Use debt-to-income ratios to manage credit

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”.

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.”

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.

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!

38 Responses to “ “Use debt-to-income ratios to manage credit”

  1. Lef-tee says:

    Hear hear!

    But will it happen? Nope.

    • Lef-tee says:

      Note that I still agree that a significant part of the problem is the result of policies that restrict the amount of land available and making changes in that area would likely also be beneficial to the affordablilty problem. But this is the way I would likely place most emphasis on.

      • PhilBest says:

        In the conclusion of the study, the B.I.S. authors say:

        “…..None of the policies designed to affect either the supply of or the demand for credit has a discernible impact on house prices. This has implications for the degree to which credit-constrained households are the marginal purchasers of housing or for THE IMPORTANCE OF HOUSING SUPPLY, which is not explicitly considered in this Study……”

      • emess says:

        I wonder if that lack of land coming on stream has anything to do with the fact that governments have deserted that field?

        In SA, the SA Housing Trust used to develop and release whole suburbs in competition to private developers – keeping them honest. Now, developers just drip feed that land onto the market, and when challenged, they scream ‘government charges’ and ‘high construction costs’.

      • Lef-tee says:

        @PhilBest

        You’re saying that a market for something fuelled almost entirely by credit is impervious to restrictions on credit?

        Where does the money come from to keep things going skyward? Chinese investors paying cash?

      • Lef-tee says:

        Seems a bit like saying that restricting the supply of petrol has no effect on how much driving people do.

      • PhilBest says:

        No, it would be like restricting the supply of petrol, and restricting the sale of petrol on credit, and thinking that would stop the price going up.

        Where does the money come from? Savings. Savings and assistance from family, are sufficient to drive house prices up just ahead of the capacity of most young people to save. The median multiples still top out at dizzy levels.

        And if there is ANY credit available at all – even LVR’s as “loose” as 50% – there will be a credit bubble to accompany the price bubble. The financial system might be rendered a heck of a lot more secure. The pool of savings as yet unapplied to house purchases can be considerable. But that is cold comfort to the cohort of people priced out of housing, possibly for a lifetime, nonetheless.

      • Lef-tee says:

        “No, it would be like restricting the supply of petrol, and restricting the sale of petrol on credit, and thinking that would stop the price going up”

        To clarify – in my analogy, the petrol IS the credit. Its the fuel that drives the bubble. Restricted supply makes it worse.

        When something costs large sums of money then most people must borrow the money to be able to purchase. Ultimately, if I can’t borrow it then I can’t keep bidding up the price.

  2. flawse says:

    We keep thinking up artificial ways to counter the artificially low interest rate regime we have devised. Why don’t we reform the way we devise interest rates such that we run a balanced economy that makes the most efficient use of resources and, in doing so, leaves a bit of the world for our children and future generations.

    • Pfh007 says:

      Exactly!

      Interest policy currently ignores a critical issue.

      If credit growth is growing rapidly where is the banking system obtaining the funds required for operations.

      As we know, they were not raising them directly from local savers (for the most part as it is too expensive trying to persuade locals to save enough) but instead from foreign wholesale lenders and foreign central banks.

      The consequence of this is that the economic activity driven by rapid credit growth was not being supported by domestic patterns of saving. It was reliant on patterns of savings by foreigners.

      If foreigners were doing this for fun (or the because they are clueless – the MMT belief) it would not be a problem but they only do it because they are getting

      1. Direct taxpayer guarantees – when they lend to Joe Hockey

      2. Effective guarantees – when they lend to Megabank

      3. Hard Assets – when they buy our companies and land.

      A critical consideration for interest policy is the extent to which the level of debt and credit growth is reliant on overseas saving habits.

      When it becomes excessive – eg the last 20 years downunder in particular – the response should be to

      1. Limit the amount of borrowing permitted from foreigners – especially for govt bonds (including those faux ones issued by Megabank) and residential real estate.

      And yes interest rates will rise slightly until we get used to a domestic saving habit sufficient for our borrowing desires.

      The cost of relying on the savings habits of foreigners are real and substantial – just ask your grandkids in 20 years from now.

      • flawse says:

        Waits, it seems forever, for the rebuttals!

      • Peter Fraser says:

        way too many inaccuracies and strawmen to be bothered.

      • flawse says:

        “way too many inaccuracies and strawmen to be bothered.”

        Which one or all?

      • Pfh007 says:

        Flawse,

        It is best that Peter keeps silent and not confuse the issue with his ‘accounting entries’ red herrings.

        He seems to imagine that because accounting entries must balance that banks have no difficulties obtaining funds to fund their operations.

        Note to Peter – fund their operations does not mean funds to make loans.

      • Peter Fraser says:

        pfh is saying that we need foreigners savings, and that foreigners are stupid, or at least MMT’rs believe that to be so.

        Lets address the silliest point first – absolutely no one from any group that I have ever heard of assumes that foreigners are stupid.

        Secondly our banks don’t need foreign money – our loans are in $AUD. The overseas borrowings are to find term lending because APRA believe that stabilises the banking system.

        Loan funding is created endogenously. Thjere is no leakage from the system as some suggest, but money can be destroyed when government budgets are in surplus, when loans are repaid, and when debts are written off. Nothing sneaks our the door when no one is watching or disappears down a crack in the sidewalk.

        Asset sales to foreigners don’t create loanable funds – it just gives us more foreign money to spend overseas.

        To the best of my knowledge bond holdings by foreigners is not high, but maybe someone here has some evidence to the contrary – love to see it if they do.

        Your attempt to muddy the waters is disappointing pfh.

      • Pfh007 says:

        Peter,

        First things first – happy new year – all the best for 2014.

        Good to hear that no one thinks foreigners are stupid or silly! I must have misunderstood the thrust of the comments made by some MMT supporters that imply that the external account does not present a constraint for a fiat currency economy.

        As for our banks not needing ‘foreign money’ – who said that they did.

        What they need are the ‘savings habits’ of foreigners NOT their shekels, pounds or Yuan.

        Those foreigners make loans to Megabank by entering the foreign exchange markets and selling their shekels, pounds and yuan to BUY $AUS. They then direct these $AUS to the bank whose IOU’s they wish to buy.

        That bank now has a large pile of $AUS which it can use to meet cheques that have been drawn on the loan accounts it ‘credited’ with accounting entries (that endogenous money you were referring to) and which have been deposited by people (selling kitchens, carports, houses etc to the borrowers) with OTHER banks.

        What is important, and what you tend to miss, is that if Megabank did not need foreigners savers to direct a supply of $AUS in their direction and not enough locals directed supplies of $AUS in their direction, they would eventually go broke when enough cheques drawn on their ‘accounting entry’ loan accounts get deposited with other banks.

        They may not need deposits to make loans but they sure need them when the borrowers start writing cheques drawing on those loan accounts and for other day to day operating expenses and liquidity requirements.

        “Asset sales to foreigners don’t create loanable funds – it just gives us more foreign money to spend overseas.”

        Who said asset sales create loanable funds? You have a loanable funds fixation.

        What foreign asset sales do is quite simple. Foreigners who wish to buy a local asset exchange their currency for $AUS (by buying them from someone who wants to sell them) and hand those $AUS over to the local flogging the asset.

        For sure no $AUS magically appeared or disappeared but the change in ownership and the decisions made by the party holding those $AUS as to what they do with them are critical.

        It matters a great deal to the specific bank, who has been directed by a customer to transfer $1B $AUS to the bank of a foreigner buyer of that currency, that they no longer have $1B $AUS on deposit. It gives them no comfort to know that the $1B is floating around in the accounts of another domestic bank.

        Using system wide accounting entries and stating that they all net to zero obscures the very real issues that arise as owners of savings move them around the banking system and most importantly the implications of insufficient locals willing to ‘deposit’ their savings with banks on terms that are consistent with the banks overall funding requirements.

        “Thjere is no leakage from the system as some suggest, but money can be destroyed when government budgets are in surplus, when loans are repaid, and when debts are written off. Nothing sneaks our the door when no one is watching or disappears down a crack in the sidewalk.”

        I am not sure what you meant by this?

        No leaks – but just a series of downpours and droughts?

        The majority of which are due to the pro-cyclical panics and deleriums of loan officers.

      • Peter Fraser says:

        “Those foreigners make loans to Megabank by entering the foreign exchange markets and selling their shekels, pounds and yuan to BUY $AUS. They then direct these $AUS to the bank whose IOU’s they wish to buy”

        So they “swap” their Shekels, Pounds, and Yuan for $AUD that already exists in the banking system – net change = Zero in $AUD.

        “They may not need deposits to make loans but they sure need them when the borrowers start writing cheques drawing on those loan accounts and for other day to day operating expenses and liquidity requirements.”

        You should know that when a bank customer writes a cheque against his overdraft, that is a loan which will be balanced by an equal deposit in the banking system. Net change within the banking system is zero.

        The banking operations are the cost of the premises, staff, and infrastructure etc that is met out of interest earned, it’s never financed by further borrowings once a bank has become established – if it had to be then the bank would be illiquid.

        Banking operation costs are not related to overdraft or LOC funding.

        “No leaks – but just a series of downpours and droughts?
        The majority of which are due to the pro-cyclical panics and deleriums of loan officers.”

        That’s meaningless.

        Happy 2014

      • Pfh007 says:

        Peter

        “Net change within the banking system is zero.”

        Looks like you missed this paragraph.

        “Using system wide accounting entries and stating that they all net to zero obscures the very real issues that arise as owners of savings move them around the banking system and most importantly the implications of insufficient locals willing to ‘deposit’ their savings with banks on terms that are consistent with the banks overall funding requirements.”

        Here are some questions for your “everything nets to zero” paradigm.

        Why do banks bother compete in offering attractive Term Deposit rates if the movement of savings around the banking system makes no net change within the banking system?

        Why do banks bother asking foreigners to buy $AUS and lend them to them if the $AUS are already in the banking system?

        Hint: Because the location of savings and the terms on which money is lent or deposited actually matter.

      • Peter Fraser says:

        “Why do banks bother compete in offering attractive Term Deposit rates if the movement of savings around the banking system makes no net change within the banking system?”

        Because although they don’t need the funds from an operational POV, APRA regulations make the banks hold deposit coverage depending on the type of finance, asset class etc. So they must hold deposits, and to do that they must compete for the on the market.
        If they fall short they borrow from a bank with a surplus, but the cost is higher. Banks settle daily using accounts run at the RBA.
        Banks that have a surplus must lend their surplus to another bank that needs it. That became the issue in the USA when banks stopped lending to each other because they didn’t know which bank could be trusted – that’s why the government stepped in and capitalised them all – to keep the lines of credit open.

        “Why do banks bother asking foreigners to buy $AUS and lend them to them if the $AUS are already in the banking system?”
        I have already told you – because APRA think that borrowing long term makes the banking system more rigid – it doesn’t but they make the rules. Hence banks go to offshore markets where they can borrow long term. It’s a regulatory requirement not a system requirement.

        “Hint: Because the location of savings and the terms on which money is lent or deposited actually matter.”
        Nope.

        The savings in the banking system is always created by credit issued by banks in Australia and to some degree by government deficits. Individuals save, but collectively we are either allowed to save or not allowed to save as a result of credit creation – it has little to do with habits.

        Pfh007 says: January 20, 2014 at 12:40 pm Peter
        “Net change within the banking system is zero.”
        Looks like you missed this paragraph.
        “Using system wide accounting entries and stating that they all net to zero obscures the very real issues that arise as owners of savings move them around the banking system and most importantly the implications of insufficient locals willing to ‘deposit’ their savings with banks on terms that are consistent with the banks overall funding requirements.”

        If you are a poor saver and spend all of your money – it just means that shopkeepers end up with your savings – it will now be savings in their bank accounts.
        Savings are not destroyed by spending, they just change hands. Savings habits determine who holds the savings, not the amount of the savings.

        Can you not see that? Think about it for awhile.

      • Sweeper says:

        Peter,

        If banks can self finance loans and create deposits at will, why do they bother paying interest on deposits? Wouldn’t that be a strange thing do if you are a profit maximising bank?

        edit: there is no regulatory reason they do this. On the contrary, in the US for example, commercial banks were once prohibited from paying interest on demand deposits. So what would be the reason?

      • Opinion8red says:

        Sweeper,

        It’s essential for maintaining the illusion.

        That “money”, in the form of creatable (ie, paper, digits) tokens, has “time-value”.

        EDIT: And, of course, in order to encourage everyone to use the banks, to “save” their “money” for them.

        It’s ALL about control, and profit. And not for the public benefit.

      • Sweeper says:

        The “illusion” is in thinking that because banks are able to credit deposits, they are also able to self finance loans. They can’t self finance loans anymore than they can finance their payrolls by crediting every employee with a freshly created deposit. It’s a deeply flawed argument that ignores the way prices adjust to changes in quantities.

        People bang on and on about these accounting identities. Yes a banks balance sheet has to balance. Does that mean all money lent = all money deposited? No it doesn’t.

        In terms of money’s time value: There is always going to be a time value for money as long as liquidity has a price. The point I’m making is; if banks can create 0% deposits at will, why do they pay any interest on deposits?

      • Peter Fraser says:

        Sweeper – banks create the loans and they hold those loans on their books, but they don’t control the deposits, they can flow to another ADI.

        As mentioned above APRA regulate to make banks hold deposit coverage for their lending. That ensures the banking system caters for both borrowers and depositors, and it rewards the savers for their prudent savings.

        The exact amout of deposit coverage depends on the borrower, and the security. For example The Federal government requires nil deposit coverage for their borrowings, state governments require a little more, local governments on memory about 40% and you and I 100% depending on the security that we offer.

        I don’t recall oll the different rates, but it’s not necessary to look at that in this exercise, it’s just necessary to understand the process and basic regulatory guides. It’s all there on APRA’s site if you are interested.

        Essentially they pay interest on deposits because their banking licence depends on satisfying APRA’s regulatory requirements, and they wish to keep their licence and avoid large fines for non-compliance.

        I didn’t say that deposits will exactly equal loans, but that won’t be too far out. Where do you think money comes from if not from the banking system. It doesn’t grow on trees.

        No lending = no money, that’s the long and the short of it unless the government decides to print without accountability, and I doubt that will happen in this era.

      • Sweeper says:

        “Essentially they pay interest on deposits because their banking licence depends on satisfying APRA’s regulatory requirements, and they wish to keep their licence and avoid large fines for non-compliance”

        Your answering a different question. I’m not asking about why they issue deposits. I’m asking why they pay any interest on deposits. You say there is no constraint on deposit creation, so why do banks pay for something they can create for free? I can tell you there is no regulatory reason for this. In fact, if it was regulated it would be to prohibit payment of interest on deposits.

      • Peter Fraser says:

        I’ve given you the reason and the explanation, but you prefer to avoid it.

        I’ll say it again – banks can create the loan but can’t control where the loan funds flow to or who will end up with the “money created”

        A borrower will take out a loan to pay for something – a house, a car, cover business set up costs, buy shares, buy a factory etc, they don’t borrow to redeposit that money into an account of the banks choosing. They borrow money to spend it.

        Money spent ends up a savings in someone elses account.

        I don’t think that I can explain that more simply.

      • Sweeper says:

        “A borrower will take out a loan to pay for something – a house, a car, cover business set up costs, buy shares, buy a factory etc, they don’t borrow to redeposit that money into an account of the banks choosing. They borrow money to spend it”

        Correct. But in your model the deposit floats around in the banking system, and even if nobody is willing to hold it there is no constraint on bank lending.

        “Loan funding is created endogenously. Thjere is no leakage from the system as some suggest”.

        So the question remains why pay for something you can create for free?

      • Peter Fraser says:

        I’ve given you the answers, but you don’t want to believe them.

        Have you ever heard of a deposit that no one wants to hold. All deposits flow to the banking system. They either stay as deposits, or they are used to extinguish debt.

        Even if the money is fragmented into employees wages, purchase of stock, rent etc – it’s all banked back into the banking system in some elses account.

        Even a cheque in the mail is a deposit in an account until it’s cashed.

        Take your time, there is no rush.

      • Sweeper says:

        You’re not going to answer this are you? Its a very simple question, if banks can create their own liabilities paying 0% interest why are they shooting themselves in the collective foot every single day by paying interest? Shareholders want answers! Why are the banking executives so stupid?

        You pretend that what you are saying is complicated and requires some sort of advanced understanding of banking operations. What you are saying isn’t complicated, it’s just completely wrong.

        “Ever heard of someone not willing to hold a deposit”? Yes I have. By definition, everybody not storing their wealth in currency or its close substitute (0% interest paying deposits) does not want to hold deposits. There are many people in that category.

        In a normal functioning economy people only want to hold a small fraction of their wealth in currency or 0% interest paying deposits. That is a very real constraint on financing lending with 0% deposits. Above that point banks have to issue interest bearing liabilities. If it is cheaper to sell these overseas, then they will. That is the real world.

      • Peter Fraser says:

        I have answered the question in full – you just haven’t listened.

        You are correct – it’s not at all complicated unless people choose to make it so.

        Cheers…

      • Pfh007 says:

        Sweeper,

        Good try but I think my first statement was right on the money.

        “Flawse,

        It is best that Peter keeps silent and not confuse the issue with his ‘accounting entries’ red herrings.

        He seems to imagine that because accounting entries must balance that banks have no difficulties obtaining funds to fund their operations.

        Note to Peter – fund their operations does not mean funds to make loans.”

      • Peter Fraser says:

        It takes time to absorb.

    • Opinion8red says:

      “It was reliant on patterns of savings by foreigners.”

      Not in any way trying to impugn your thesis, but … what savings by foreigners?

      “..they were not raising them directly from local savers … but instead from foreign wholesale lenders and foreign central banks”

      Who in turn, have not been using money “saved” either, but new debt created, by the trillions, out of thin air.

      • Pfh007 says:

        Absolutely!

        ‘Savings habits of foreigners’ does not necessarily mean a virtuous process of deferring immediate consumption for the purpose of longer term investment.

        A lot of the foreign ‘savings’ being used to purchase $AUS to buy our IOUs and assets are simply ‘accounting entries’ created by foreign central banks by the trillion.

      • Opinion8red says:

        Excellent. We understand and agree, on this point, with perfect harmony :-)

  3. aj. says:

    In the end the market can make these high risk loans because the machinery of the state supports it. There is no significant moral hazard for the lender, the mass of loans really are too big to fail.

    So another approach would be to belt the market for the recoverability of these loans.

    Make residential property loans a big market risk and a sovereign risk.

    1. Make it explicit that lending ratios have to be declared and those high debts are not supported by mug tax-payers. i.e. lenders to those banks and shareholders are taking big risks.

    2. Make it clear that local and foreign lenders and shareholders for residential housing are at at significant risk of having the security seized in the event of an economic shock. Ie the assets will be nationalised to protect the taxpayer and the debtors.

    The post is right, we really have to look past interest rates as a tool, they are totally gamed.

    • flawse says:

      “The post is right, we really have to look past interest rates as a tool, they are totally gamed”

      Yep! But any artificial contrivance we put in place to try to correct the artificial distortion of the natural credit limiter will be gamed. It’s just another step in the game!

  4. Peter Fraser says:

    wow – that post deletion was FAST.
    I’m impressed.