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Residential Real Estate & Financial Stability

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Apologies if this was already posted at the time but I've just come across this December 2015 Report on residential real estate and financial stability in the EU from the European Systemic Risk Board and thought it might potentially be of interest:

ESRB, Report on residential real estate and financial stability in the EU, December 2015

Executive Summary

The report investigates how structural features of, and cyclical developments in, residential real estate (RRE) markets in the EU may affect financial stability and how related risks can be addressed. The report is structured in four main sections covering: (i) an analysis of the structural features of RRE markets in Europe, (ii) the historical experience in Europe as regards financial stability risks emerging from the real estate sector, (iii) an investigation into the possible role of structural features of RRE markets in such risks, and (iv) the policy instruments that can be used to address the risks stemming from residential property markets.

i) Analysis of the structural features of RRE markets

The structural features of RRE markets can be usefully grouped into demand-side, supply-side and institutional factors. Demand-side factors include household income, credit availability and interest rates, home ownership rates, and demographic factors. Supply-side elements encompass factors such as residential investment, housing construction and construction costs. Institutional factors include housing taxes and subsidies, mortgage contract features (e.g. variable vs. fixed rate contracts), as well as foreclosure and insolvency procedures.

The report shows how EU Member States differ widely in terms of these structural features. For example, in the Netherlands and Estonia, housing taxes decrease the marginal cost of acquiring a house, while in France and Greece they increase the costs substantially; in Sweden the average mortgage maturity is more than 40 years, while in Hungary it is only 15 years.

ii) Historical experience of RRE markets and financial stability risks

The report develops a conceptual framework of how the housing market, real economy and financial sector are interlinked. Tight links tend to reinforce feedback loops between the financial sector and the real economy. Structural features of national RRE markets may further amplify or dampen the transmission channels.

Several indicators relevant for a financial stability analysis of RRE markets are explored conceptually and empirically. An existing ESRB database is used to identify real estate-related banking crises, with the report also exploring several measures of the depth of a crisis. The report identifies possible indicators that might be particularly relevant during the build-up of financial stability risks in RRE markets and investigates how they behaved prior to the recent financial crisis. Different indicators may be useful depending on the phase of the real estate cycle. Possible early warning indicators of a real estate boom include cyclical indicators of credit and/or real estate prices, combined with their corresponding structural indicators (such as bank credit-to-GDP and price-to-rent ratios); relevant indicators for the bust phase include decreases in loan supply and house prices, and rising non-performing loans and bankruptcy rates. Finally, the similarities and differences between the most recent crisis and the real estate-related banking crises of the 1990s are explored.

The analysis of real estate indicators has highlighted that comparable high-quality data on some key metrics for financial stability monitoring and policy-making are still not available. The expert group therefore recommends that harmonised definitions of key indicators, such as LTV, LTI, DTI and DSTI, be developed, at least for monitoring and cross-border comparison purposes. These harmonised indicators should not prevent national authorities from continuing to use indicators based on their own definitions to accommodate national specificities.

An analysis of the time-series behaviour of key cyclical real estate-related indicators around crisis events leads to some interesting conclusions. Crises tend to be preceded by lower funding costs, better access to credit, rising debt levels and an underestimation of risks. Risks and vulnerabilities accumulate in the form of external imbalances, booming construction activity, excessive bank credit growth, higher private sector leverage, and overvalued RRE prices.

iii) Structural features of RRE markets and financial stability risks

The analysis points to sharp differences across countries both in the incidence and depth of RRE-related crises. The report provides a first analysis of the potential interplay between structural and cyclical features of European RRE markets and financial stability risks using both graphical and econometric analysis. Structural market features may increase vulnerabilities before real estate-related banking crises and can exert an amplifying or dampening effect when the crisis materialises. However, the role of structural features of real estate markets in shaping the real estate cycle and how they affect financial stability is difficult to assess.

The report finds preliminary empirical evidence that structural features do matter for financial stability. Initial results highlight the role of structural features, such as high LTV ratios, a favourable tax treatment of housing and high levels of bank leverage, in increasing the vulnerability of countries to real estate-related distress events. Empirical work suggests that high shares of new lending granted at a variable rate, by contrast, are associated with a lower probability of upcoming distress, though this result is likely to depend crucially on the evolution of the interest rate environment.

While structural market features may indirectly influence cyclical developments in the build-up phase, they are likely to directly influence the depth of a crisis. Imbalances and structural developments during the upturn phase are perhaps more likely to affect resilience to a negative shock, rather than influencing the likelihood of that shock occurring. Future research would be needed to analyse more closely the depth of real estate-related banking crises, and the role of cyclical and structural characteristics in shaping the impact of crises.

iv) Policy instruments to address financial stability risks

Real estate macroprudential instruments can be grouped into those tackling three “stretches”, notably relating to borrowers’ income, the underlying collateral backing loans and banking system resilience. In recent years, instruments related to income stretch (LTI and DSTI caps, affordability requirements, amortisation requirements), collateral stretch (LTV caps, amortisation requirements), and banking system stretch (sectoral capital requirements) have been introduced in a number of Member States.

The report provides guidance on the design and use of instruments drawing both on analytical work and emerging experience across countries. A careful design of instruments is crucial for enhancing their effectiveness and avoiding any potential unintended consequences. The report discusses specific detailed design features of each instrument such as the definition of variables and exemptions and suggests ways to deal with potential pitfalls in the use of instruments. It also discusses the trade-offs between fixing and adjusting instruments over the financial cycle. While fixing instruments may create a more predictable environment for the targeted institutions and minimise the risk of inaction bias and implementation lags, it carries the risk that the settings of instruments do not keep pace with new market developments and may create a “comfort zone” for policy-makers. Member States’ implementation of measures differs along most dimensions, and the only relatively recent introduction of measures in most cases means that the evidence for determining “best practice” is still relatively scarce.

A combination of instruments seems likely to be the most suitable response to vulnerabilities stemming from excessive credit growth and leverage related to RRE lending. In this way, different channels through which systemic risks may build up or unfold can be addressed and any circumvention of the rules is made more difficult. Capital-based instruments may be the most effective in directly enhancing resilience, whereas restrictions related to income and collateral stretches are comparatively more effective in curbing the financial cycle. Income stretch instruments are likely to be the most constraining in the build-up phase, whereas a collateral buffer also contributes to system resilience in a downturn. In practice, a combination of instruments, even if not applied simultaneously, is the rule rather than the exception, in particular for collateral and income stretch instruments.

When deciding on the appropriate level of an instrument, a range of different potential calibration methods can be used, potentially in combination. These might range from practical exercises benchmarking experience against other countries to more academic approaches. Expert judgement is likely to be needed given the complexity involved in fully grasping the systemic risks and the uncertainty surrounding the likely impact of the instruments.

Finally, policies influencing structural characteristics of RRE markets themselves might positively contribute to financial stability. The apparent role of structural characteristics of markets in explaining different crisis experiences across countries also points to a broader policy conclusion: that rather than tackling emerging cyclical imbalances in markets through macroprudential intervention, policies influencing structural characteristics of RRE markets might positively contribute to financial stability. This might be a useful topic for further work.

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