending can have on the overall financial system and (ii) the economy can suffer if too many borrowers take on more debt than they are able to service.
DTI policies can support financial stability by reducing the scale of mortgage defaults during a severe economic downturn. All else equal, borrowers with higher DTI ratios have less disposable income to draw on as a buffer to avoid defaulting on their mortgage, without selling their home, in a period of lost income or higher mortgage rates. Loan serviceability is a crucial determinant of probability of default, reflecting that many borrowers will attempt to service loans even if they are in a position of negative equity. For example, the rise in mortgage defaults after the GFC in Ireland and the US were strongly linked to borrowers’ ability to pay – including regional unemployment, loan-to-income ratios and interest rate structure.2
Even if high-DTI loans do not directly result in losses to the banking system, they could indirectly impact the soundness and efficiency of the financial system. Forced house sales by high-DTI borrowers would likely amplify house price declines, impair the ability of banks to resolve distressed loans, and increase loss given default for banks. High-DTI households are also likely to reduce consumption more sharply during a severe downturn, in an attempt to continue servicing loans and increase precautionary savings. A number of studies have found that sharp falls in consumption by indebted households reinforced the economic impact of the GFC. There is also evidence that highly indebted households in New Zealand cut back on consumption more sharply than other households.3
DTI policies can complement other macro-prudential policies, including LVR policies. DTI policies can increase the resilience of households to income shocks, reducing the number of forced house sales in a downturn, and LVR policies can increase the equity buffers of households, reducing the losses faced by banks if borrowers come under stress. Using both policies at the same time is likely to achieve a more targeted response to rising housing market risks, given that both LVR and DTI ratios are important drivers of the scale of mortgage losses during a severe downturn. Tightening policy along only one of these dimensions would likely entail larger efficiency costs to achieve a given reduction in the downturn loss rate.
An important feature of a DTI policy is that the borrowing capacity of constrained borrowers grows in line with their incomes. In contrast, sharp rises in house prices unlock borrowing capacity for existing property owners under an LVR policy, especially for borrowers with a large portfolio of property. This suggests that a DTI policy could have a more enduring impact in leaning against rising debt levels (and potentially house prices) throughout a house price boom, thereby increasing the effectiveness of macro-prudential policy in dampening the extremes of a credit cycle.
International use of DTI policies
Serviceability standards are a particular area of focus for supervisors at present, reflecting concerns that the current extremely low level of mortgage rates could lead households to take on excessive debt. Limits on DTI ratios or loan serviceability are becoming increasingly common in countries with rising house prices (table A1). At least 10 advanced economies apply a limit on high-DTI lending, including the UK, Ireland and Norway.4 Other countries, including Australia, have introduced guidelines for banks on mortgage origination standards (such as how to account for the risk of higher mortgage rates over the term of a mortgage).
Table A1: Selected interventions related to mortgage serviceability
|Debt-to-income limits||Ireland||No more than 20% of lending above 3.5||Owner-occupiers only|
|United Kingdom||No more than 15% of lending above 4.5||Owner-occupiers only|
|Other examples: Norway, Singapore.|
|Debt service ratio limits||Canada||Maximum of around 40% to qualify for government insurance||All mortgage lending that can qualify for government insurance|
|Hong Kong||Limit of 50% for owneroccupiers and 40% for investors||Bank mortgage lending|
|Other examples: US, South Korea, Israel, Lithuania, Estonia.|
|Prudential guidelines||Australia||standards for origination tests (e.g., assumed interest rate, living expenses)||Bank mortgage lending|
|Other examples: Switzerland, Germany, UK.|
1 Fiennes, T (2016), ‘New Zealand’s evolving approach to prudential supervision’, speech delivered to the NZ Bankers’ Association in Auckland.
2 For example, see Kelly, R and T O’Malley, ‘A Transitions-Based Model of default for Irish Mortgages,’Research Technical Paper 17RT14, Central Bank of Ireland 2014; and Gerardi K, K Herkenhoff, L Ohanian & P Willen (2015) ‘Can’t Pay or Won’t Pay? Unemployment, Negative Equity, and Strategic Default’, NBER Working Papers 21630
3 See Thornley, M, (2016) ‘Financial stability risks from housing market cycles’ for more discussion of the relationship between consumption and indebtedness. See Bascand, G, (2016),’Changing dynamics in household behaviour’ for more discussion of the New Zealand evidence.