The Financial Services Bill: the Financial Policy Committee's macro-prudential tools

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1 The Financial Services Bill: the Financial Policy Committee's macro-prudential tools Response by the Council of Mortgage Lenders to the HMT Consultation Paper Introduction 1. The CML is the representative trade body for the residential mortgage lender industry which includes banks, building societies and specialist lenders. Our 114 members currently hold around 95% of the assets of the UK mortgage market. In addition to lending for home-ownership, the CML s members also lend to support the social housing and private rental markets. 2. We are grateful for the opportunity to respond to the consultation document issued by HMT on the Financial Policy Committee s (FPC) macro-prudential tools under the Financial Services Bill. While we strongly support the general aims of the FPC to ensure financial stability, we remain concerned that there is a risk inherent in the structure of the regulatory system for overlap, potential conflicting objectives and an increasing and cumulative burden of regulation between the FPC, the Prudential Regulatory Authority (PRA), the Financial Conduct Authority (FCA) and the Monetary Policy Committee (MPC). 3. We have concerns about the suitability of some of the macro-prudential tools requested by the FPC and question whether these tools will be more effective than existing tools used in macro economic policy. 4. Finally, we continue to believe that the FPC will be most effective, when it implements its macro-prudential policy in a measured, clear and transparent way to ensure that the market understands the rationale and can adapt its lending procedures in an orderly way. We, therefore, have some comments on the desirable process for the FPC to follow. 5. Our response is structured to provide some general comments on the operation of the FPC and answers to specific consultation questions highlighted, as they relate to the operation of the mortgage market. Overview of the FPC 6. While we are supportive of the broad objectives and functions of the FPC, we are mindful that its decisions could have far-reaching affects on consumers and the UK housing and mortgage market. For this reason, we would wish to see the FPC exercise appropriate caution and consider formal, robust and transparent assessments of the impact of using macro-prudential tools. 7. With the creation of a number of new regulatory bodies i.e. the Financial Policy Committee (FPC); the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) together with existing bodies i.e. the Monetary Policy Committee (MPC), there needs to be absolute clarity of the roles and responsibilities of each to ensure that there are no conflicts between different bodies and especially between micro and macro-prudential regulation. We, therefore, believe it is critical that the role of the FPC needs to be clearly and unequivocally defined to avoid overlap and confusion. The new architecture of prudential regulation has been built from a number of areas including national and international influences. In this process, it would appear that an overarching, co-ordinated and comprehensive approach has been difficult to construct. 8. Alongside this, we believe that the FPC needs to have the appropriate tools available to implement its defined objective. The tools available to deliver the objectives of the FPC should have clear advantages over alternative macro-economic tools, e.g., monetary policy as implemented by the MPC or micro-prudential tools as exercised by the PRA or FCA. 9. We would contend that an improved, regulatory regime already exists as a response to the financial crisis, including a sophisticated capital regime which can curb excessive lending. For address North West Wing Bush House Aldwych London WC2B 4PJ telephone fax website

2 example, the imposition of counter-cyclical capital buffers which will be introduced by Basle 3 and CRD 4 should send a clear indication to the market of the dangers on excessive lending and encourage lenders to modify their behaviour. This improved, sophisticated and targeted regulatory architecture, we believe, is likely to be more efficient at restraining lending without the potential for significant unintended consequences than the potentially blunt policy tool of, for example, LTV or LTI caps. Finally we believe that it is critical in this process that the way the FPC delivers macroprudential regulation is clear and is communicated to the various stakeholders in such a way that enables transparency and accountability. Objectives for the FPC 10. The Financial Services Bill outlines that the primary objective of the FPC is to protect and enhance the stability of the financial system in the UK. However, the FPC will also have a secondary objective to support the economic policies of Her Majesty s Government, including its objectives for growth and employment. In addition, the Bill will prohibit the FPC from undertaking any action that it believes would have significant, adverse effects of the capacity of the UK financial sector to contribute to the growth of the UK economy in the medium or long term. 11. We believe the additional objectives given to the FPC may lead to potential conflict, and dilutes the clarity of objective and purpose for the FPC unlike, for example, the clear objective set for other macro economic policy objectives e.g. the control of inflation. We would highlight the concern that the FPC s actions do not enervate the financial services sector. What is needed, therefore, is for the FPC to be clear in all its work about how it is making any pay-off between these objectives and what it sees as the consequences of its actions for each of its objectives. Appropriate levers 12. The Bill envisages the FPC using a number of levers to meet its objectives. This includes the identification of risks within its Financial Stability Report, the power to make recommendations and to mandate direct action by both the PRA and FCA. In addition to recommendations to the regulators, the FPC will also have the power to make them to the Treasury, the Bank of England and directly to the industry. We consider this suite of levers to be appropriate. 13. The FPC will also have at its disposal a macro-prudential tool kit. Initially it is proposed that these tools will be: 1. Countercyclical capital; 2. Sectoral capital requirements; and 3. A leverage ratio. 14. However, the Bill also outlines a number of other macro-prudential tools it is considering, including loan to value (LTV) and loan to income (LTI) restrictions. These are of especial interest to the mortgage market. 15. It is proposed that additional tools can be added to the armoury of the FPC by way of secondary legislation. As set out in the draft Order in the consultation paper, such secondary legislation will, however, need positive resolution. Given the importance of the FPC applying macroprudential regulation to the economy in general and specifically to the residential housing market, we believe positive resolution is vital to allow this greater debate and transparency over this process. 16. We remain concerned with the potential introduction of LTV or LTI caps and the operation of specific sectoral capital requirements. We would argue that, potentially, LTV or LTI caps are a blunt tool that may have significant unintended consequences. Macro-prudential regulation for stability purposes is a relatively new area of regulatory oversight and, therefore, many of the tools are untested. We would contend that there is limited data from the UK or other jurisdictions at present to fully understand the effect of LTV/LTI caps. Further evidence on the efficacy of how these tools have worked where they have been applied e.g. in Hong Kong, Sweden and Canada is needed before the FPC should consider their implementation. We would emphasise that the housing market in the UK is distinct from other markets in terms of its size and significance to the broader economy. We, therefore, would emphasise that actions in this market can have considerable impact on the economy and need to be approached with caution. 17. There is a general lack of consensus as to the effectiveness of LTV or LTI caps. The FSA decided that they were not appropriate tools for conduct regulation. In the consultation on the mortgage market review (DP 09/03), the FSA said:

3 the potential disadvantages of across-the-board LTV and LTI caps combined with the availability of other potential levers, means that we are not yet convinced that the case has been made for the outright ban of loans above some defined LTV or LTI level. [CML emphasis]. We do not believe that there have been developments since then which would cause that judgement to be reversed. 18. We do, however, recognise that an IMF working paper Macro-prudential policy: what instruments and how to use then, drawing on an empirical study of 49 countries concluded that a range of macro-prudential tools including LTV/LTI caps could be effective in mitigating systemic risk. We also have the Liikanen report into the structure of EU banking which also recommended the use of LTV or LTI caps employed by national supervisors in all EU member states. 19. There is a risk that an LTV cap would lead to gaming of the system by which borrowers would get top up loans, secured or unsecured above whatever LTV cap was set. There is some evidence from other countries that this has happened. While this might not render LTV or LTI s ineffective as macro-prudential tools, from a consumer standpoint it might mean borrowers over-stretch themselves to get on the housing ladder, for example, by using unsecured borrowing to satisfy LTV requirements. Alternatively, it risks creating a two-tiered market where access to housing is only available to those able to afford the higher cost of additional borrowing above the imposed LTV cap. 20. It should be noted that the Financial Services Authority s mortgage market review (MMR) also has an impact on higher-risk lending; for example, all income will need to be verified, and there are more stringent rules on affordability assessments and stress testing of affordability. In both cases, we believe that such targeted regulation will control excessive high-risk lending more effectively than the blunt universal tool of a LTV/LTI cap. 21. We would conclude, therefore, that further review of the effectiveness of such macroprudential tools is necessary before their adoption in the UK. We would emphasise that LTV or LTI caps are relatively untested and unproven areas of macro-prudential regulation. As such, we suggest that for clarity and efficiency the FPC should be equipped with only a limited number of tools to enable the market and the FPC to evaluate the operation of these tools. So, we believe that the CP has ended in the right place by not recommending that a power to specify LTV or LTI is granted to the FPC. Furthermore, any such adoption should be done in conjunction with developments on an EU level to ensure that UK firms are not disadvantaged vis-à-vis their European competitors. (We provide further comment on the operation of LTV or LTI caps in the Annex attached to this paper). 22. But we acknowledge that, given past history, the property market is likely to be the subject of macro-prudential intervention of some nature. Requiring lenders to hold additional capital would be one way of imposing some control of the market, and we would highlight that existing regulation exists to allow this to occur e.g. BIS 3. Sectoral capital requirements could also be a way of cooling an overheating market while allowing lenders to gradually change their business model and/or continue to lend but with suitable capital levels to reflect the additional riskiness of such new lending. We have, however, some concerns over the implementation and operation of sectoral capital requirements. 23. We would suggest that to cool an overheating sector of the market it would be possible to introduce high capital risk weightings to reflect this which would be a more targeted approach. It would not, however, stop firms from growing their businesses, but merely ensure that the level of capital reflected the additional risk. Such an approach would also favour those firms that prudently built up capital reserves to enable them to continue to grow. 24. However, as with LTV or LTI caps, sectoral capital controls is a relatively untested area of macro-prudential regulation and, therefore, needs to be approached and implemented with caution. We also note that the use of sectoral capital requirements may not be confined to new lending to a particular sector, but may apply to the whole stock of lending to a sector undertaken by a firm. We have serious concerns that the imposition of higher capital requirements on the whole stock of given lending retrospectively, may pose a significant burden to firms. We would highlight that for lenders it is difficult to change capital levels at short notice. It takes time to raise capital and once raised it is difficult for firms to subsequently reduce capital levels should economic and market conditions change and the FPC remove capital restraints, thereby potentially leaving firms with excess capital. We believe this may result in considerable volatility in firms level of capital, send misleading and confusing signals to the capital markets and, ultimately, make it harder and more expensive for firms to raise capital. Unlike perhaps LTV/LTI caps, capital ratios can not be adjusted on an on/off basis. 25. As an untested area we believe more detail needs to be provided on the operation of sectoral capital requirements. For example, we believe that the FPC needs to provide clear definitions as to the sectors additional capital requirements might be imposed on and more explanation as to how such requirements would work in practice. We are keen to ensure that the cumulative level of

4 regulation does not unduly inhibit business. We, therefore, believe further consultation is needed to establish how sectoral capital controls would work in practice. 26. Alongside clarity of how sectoral capital regulation would work, we believe this is necessary for the operation of the counter cyclical buffer (CCB). The Financial Services Bill does not detail how the FPC will implement the CCB in practice. We believe this is necessary both for transparency and clarity to the market but also to allow firms to effectively plan and raise capital in an orderly method. There is a danger that the FPC can impose additional capital requirements either through sectoral capital requirements or the CCB at a time when raising capital in difficult and made more so if a number of institutions need to raise capital at the same time. Implementation of macro-prudential policy 27. Given the impact that the FPC s decisions and use of macro-prudential tools can have on consumers and the UK economy, we believe it is vital that the FPC has a clear, open and transparent approach to the use of such tools. This would entail the FPC having a set of criteria by which it would judge whether it was necessary to intervene, a mechanism by which it would give notice to the industry of its intentions, and a mechanism for monitoring the impact of any intervention. 28. We agree with the conclusions of the FPC that it should not be an over-activist regulator or engage in fine tuning. We believe that in many cases activities by other regulators both at a macro and micro-prudential level can assist in preventing a sector of the economy from over heating. 29. Such early and clear indication of the thoughts of the FPC, we believe would enable the market to adjust, modify its behaviour and as such, may make the final imposition of any regulation unnecessary or at least less likely. We, therefore, welcome the requirements within the draft Bill for the FPC to enter a transparent process. While we support the view that the FPC should provide detailed explanation as to the reasoning behind its decisions, etc., within the Financial Stability Report (FSB), we would also like to see the FPC engage with a variety of stakeholders prior to any use of macro-prudential tools to ensure the market has time to react, etc. 30. Finally, we would suggest that the FPC needs to indicate which economic indicators it is tracking in relation to the housing market. These might include, but not be limited to: house prices, house price to earnings ratios, and household debt to income ratios. By doing so, it will enable lenders in the market to adjust lending strategies ahead of the imposition of further regulation. Specific Responses to Consultation Document 3) Do you agree that sectoral capital requirements will be an effective macro-prudential tool? As outlined above, we believe that sectoral capital requirements, as part of the sophisticated capital regime already in place could be an effective macro-prudential tool, although as also highlighted above, this is a relatively new and untested area of macro-prudential regulation. We believe, therefore, that considerably more discussion and consultation is needed to establish how such controls would, in practice, operate. We believe the FPC needs to provide further clarity as to the sectors that could experience higher capital requirements and how this new macro-prudential tool would be used. We have significant concerns with the suggestion that changes in capital weighting could affect a whole stock of lending. We believe this could place significant capital burdens on firms and that the focus of macro-prudential regulation should be to curb new, excessive borrowing; i.e., existing lending should not be impacted, but future lending should be. We are concerned that such controls could have the effect of creating considerable volatility in firms capital base and, as such, may make it harder and more expensive for firms to raise capital. 4) Do you agree that the FPC should have the ability to apply granular requirements e.g. differentiated by LTV or LTI for residential property-related assets? We remain concerned that the use of LTVs/LTIs as a macro-prudential tool is relatively untested and unproved. We are not convinced that the efficiency of LTV/LTI caps has been proved and in the context of a sophisticated and comprehensive micro-prudential regime is a relatively blunt tool to prevent excessive lending. Differentiated requirements could have further unintended consequences. 12) What is the assessment of the advantages and disadvantages of granting the FPC a power to set and vary maximum LTV and/or LTI ratios?

5 We do recognise that the imposition of LTV/LTI caps has the policy advantage of being easily understood to the man in the street and, therefore, benefits from simplicity and a broad understanding. Against this, however, we would contend that such controls could serve as a blunt tool. As outlined above, for a variety of reasons, we believe that LTV/LTI caps will not prove as effective as other existing forms of regulation currently in place and designed to prevent excessive lending to a particular sector. Contact 31. This response has been prepared by the CML in consultation with its members. If you have any comments or queries on this response, please contact Jon Saunders, Senior Policy Adviser: jon.saunders@cml.org.uk December 2012

6 Annex Further Considerations in the debate on LTV/LTI There is one particular issue which needs consideration. Within the UK mortgage market, we have serious concerns that the imposition of LTV or LTI caps could have a disproportionate impact on certain sectors of society. For example LTV caps are likely to have a bigger impact on first-time buyers (FTB) a sector which is already struggling to enter the market. Any impact on this crucial sector of the market has a significant impact on those already on the housing ladder by making it more difficult to start a chain. A number of jurisdictions provide for first-time buyers to take out higher LTV amounts, subject to also taking out mortgage insurance. Such a differentiated approach would address some of the affordability aspects, but at higher cost to the borrower. This would risk putting put additional pressures on both the private and social rented sectors. LTV caps do not take account of legitimate mitigants to lending at higher values e.g. a charge over other security or evidence of an ability to pay-down within an expected timetable from alternative sources e.g. maturing investments. High LTVs are an issue for the market only when losses are realised and the value of the property exceeds the value of the loan. We would contend that government macro-prudential policy should not disadvantage individuals willing and able to meet monthly repayments and having a plausible exit strategy. We would mention in the current environment most lending is done on an interest and capital repayment basis. Thus monthly payments produce an improving LTV position and, therefore, can bring the outstanding loan value below that of any imposed cap. The imposition of LTV caps would also risk instantly creating mortgage prisoners for those borrowers whose LTV/LTI is above the threshold since they would not be able to re-mortgage to a new lender or to move (unless they are downsizing or moving to a cheaper property thereby bringing them back into line with the LTV/LTI threshold). To some extent, such problems could be mitigated by allowing remortages that were risk-reducing in nature, for example negative equity cases trading down to lower value properties. We would suggest that wider government policy may complicate the use of LTV/LTI caps and render them less effective than other forms of for prudential regulation purposes. There would need to be recognition that government policies around low cost home ownership or NewBuy may not be compatible with a more general macro-prudential objective. Should LTV/LTI caps be imposed we would suggest that government may also want to carve out sectors of the mortgage market which would inevitably weaken the efficiency of LTV/LTI s as a macro-prudential tool. It should be mentioned that LTI caps generally disregard non-earned income which can be significant. Again we do not think that macro-prudential policy should discriminate against a section of the population whom are good but non-standard credits. Likewise, LTIs can only be a snap-shot of the current financial position of the borrower and can not take account of changing financial position of individuals. In a competitive market we note that it is extremely difficult for lenders to exit markets. We would also note that for some members of the CML mortgage lending is their principal business, e.g. building societies are subject to nature limits. In both cases a blunt LTV/LTI cap would mean serious issues to the business model.