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Financial stability risks from housing market cycles

Michael Thornley

Boom and bust cycles are prevalent features of housing markets in advanced and developing economies around the world. These cycles can present a risk to financial stability. Housing booms often precede financial crises, and the size of a boom, and its subsequent bust, can be amplified by highly leveraged mortgage lending.

The financial system can face large ‘direct’ losses on mortgage loans in the event of a housing market downturn. A number of factors influence the size of these losses, but there is evidence that losses are higher on loans to highly levered households and to property investors.

The financial system is also ‘indirectly’ exposed to the housing market via the impact of a housing downturn on household consumption and economic output more generally. This exposure increases as household debt levels rise, because heavily indebted households tend to reduce spending more aggressively after a housing bust. In addition, the financial system may face losses on lending to sectors that are closely connected to the housing market e.g. the construction and commercial property sectors.

Capital requirements bolster the resilience of individual financial firms against these risks, but in some circumstances they may not be sufficient to preserve the proper functioning of the financial system as a whole. As a result, macroprudential actions aimed at mitigating risks from housing market cycles may be justified to help preserve financial stability and longrun economic growth.