Use debt-to-income ratios to manage credit

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ScreenHunter_19 Feb. 20 09.08

By Martin North. Cross Posted from Digital Finance Analytics Blog

Last November the Bank of International Settlements published an interesting working paper entitled “Can non-interest rate policies stabilise housing markets? Evidence from a panel of 57 economies “. The paper discussed the relative effectiveness of a number of policies, over and above the blunt instrument of interest rates, and capital buffers which are designed to help manage the dynamics of the property market. These additional Macroeconomic levers targetting credit policy as the Economist reported last year are important.

“ECONOMICS undergrads learn early on about two levers to manage the macroeconomy: fiscal policy and monetary policy. Events of the last five years make clear that there is a third lever that while poorly understood and difficult to model, it is at times critical: credit policy”.

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The BIS, using research analysis covering multiple markets, reached an interesting conclusion in their paper. Whilst there may be some benefits in capping Loan-To-Value ratios (as New Zealand has done, and the IMF advocated), the best mechanism to manage house prices is to target debt service to income ratios. The logic is because LVR controls won’t impact borrowing in a rising market, (as house prices rise, borrowing can grow). On the other hand a debt service to income ratio is not impacted by rising house prices, so consumers would not be in a position to borrow any more even if house prices did rise. Therefore it is a more effective control.

Reading recent papers from the UK, including evidence given by Bank Of England Governor, Mark Carney, it appears that UK is actively considering such measures, despite reassurance to Parliament there that a housing bubble was unlikely (even though there has been a bounce in lending and prices have risen more than 5%). He also said they were actively monitoring lending standards in the UK.

“It’s been that deterioration in lending standards…that type of behaviour that drives the last bubble-like phase of the housing market and creates the financial stability problem.”

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Given the current state of the Australian market, with prices rising fast, demand for investment loans in particular high, and banks willing, perhaps desperate to lend at higher LVRs, perhaps APRA/RBA should also be looking at debt servicing to income ratio targets in Australia. Not least because the current HIA-CBA Housing Affordability Index used by the banks is pretty weak, especially when interest rates are low.

Its weakness was highlighted last week in a good article from the ABC’s Michael Janda highlighting the problematic affordability measures used by the banks currently. His conclusion was:

What is certain is that Australian housing isn’t affordable unless you’re betting the house on rates staying at record lows for decades, and that’s a very risky financial move – just ask the now homeless honeymoon rate buyers in the US.

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It is time for policy review on debt to income servicing ratios, and the BIS paper offer some important pointers – I hope our regulators are across its contents!

About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.