Stefan Gerlach: Housing markets and financial stability
Speech by Mr Stefan Gerlach, Deputy Governor of the Central Bank of Ireland, at the
National University of Ireland, Galway, 20 April 2012.
* * *
Introduction
It is an honour for me to participate in this conference on "Contemporary Housing Issues in a
Changing Europe."1 This is my first trip in Ireland away from Dublin and I am very pleased to
be here.
As you all well know, there are many aspects of housing that influence, and are the objective
of, public policy. Policy makers in Ireland and abroad thus worry about the cost and
availability of housing, the role of planning procedures in housing development, and the
rights of tenants and distressed mortgage borrowers, to mention but just a few a topics.
It will therefore come as no surprise to you that central banks and financial regulators also
worry a great deal about the housing market and the banks and households that are its key
actors. To fit with the broad theme of the conference, I have decided to talk this afternoon on
the topic of "Housing Markets and Financial Stability." The main focus of my talk is to explain
why central banks are concerned about housing market developments. One reason is the
risk of housing bubbles that can have far-reaching implications for financial stability. I will
therefore also discuss what policies can be adopted to mitigate the likelihood that a bubble
occurs and the consequences if it does. Following the financial crisis, central banks across
the world will attach even greater weight to housing market developments, so this is a timely
topic.
Central banks and the housing market
It is useful to start by asking why central banks and financial regulators worry about the
housing market.2 They do so for three reasons: for monetary policy purposes; for financial
regulatory reasons and because of financial stability concerns.
First, the housing market is a key link in the chain of events through which monetary policy
impacts on the economy. Since housing is typically constructed or purchased using borrowed
funds, the cost of borrowing is a major part of the overall cost of housing. A tightening of
monetary policy increases these costs and therefore moderates the demand for housing,
which reduces property prices and leads to a fall in construction activity.
The decline in property prices also decreases collateral values and banks' willingness and
ability to lend to firms and households. Furthermore, it also reduces households' wealth
perceptions. The overall effect is to lower the demand for goods and services in the
economy, economic activity and inflation pressures.
But while crucially important, the role of housing in the monetary transmission mechanism is
well known and in the interest of brevity I will not focus on it here.
The second reason central banks worry about the housing market arises from the fact that
mortgages are the single biggest financial transaction most households undertake. Property
lending is a major component of households' liabilities and an important exposure of
mortgage lenders. Central Banks that have responsibility for micro-prudential supervision
and regulation and for customer protection, as the Central Bank of Ireland does, will wish to
ensure that individual banks make sound lending decisions in order to protect their balance
sheets and that they deal fairly with customers.
Given the developments in Irish housing markets in recent years, my colleagues at the
Central Bank have given a number of speeches on mortgage markets and mortgages arrears
in the recent past.3 I will therefore not discuss this aspect of housing markets today.
The third reason central banks are concerned by housing markets is, as we have seen in
Ireland, that large declines in property prices can trigger an episode of financial instability.
The borrowing capacity and credit demand of households and firms are affected by changes
in the prices of properties. Since they are often used as collateral for bank lending, rising
property prices are typically associated with rapid credit expansion. Developments in the
property market therefore affect banks' capital positions and their lending capacity, both
directly through changes in the valuation of their holdings of real estate assets and, if
property prices fall, indirectly via changes in non-performing loans.
A sharp fall in property prices can lead to financial instability in many ways. A decline in
prices tends to be associated with economic weakness as housing construction grinds to a
halt, triggering financial strains and defaults among property developers, construction
companies and real estate firms. Rising unemployment also leads to mortgage arrears and
defaults among households. The overall effect can be a sharp worsening of banks' balance
sheets.
It is this link between housing prices and financial stability that I wish to focus on this
afternoon.
Property bubbles
Next I will review how the property bubble developed here in Ireland and put it into an
international context. My main point is that housing bubbles are not only highly adverse
events, but they are common and similar. Nevertheless, too few policy makers have learned
too little from the historical experience.
Figure 1 shows annual property price indices in nominal terms from the BIS website for
10 countries, indexed so that 1999 equals 100. The figure tells a familiar story: property
prices rose sharply across the world in the decade before the financial crisis started in 2007.
The diversity of the price changes between 1999 and 2007 is staggering, ranging from
-6% in Germany to over 160% in Spain, which corresponds to an average annual increase
of between -0.85 and 12%. These large differences between countries in the extent of the
price increases are interesting. It is particularly notable that the price increases in the
US - 75% in this period or 7% annually - were rather modest from an international
perspective.
Figure 2 shows credit expansion in the same economies, using data from the IMF. As can be
seen, the run-up in property prices was associated with large increases also in credit, which
varied between 23% in Germany to in excess of 400% in Ireland.
The fact that credit and housing prices rose together can be interpreted in several ways.
Many believe that it reflects changes in banks' willingness and ability to lend - arising, for
instance, from excessively expansionary monetary policy, securitisation and reduced risk
perceptions - that triggered property price bubbles across the world.
But it is also possible that rapid economic growth led households to revise up their
expectations of future income and raise their demand for housing. Indeed, the
macroeconomic environment before the start of a property bubble is typically highly
favourable. This was certainly the case in Ireland, where real GDP grew at an average rate
of 6% per year in the period 2000 to 2006.
Specifically, asset prices were rising, labour market participation rates and nominal wage
growth were high and unemployment was low. With the housing stock essentially given at
any point in time, greater demand for housing leads to sharp and sustained increases in
property prices. Such advantageous conditions can lead households to expect additional
capital gains that typically exceed the cost of borrowing, triggering further increases in
property demand.
As we now know, the global property market boom was followed by a collapse in prices that
has cumulatively been very large. Among the countries in Figure 1 which have experienced
price declines over the period, falls have been between 46% in Ireland and 3% in New
Zealand between 2007 and 2011.4 The left-hand panel of Figure 3 shows that the size of fall
mirrored the increase before the crisis.
However, the sheer size of a rise in property prices is not the most important factor in
determining how severe the bust will be. Rather, what matters is whether the asset price
boom is funded by credit. If so, the evidence suggests that the cost of a bust is much
greater.5
The right-hand panel of Figure 3 shows that house price falls following the crisis are
negatively related to the extent of credit expansion before the crisis. Overall, these data show
that the rapid increases in property prices and credit are typically followed by large price falls.
Thus, the IMF (2011a) studies a number of emerging market and advanced economies and
finds that faster growth in mortgage credit during booms was accompanied by stronger
house price growth at the time, and greater house price declines and larger increases in
non-performing loans during busts. Furthermore, IMF (2012) finds that housing busts and
recessions associated with higher leverage in the boom phase tend to be longer and more
severe, while Jorda, Schularick and Taylor (2011) find that recessions preceded by greater
private-sector leverage6 are associated with worse outcomes in terms of economic growth,
investment spending, and credit growth than those associated with less leverage. These
effects are amplified if the recession coincided with a financial crisis.7 Overall, the
international evidence shows that mortgage credit growth and the state of the economy
during the boom explain most of the subsequent differences in house prices and bank loan
losses.8
The recent financial crisis was started in much the same way as many other crises, that is,
by a huge property price bubble that was financed by massive credit expansion by banks.9
Such dramatic falls in house prices as were experienced during the crisis were followed by
widespread fragility in the financial sector as borrowers' balance sheets became stressed.
Once the falls became large enough and a sufficiently large number of borrowers were
affected, a full-blown financial crisis ensued.
House prices, financial crises and fiscal stability
Unfortunately, the Irish housing bubble was not an atypical event. It is therefore of interest to
look more generally at property price booms and financial stability to see what the
consequences of the bursting of a housing bubble are. In this section I look first at the
consequences for the broader economy before looking at their impact on governments' fiscal
positions.
Macroeconomic effects of housing bubbles
Financial crises associated with speculative boom-bust episodes have been traced back as
far as the Holy Roman Empire in the 17th century.10 Not all of these, of course, relate to
property bubbles, although many do. Indeed, there is ample historical evidence of house
price boom-bust cycles and their economic effects.
Work by the IMF11 found that approximately 40 per cent of house price booms were followed
by busts,12 resulting in, on average, 30 per cent house price declines, and lasting for
approximately four years. Reinhart and Rogoff (2009a) find that the cumulative decline in real
house prices, from peak to trough, is in excess of 35 per cent over an average period of
6 years, although declines of 50 and 60 per cent have also been recorded (Figure 4).13
So house price booms frequently end in a bust. But how frequently do they end in a financial
crisis? Reinhart and Rogoff (2009a) in their celebrated study of financial bubbles show that
house price increases are indeed common prior to banking crises (Figure 5). Bordo and
Jeanne (2002) find that financial crises are generally triggered when house prices have
peaked, or immediately after they have started falling. Of 15 advanced economies over the
period 1970-2002, they identified 20 episodes of housing booms, of which 11 were followed
by a bust. Of these 11 boom-bust cycles, 6 involved banking crises.14 Crowe et al. (2011a)
8
See IMF (2011a).
9
Kindleberger and Aliber (2011) state that "Bubbles result from the growth of credit that proves too high to be
sustainable; when the credit growth slows, some asset prices begin to decline".
10
See Kindleberger and Aliber (2011) for a history of bubbles and crashes.
11
IMF (2003). The analysis is carried out on 14 countries.
12
ECB (2003) finds that 55 per cent of booms in real house prices in EU countries were followed by busts.
13
Japan experienced a long decline in house prices following the 1992 crisis. However, excluding Japan from
the sample still leaves the average duration of house prices declines following financial crises in excess of
5 years. Claessens et al. (2008b) find that house prices decline for an extended period, "typically much more
than three years".
14
In a study of 14 OECD countries, Barrell et al. (2010) find that a single percentage point rise in real house
price growth is sufficient to raise the probability of a crisis in the range of 0.07% (in the US) to 0.74% (in
France). The unweighted average marginal effect of the 14 individual country effects is 0.31%. Reinhart and
Rogoff (2009a) find that real house prices are one of the best indicators of banking crises.
show that, of 23 countries that experienced booms in both real estate and credit before the
crisis, 21 experienced either a financial crisis or a significant drop in GDP growth, while of the
seven countries that experienced a boom in real estate only, just two had a systemic
financial crisis.15
The evidence regarding the impact on the real economy is similarly stark. Recessions that
coincide with housing busts are, on average, longer and more pronounced than others.16 The
macroeconomic effects of the bursting of a bubble are studied in Claessens et al. (2008b).17
They find that the prolonged nature of house price declines following busts has a significant
impact on a range of real economy indicators (Figure 6). Specifically, they find that output,
investment and credit begin to decline once house prices have peaked, while consumption is
slowing. Inflation typically increases for a number of quarters after the house price peak,
before declining sharply. The unemployment response is even more lagged, remaining
steady for almost 2 years before increasing. It is therefore no surprise that almost five years
after housing prices started to fall, the recovery in Ireland is still very weak.
The left-hand panel of Figure 7 shows the evolution of house prices, from their peak, through
the crisis period for a sample of the "Big Five" crisis countries identified by Reinhart and
Rogoff (2009a), Korea and Ireland.18 Clearly, Ireland has experienced a comparatively
severe house price drop. The right-hand panel of Figure 7 shows the falls in GDP in the
same economies. Ireland has also experienced one of the greatest falls in real GDP and one
of the slowest recoveries.
It is interesting to note the difference in the time frame for recovery between house prices
and GDP. While GDP in this sample of countries typically recovered to peak levels within
6 years, the recovery in house prices was much delayed. In the Nordic countries, the
recovery took between 10 and 22 years, while house prices have not yet recovered to
pre-crisis levels in Korea and continue to decline in Japan.
Overall, these graphs suggests that economic activity in Ireland will recover only gradually
and that it may take a long time before house prices return to their level in 2007.
Public debt and deficits
Another, related consequence of a financial crisis is a sharp deterioration of government
finances. Nowhere have the consequences for public finances of the financial crisis that
started in 2007 been more apparent than in Ireland. However, the Irish experience was not
an outlier. Reinhart and Rogoff (2009a) find that public debt rises, on average, over 85 per
cent following a financial crisis.19
There are three reasons why public finances deteriorate so much after a financial crisis. First,
the economic slowdown reduces tax collections. The resulting loss of revenue was
particularly dramatic in Ireland where during the boom years the government relied
increasingly on taxes that were dependent on the state of the business cycle, and on activity
in the housing market in particular. When the crisis struck, tax revenue collapsed
(see Figure 8). Second, weaker economic growth translates into greater need for
government expenditure on unemployment support and social welfare (see Figure 9). Third,
if banks incur sufficiently large losses, the government may be forced to inject capital in the
banking system, potentially leading to large increases in public debt.
Ireland's current fiscal problems largely result from the effect of the housing bubble on the
public debt. As Figure 10 shows, following the onset of the crisis in 2007, Ireland has
experienced very large public deficits and a rise in the ratio of public debt to GDP from
25% in 2007 to 105% in 2011. This increase in public debt was so large that investors grew
concerned about the Government's ability to service the debt, impairing the Government's
access to financial markets in 2010 and requiring outside financial assistance.
This large public debt makes it very difficult for the Government to support economic
recovery through any sort of expansionary fiscal policy. Indeed, the sheer size of the debt
requires the Government to pursue tight fiscal policies. It also has to be borne in mind that,
should banks' loan losses rise further than currently expected, further upward pressure would
be put on an already high debt ratio.
Macro-prudential policy
Given the devastating consequences housing bubbles can have, policy makers have good
reasons to attempt to prevent them. But, while some housing bubbles are followed by a
crisis, not all are. Unfortunately, it is impossible to know in advance which bubbles are
followed by a crisis.20 This uncertainty can bias policy makers in favour of inaction. One
particular problem is that the boom phase is associated with rapid growth of real income,
falling unemployment, rising tax revenues, increasing asset prices and high bank profitability.
With households, government and banks all doing well, there is little political support for
policies intended to prevent the bubble from growing further, even when policy makers
believe them necessary. To avoid such a scenario, the policy makers responsible for the
overall health of the financial system - the macro prudential authority - must have a clear
mandate and be independent.
Following the crisis, there has been much work on the development of macro-prudential tools
that reduce the likelihood of property-driven financial crises, and that reduce or limit their
consequences if they do occur. As the Central Bank is the macro-prudential authority in
Ireland,21 the bank is following this debate closely.
What are macro-prudential tools? The IMF (2011c) proposes two criteria. First, they explicitly
and specifically target the build-up of risk across the financial system - systemic risk - as the
bubble grows. Second, they are controlled by the macro-prudential authority.22 However, few
macro-prudential tools have been used systematically and there is little practical experience
for policy makers to rely on.23 Nonetheless, several tools that target real estate lending have
been adopted in a small number of economies.24 They can be grouped in three broad
categories.25
The first category relates to capital requirements on property lending. For instance, capital
requirements for mortgages for buy-to-let properties could be increased relative to those for
primary dwellings. This would tend to reduce this type of lending, which appears to be
associated with greater credit risk, and ensure that banks' resilience is bolstered by the
additional capital buffer.26
Second, dynamic provisioning requires banks to hold provisions against expected losses due
to credit risks. This tool has been implemented in Spain, where banks are required to build
up buffers against performing loans in an upturn, which can then be drawn down in a
recession.27 This naturally slows bank lending in the boom phase and leaves banks in a
better position to withstand loan losses in a crash.
Third, limits on loan-to-value (LTV) and loan-to-income (LTI) ratios target the
creditworthiness of borrowers more explicitly. While LTV limits help ensure that the
underlying collateral - the property - is sufficient to cover the loan, were the borrower to
default, LTI limits enhance the creditworthiness of borrowers by limiting their repayment
burden. Tightening these ratios in the as the boom gets underway raises the ability of the
financial system to cope if the bubble bursts. Their potential use in Ireland warrants further
reflection.28
It is sometimes argued that tighter monetary policy - higher interest rates - is the appropriate
way to deal with property bubbles. However, monetary policy is a blunt tool that affects all
lending, risky and less risky. In contrast, macro prudential tools can be targeted narrowly on
the most risky borrowers. Such a sharp focus may lower the overall cost of preventive action.
However, the narrow focus may enable borrowers and lenders to seek to circumvent the
restrictions. For instance, Crowe et al. (2011a) report that, in Korea lower LTV limits were
implemented for loans of less than 3 years substantially increasing the popularity of loans of
three years and one day. Furthermore, LTV limits have been circumvented by taking out a
personal loan to cover a portion of the house price. Moreover, measures aimed at limiting
credit provision by banks risk pushing lending into other, less regulated, sectors. To
overcome these problems, policy makers will likely employ several macro prudential tools at
the same time. While this may reduce the risk of avoidance, it may be difficult to calibrate the
setting of the different policy instruments since they are likely to interact. It is to be expected
that re-calibration of instruments will take place regularly as experience with macro prudential
policy is gathered.
In addition, using macro-prudential policy requires detailed micro and macro data in order to
determine whether and which tools are needed. Moreover, there is a need for expert
judgement, which will be a scarce commodity at the outset.29 There are also requirements in
terms of the legal framework in countries in enabling the imposition of macro-prudential
24
For a discussion of policy practices internationally, see, for example, Honohan and Laeven (2005). Honohan
(2010) discusses policy actions undertaken and available in Ireland before the current crisis.
25
See Crowe et al. (2011a).
26
Risk weights on certain types of riskier property lending were introduced in Ireland in 2006-7. Honohan (2010)
concludes had such a surcharge been implemented earlier, it might have been more effective.
27
For a discussion of dynamic provisioning in Spain, see Saurina (2009).
28
A similar process is underway in the UK where the Financial Policy Committee (FPC) is considering potential
macro prudential tools, including LTV and LTI limits. See: http://www.bankofengland.co.uk/publications/Documents/
records/fpc/pdf/2012/record1203.pdf
29
See BIS (2010), which finds that of 22 countries surveyed, all relied exclusively on judgement in setting macro
prudential policy.
instruments. Macro prudential instruments are often forward looking and preventive in nature
and it may be difficult, if the legal framework places the burden of proof on the macro
prudential authority, to justify a tightening of macro prudential policy, particularly in a situation
in which financial tensions are not clearly evident to outside observers.
Nonetheless, there is evidence that such policies can be successful. In terms of the impact
on housing market activity, Ahuja and Nabar (2011) using data on 49 emerging and
advanced economies find that LTV limits slow property price growth. In a case study of Hong
Kong SAR, they find that tightening LTV limits reduced both transaction volumes and price
growth, albeit with a lag.30 Wong et al. (2011), using data on Hong Kong, Singapore and
Korea, find that the impact of LTV limits on property market activities is inconclusive, but that
there is strong evidence that they restrict household leverage.31
In terms of the impact on the banking sector, Lim et al. (2011) based on IMF survey data32 of
countries' experiences find that LTV and LTI limits and dynamic provisioning, among other
instruments, may be effective in reducing credit growth. Ahuja and Nabar (2011) find that
LTV and LTI limits slow property lending and that LTV limits lower non-performing loans over
the longer term, while Wong et al. (2011) find that LTV limits had a significant positive impact
on banking stability in Hong Kong SAR.
Conclusions
The financial crisis has once again highlighted the risk property market developments can
pose for financial stability. This is an important reason why central banks pay great attention
to the developments in the housing area, including to the evolution of house prices, the rate
of credit expansion, the cost and availability of mortgages and so on.
There is now great attention being focussed by policy makers across the world on how to
best avoid a repetition of the crisis. Unfortunately, the property bubble in Ireland was
particularly large, the resulting financial crisis was particularly severe, and the impact on the
Irish economy is likely to be felt for many years to come. It is therefore important that we in
the Central Bank think particularly carefully about housing developments and whether they
pose risks to financial stability.
To do so, we need to think about what macro prudential policy framework is suitable to us.33
In particular, we need to explore whether macro prudential tools such as those I have
discussed may play a useful role in Ireland. There is much work - which is highly technical
and will involve regulators, economists, statisticians and lawyers working together - to be
done.
Thank you for your attention.
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BIS central bankers' speeches 11
12 BIS central bankers' speeches
Figure 4: Past and ongoing real housing price cycles and banking crises:
peak- to-trough declines (left panel) and years duration of downturn (right
panel)
Source: Reinhart and Rogoff (2009b)
Notes: Each banking crisis episode is identified by country and the beginning year of
the crisis. Only major (systemic) banking crisis episodes are included, subject to data
limitations. The historical average reported does not include ongoing crisis episodes.
For the ongoing episodes, the calculations are based on data through the following
periods: October 2008, monthly, for Iceland and Ireland; 2007, annually, for
Hungary; and 2008:111, quarterly,