Loan-to-value policy as a macroprudential tool: The case of residential mortgage loans in Asia

Introduction

The global financial crisis of 2007–2009 underlined the need for central banks and financial regulators to take a macroprudential perspective on financial risk, i.e., to monitor and regulate the buildup of systemic financial risk in the economy as a whole, as opposed to simply monitoring the condition of individual financial institutions (microprudential regulation). This has been highlighted in numerous reports, e.g., G30 (2009), IMF (2009), Brunnermeier et al. (2009), and TdLG (2009). The regulatory response to this in advanced economies, under the guidance of the G20 and the Financial Stability Board, has tended to focus on strengthening the liability side of banks’ balance sheets by enforcing stricter capital adequacy requirements, including the introduction of a countercyclical buffer and the introduction of liquidity requirements (see, e.g., BIS 2010a).

However, financial crises can also be mitigated by improving the asset side of banks’ balance sheets, i.e., reducing the risk that they will make poor loans that ultimately become non-performing loans (NPLs), and increasing the amount that can be recovered from NPLs. Such measures broadly restrain banks from lending excessively during boom periods, and also tend to reduce the losses they may incur during downturns. Central banks or financial regulators (depending on which entity has responsibility for supervising banks) can use a number of macroprudential tools to restrain the buildup of NPLs, including loan-to-value (LTV) ratios, debt-service-to-income ratios, credit exposure limits on specific sectors (especially real estate), underwriting standards, and limits on loan growth, among others.

Use of the LTV ratio as a macroprudential tool in Asia

Although these kinds of measures have generally lost favor in advanced economies, they have been actively used in Asian economies. Among them, the LTV ratio has been one of the most popular, and has been used in the People’s Republic of China (PRC); Hong Kong, China; Indonesia; Japan; the Republic of Korea; Malaysia; the Philippines; Singapore; Taipei,China; and Thailand.

LTV ratios cap the percentage of the value of an asset that can be financed by a bank loan, thereby ensuring an adequate cushion of collateral value for the loan in case it should sour. A good description of the issues related to them can be found in Borio, Furfine, and Lowe (2001). Some economies impose LTV ratios all the time, while others impose them only as needed. LTV ratios in Asia normally range between 70% and 80%, although sometimes they are set lower when real estate markets appear frothy. Given the wide use of LTV ratios, it is useful to analyze the effectiveness of this measure in controlling housing loan growth.

Analysis of LTV ratio impacts

Most studies have focused on the impacts of LTV ratios on macro-level variables, such as total bank credit or housing prices. Our recent study (Morgan, Regis, and Salike 2015) is one of the few that analyzes bank-level responses to LTV policies, and is the first one we are aware of to focus directly on the impact of LTV ratios on the residential mortgage loan (RML) market. Since LTV policies target mortgage loans, this is the item in banks’ balance sheets that should be analyzed rather than some measure of overall financial stability, as in much of the previous literature. Other studies with a bank-level approach include Claessens et al. (2013) and Wang and Sun (2013), although they used different dependent variables.

The key empirical question is the extent to which LTV can inhibit the growth of bank lending. Our benchmark hypothesis is that an LTV cap would restrain the growth of RMLs relative to the case of having no LTV cap. The overall average growth of mortgage loans of banks in the sample of the studied Asian economies during 2003–2011 was generally quite high. Even after disregarding extreme values, the robust mean growth rate was 7.8%. The high growth rate of mortgage lending in these economies may explain why the use of LTV has been so active in the region.

Methodology

The residential mortgage loans of a bank can be explained as a function of both individual bank conditions and macroeconomic country-specific variables. Independent variables used in this study included those widely used in similar kinds of studies of determinants of bank loans and bank profitability. To assess the effectiveness of LTV policy as a macroprudential tool in the mortgage loan market, we used a dummy variable for the use of an LTV ratio to compare economies and years where the policy was implemented, with alternative country-year combinations where the policy was not used.

The study used annual unbalanced panel data of 201 banks, with time periods ranging from 2 to 7 years. The banks were from 11 Asian economies: the PRC; Hong Kong, China; India; Indonesia; Japan, the Republic of Korea; Malaysia; the Philippines; Singapore; Taipei,China; and Thailand. Depending on the equation specifications, the total number of observations ranged from 500 to more than 700.

The bank-specific data vary widely across banks and countries, resulting in a quite heterogeneous sample with a large proportion of outliers. Therefore, an alternative method to the classical ordinary least squares (OLS) was used—the MM-estimator, which uses “weights” to handle extreme values. The procedure reduces the weights of observations identified as outliers to minimize their influence. As much as 25% of the sample was assigned weights of less than half of those for OLS, which provides some evidence that outliers may be a serious issue in this study.

Results support effectiveness of LTV ratios

Our results confirm the hypothesis that LTV caps reduce the growth of RMLs, which may have a positive impact on macroeconomic stability. The LTV dummy variable is statistically significant and negatively correlated with mortgage loans. Robust estimates suggest the growth rates of RMLs in LTV and non-LTV economies are 6.7% and 14.8%, respectively. Of this 8.1 percentage-point difference, our results imply that the use of an LTV ratio explains about 5.6 percentage points of this difference directly, and even more once its indirect effects on other predictors are considered. Extensive sensitivity analysis and use of alternative methodologies support these results.

Conclusions

Our study makes a number of contributions to the literature on the effectiveness of LTV ratios. First, it comprehensively deals with the problem of outliers in a large and diverse panel data set of banks using robust-to-outliers methods. Empirical studies based on a least-squares approach would be highly sensitive to the large number of outliers detected. Second, it uses a number of different techniques to isolate the differences in behavior of mortgage markets between economies that use or do not use LTVs. The findings generally support those of other studies that LTV ratios can reduce the overall growth rate of housing loans and thereby contribute to financial and economic stability in Asian economies.
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References:

Bank for International Settlements (BIS). 2010. Group of Governors and Heads of Supervision Announces Higher Global Minimum Capital Standards. Basel, Switzerland: Basel Committee on Banking Supervision, Bank for International Settlements.
Borio, C., C. Furfine, and P. Lowe. 2001. Procyclicality of the Financial System and Financial Stability: Issues and Policy Options. BIS Papers No. 1. Basel, Switzerland: Bank for International Settlements.
Brunnermeier, M., A. Crocket, C. Goodhart, A. Persaud, and H. S. Shin. 2009. The Fundamental Principles of Financial Regulation. Geneva and London: International Center for Monetary and Banking Studies and Centre for Economic Policy Research.
Claessens, S., S. R. Ghosh, and R. Mihet. 2013. Macro-prudential Policies to Mitigate Financial System Vulnerabilities. Journal of International Money and Finance 39: 153–185.
G30. 2009. Financial Reform: A Framework for Financial Stability. Washington, DC: Group of Thirty.
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Morgan, P., P. J. Regis, and N. Salike. 2015. Loan-to-Value Policy as a Macroprudential Tool: The Case of Residential Mortgage Loans in Asia. ADBI Working Paper 528. Tokyo: Asian Development Bank Institute. Available: http://www.adbi.org/publications/loan-value-policy-macroprudential-tool-case-residential-mortgage-loans-asia
TdLG. 2009. The High-Level Group on Financial Supervision in the EU. Brussels: The de Larosière Group.
Wang, B., and T. Sun. 2013. How Effective are Macroprudential Policies in China? IMF Working Paper 13/75. Washington, DC: International Monetary Fund.

Photo: By Chongkian (Own work) [CC BY-SA 3.0], via Wikimedia Commons