Mortgage regulation in turbulent times

Monday this week we could read in Norwegian media that the Financial Supervisory Authority (FSA) wanted to make mortgage regulation “even stricter”.

ON 4. OCT 2022

Monday this week we could read in Norwegian media that the Financial Supervisory Authority (FSA) wanted to make mortgage regulation “even stricter”. [1] This comes at a time when the inflationary pressure in Norway and abroad is high, and Norges Bank is set to increase the interest rate from zero to three percent over a two-year period. Do we need tighter mortgage regulation at this point? While the FSA apparently believes so, many seem to disagree.

Let us start by revisiting the intention of the regulation. The FSA states that the goal is to enhance financial stability, and writes that high household indebtedness and high housing prices pose a substantial threat to financial stability.[2] There are at least two points worth discussing here. First, what is the link between financial stability and household indebtedness, and second, how is household indebtedness going to be affected by the current macroeconomic environment.

High household debt may be problematic if it makes households more sensitive to negative shocks. For instance, consider a sudden collapse of the oil price, which causes several individuals to become unemployed. If households react by dramatically cutting consumption, this will imply lower demand for firms, which might lead them to cut back further on employment. Lower household demand can thus amplify the downturn. Several studies have found high household debt to be correlated with larger spending cuts in response to negative shocks. This is why the FSA is worried that high debt among Norwegian households pose a threat to financial (or macroeconomic) stability. Put differently, high debt might entail a macroeconomic cost which is not internalized by households, creating room for welfare improving regulation. 

There are however two reasons why we should be cautious about equating high debt levels to financial instability. First, correlation does not imply that high debt levels cause larger spending cuts in downturns. For instance, Lars Svensson argues that the observed correlation is in fact caused by an omitted variable, which he calls the housing collateral channel.[3] Second, focusing solely on debt levels leaves out other important aspects of household balance sheets, which might also be affected by regulation. In our paper "The leverage-liquidity trade-off of mortgage regulation", we find that although the regulation lowers leverage, it also reduces liquidity as households need to satisfy the downpayment requirement. While lower leverage makes them less vulnerable to negative wealth shocks, lower liquidity makes them more vulnerable to negative income shocks. In sum, we find that the two effects roughly cancel each other out, leaving financial stability unchanged.

Leaving the causal relationship between household indebtedness and financial stability aside, a separate question is how the current macroeconomic environment is going to affect debt and house prices. In general, the interest rate hikes are expected to lead to lower household credit growth and falling house prices.[4] For instance, Norges Bank is projecting that credit growth falls steadily over the coming years, while house price growth becomes negative next year.  Statistics Norway is expecting an even larger decline in credit growth and negative house price growth for a two-year period. If these expectations are realized, any externalities connected to household indebtedness are likely to fall. As such, the need for mortgage regulation to dampen credit growth should go down.

While the FSA has recommended tightening the regulation, specifically lowering the maximum debt-to-income ratio and the banks’ room for deviating from the requirements, the final decision lies with the Ministry of Finance. The FSA recommended tightening the regulation back in 2020 as well, but the suggestions were not implemented. With the current macroeconomic environment, it seems probable that the outcome will be the same this time around. 

[1] DN 03.10.2022:  https://www.dn.no/eiendom/finanstilsynet-anbefaler-a-stramme-inn-utlansforskriften/2-1-1323280

[2] FSA 03.10.2022: «Formålet med utlånsforskriften er å bidra til finansiell stabilitet ved å stille krav til finansforetakenes utlånspraksis for å forebygge finansiell sårbarhet i husholdninger og finansforetak. Høy gjeldsgrad i husholdningene og høye boligpriser utgjør en betydelig risiko for den finansielle stabiliteten.»

[3] See for instance: Svensson, Lars EO. "Housing prices, household debt, and macroeconomic risk: problems of macroprudential policy I." Stockholm School of Economics, mimeo, February (2019).

[4] Note that the expected decline in debt comes about even though the real interest rate is negative due to the increase in inflation. The reasoning is that higher nominal interest rates dampens economic activity through a reduction in households’ disposable income.