LOAN-TO-VALUE RATIO AS A MACRO-PRUDENTIAL TOOL HONG KONG S EXPERIENCE AND CROSS-COUNTRY EVIDENCE

Transcription

1 Working Paper 01/ February 011 LOAN-TO-VALUE RATIO AS A MACRO-PRUDENTIAL TOOL HONG KONG S EXPERIENCE AND CROSS-COUNTRY EVIDENCE Eric Wong, Tom Fong, Ka-fai Li and Henry Choi * Research Deparmen, Hong Kong Moneary Auhoriy Absrac This sudy assesses he effeciveness and drawbacks of maximum loan-o-value (LTV) raios as a macroprudenial ool based on Hong Kong s experience and economeric analyses of panel daa from 13 economies. The ool is found o be effecive in reducing sysemic risk semming from he boom-and-bus cycle of propery markes. Alhough he ool could impose higher liquidiy consrains on homebuyers, empirical evidence shows ha morgage insurance programmes (MIPs) ha proec lenders from credi losses on he porion of loans over maximum LTV hresholds can miigae his drawback wihou undermining he effeciveness of he ool. This finding indicaes he imporan role of MIPs in enhancing he ne benefis of LTV policy. Our esimaions also show ha he dampening effec of LTV policy on household leverage is more apparen han is effec on propery marke aciviies, suggesing ha he policy effec may mainly manifes in impacs on household secor leverage. JEL classificaions: G1; G8 Key words: sysemic risk, macroprudenial policy, loan-o-value raio, Hong Kong Auhors Addresses: ecwong@hkma.gov.hk; pwfong@hkma.gov.hk; kfli@hkma.gov.hk; hmhchoi@hkma.gov.hk The views and analysis expressed in he paper are hose of he auhors and do no necessarily represen he views of he Hong Kong Moneary Auhoriy. * The auhors would like o hank Dong He, Cho-hoi Hu John Hassler and paricipans a he workshop on Housing markes, moneary policy and financial sabiliy organised by he Sveriges Riksbank on 1 November 010 for heir useful commens and suggesions.

2 - - EXECUTIVE SUMMARY: In he afermah of he global financial crisis, here is a growing consensus ha macroprudenial policy should complemen he exising policy frameworks of cenral banks o address sysemic risk. Agains his backdrop, his sudy assesses he effeciveness and drawbacks of maximum loan-o-value raios (i.e., LTV policy) as a macroprudenial ool based on he experience of Hong Kong and economeric analyses of panel daa from 13 economies. Boh Hong Kong s experience and hese empirical resuls sugges ha LTV policy is effecive in conaining sysemic risk by reducing he sensiiviy of morgage defaul risk o propery price shocks. The simulaion resuls sugges ha if he maximum LTV raio were o have been relaxed from 70% o 90% before 1997, he delinquency raio righ afer he 40% decline in propery prices in would have been 1.7%, compared o he acual level of 0.84% a he end of However, he significan use of morgage insurance programmes (MIP) in Hong Kong seems o sugges ha LTV policy could impose significan liquidiy consrains on homebuyers. Neverheless, empirical findings show ha MIPs can reduce liquidiy consrains wihou undermining he effeciveness of he ool. This indicaes he imporan role of MIPs in enhancing he ne benefis of LTV policy. To beer undersand wheher LTV policy would be an effecive insrumen for sabilising propery marke aciviies, his sudy examines he shor-erm effec of ighening LTV caps on propery marke aciviies for Hong Kong, Korea and Singapore. Of he hree economies, only Hong Kong shows mild evidence of a dampening effec of ighening LTV caps on propery marke aciviies. This resul is conrary o srong empirical evidence indicaing ha ighening LTV caps will reduce household secor leverage for he hree economies. These resuls indicae ha he main channel hrough which LTV policy reduces sysemic risk should be is effec on household secor leverage raher han propery marke aciviies. One cavea is ha he indirec effec of LTV policy via he impac of household leverage on he propery marke is no refleced in his analysis.

3 - 3 - I. INTRODUCTION The global financial crisis has demonsraed ha moneary policy and microprudenial banking regulaions are no sufficien o preven he build-up of sysemic risk 1. There is a growing consensus ha macroprudenial policy should complemen he exising policy frameworks of cenral banks/supervisory auhoriies o address sysemic risk (Bank of England, 009; European Cenral Bank, 010; Inernaional Moneary Fund, 010; Swiss Naional Bank, 010). Maximum loan-o-value (LTV) raios on morgages (henceforh referred o as LTV policy ) are being considered or have been recenly adoped by some counries as a macroprudenial insrumen o fill he policy gap: for example, in Hungary, Norway, Sweden and he UK. Despie wider recogniion of LTV policy in he policy communiy, empirical evidence wih regard o some key issues remains scan. Firs, how effecive is LTV policy in reducing sysemic risk arising from he boom-and-bus cycle of propery markes? Secondly, would LTV policy creae significan drawbacks for poenial homebuyers (i.e., would hey be unable o qualify for morgages because of liquidiy consrains) even hough hey could susain loan repaymen (see Financial Services Auhoriy, 009)? Thirdly, should morgage insurance programmes (MIPs) 3 be considered as a means o complemen LTV policy o reduce his drawback, creaing a way for banks o offer morgage loans a raes higher han he maximum LTV raio wihou incurring addiional credi risk? If so, would MIPs reduce he effeciveness of LTV policy? Finally, on op of is role in conaining sysemic risk in he banking secor, should LTV policy be adoped as a means o sabilise propery marke aciviies? The objecive of his sudy is o provide empirical evidence regarding hese key issues, in par based on Hong Kong s experience 4 and in par using panel-daa economeric analyses from 13 economies. In Secion II, we begin wih a brief hisory of he LTV policy in Hong Kong. Srong evidence is found ha he LTV policy has helped According o Caruana (010), sysemic risk is defined as he risk of disrupion o financial services ha occurs because of he impairmen of all or par of he financial sysem and can have serious negaive consequences for he real economy. Hungary, Norway and Sweden have formally declared ha ha hey will adop LTV policies (Magyar Nemzei Bank, 010; Financial Supervisory Auhoriy of Norway, 010; Swedish Financial Supervisory Auhoriy, 010), and he Financial Services Auhoriy in he UK has no ruled ou he possibiliy ha i will employ such a policy in he fuure (see Financial Services Auhoriy, 009). Throughou his sudy, MIP refers o insurance ha aims o proec lenders from losses due o morgage paymen defaul by borrowers. In some jurisdicions, such insurance is also called lenders morgage insurance. Hong Kong s experience offers several advanages wih regard o he assessmen of LTV policy. The long hisory of is LTV policy (wih almos 0 years in operaion), coupled wih subsanial, frequen swings in propery prices and banks significan exposure o propery-relaed lending, easily indicaes he long-run prudenial effec of LTV policy on banking sabiliy. In addiion, he absence of an independen moneary policy under he Linked Exchange Rae Sysem, which creaes a predominan role for Hong Kong s LTV policy in safeguarding banking sabiliy, also makes assessmen easier.

4 - 4 - he Hong Kong banking secor o weaher he boom-and-bus cycle of he propery marke during he pas wo decades. However, evidence also indicaes ha he LTV policy may impose significan liquidiy consrains on homebuyers. Neverheless, o he exen ha his drawback exiss, he MIP in Hong Kong has assised homebuyers in overcoming heir liquidiy consrains wihou incurring addiional credi risk in he banking sysem. In Secion III, we provide empirical evidence of wo key issues using economeric analyses of panel daa from 13 economies. Specifically, our esimaion resuls show ha (1) LTV policy enhances banking sabiliy mainly by reducing he responsiveness of morgage defaul risk o propery price shocks and () alhough in principle MIPs may reduce he effeciveness of LTV policy, here is no clear evidence o suppor his concern. In an aemp o shed ligh on wheher LTV policy can be used o sabilise propery marke aciviies, Secion IV conducs anoher se of economeric analyses based on daa from hree economies (Hong Kong, Singapore and Korea) 5 ha have adoped LTV policies. Overall, we find mixed evidence of he effec of ighening LTV caps on propery marke aciviies. However, here is srong empirical evidence indicaing ha ighening LTV caps will reduce household leverage. The resuls presened in his paper conribue o recen discussions on he use of LTV policy in wo ways. Firs, he resuls in Secions II and III empirically address he quesion of he main benefis and coss of LTV policy and he imporance of MIPs in implemening LTV policy. Secondly, our empirical findings in Secion IV provide a beer undersanding of he ransmission mechanism of LTV policy, which should shed ligh on he issue of wheher LTV policy should be adoped as a ool for sabilising propery marke aciviies. The policy implicaions will be discussed in he final secion. II. A BRIEF HISTORY OF THE LTV POLICY AND THE MIP IN HONG KONG The LTV policy in Hong Kong has long played a vial role in safeguarding banking sabiliy. The policy was creaed because of some special characerisics of he Hong Kong financial sysem. Firs, residenial morgage lending (RML) has always been one of banks larges areas of risk exposure. Since 1991, he banking secor s RML has never been lower han 0% of is lending for use in Hong Kong, wih a maximum of 37% regisered in Sepember 00. Secondly, propery prices have hisorically exhibied srong cyclical paerns such ha if bank exposure o he propery marke were no properly managed, banking sabiliy could be seriously hreaened. In fac, previous 5 Malaysia has also adoped LTV policy. However, he lack of availabiliy of sufficienly long-erm ime series daa precludes he analysis for Malaysia. More specifically, he relevan daa series are only available for 1999 and laer.

5 - 5 - research by Gerlach and Peng (005) finds ha bank lending in Hong Kong is largely driven by propery price movemens 6, suggesing ha sysemic risk is largely associaed wih developmens in he propery marke. Thirdly, in he absence of independen moneary policy under he Linked Exchange Rae Sysem, he Hong Kong Moneary Auhoriy (HKMA) mus seek aleraive policies for managing he sysemic risk semming from he ineracion beween he propery marke and he banking sysem. The LTV policy was finally inroduced as an insrumen o srenghen banking sysem's resilience agains asse price volailiies, and o reduce he risk of bank credi becoming a source of cycle amplifier, raher han o manage asse price cycles/marke aciviies or o arge asse prices. Figure 1 provides a succinc graphical summary of he developmens in LTV policy ogeher wih he movemens in propery prices and he morgage delinquency raio in Hong Kong. The developmen of LTV policy in Hong Kong can be broadly divided ino four phases. The major developmens in each phase are summarised below: Figure 1. The LTV policy, real propery prices and morgage delinquency raio in Hong Kong Max. LTV raio 40 90% 70% 00 60% Max. LTV of 70% has been adoped as a long-erm regulaory policy in 1995 All properies Since 1991, max. LTV raio of 70% evolved as an indusry sandard PV<=HK$1mn PV>HK$1mn Index value in Oc 1997 = 100 PV<HK$0mn PV<HK$8mn PV<HK$1mn All properies PV>=HK$0mn HK$8mn <=PV< HK$1mn PV>=HK$1mn or non-owner occupied properies Price index for luxury properies (lhs) Max. LTV raio 4.0% % 70% 3.0% 60%.5% 50%.0% 1.5% 1.0% day delinquency raio (rhs) Price index for mass properies (lhs) 0.5% 0.0% Source: HKMA 6 Gerlach and Peng (005) conduc Granger causaliy ess for propery prices and bank lending in Hong Kong. They find ha propery prices Granger cause bank landing in Hong Kong bu no he oher way around.

6 - 6 - Phase 1: Before 1997 Prior o he adopion of he LTV policy in 1991, Auhorized Insiuions (AIs) 7 in Hong Kong were allowed o gran morgage loans up o 90% of he purchase price or he marke value of he propery (whichever amoun was he lower) under he Third Schedule of he Banking Ordinance, he legal framework for banking supervision in Hong Kong. In view of he poenial sysemic risk of RML, he Commissioner of Banking 8 inended o lower he 90% LTV raio hreshold o 70% in During a consulaion wih he banking indusry in 1991, banks offered o adop he 70% LTV policy volunarily. 9 The policy has since fully endorsed by he Hong Kong Governmen as a prudenial measure and evolved ino a banking indusry sandard inended o guard agains over-exposure o he propery marke. On November 1995, he Hong Kong Governmen confirmed a a Legislaive Council meeing ha he 70% LTV policy should adoped as a long-erm regulaory policy. Phase : From 1997 o 1999 Agains he backdrop of a sharp rise in residenial propery prices in 1996, signs of speculaive aciviies (paricularly a he upper end of he propery marke) and he rapid increase in RML 10, he HKMA issued guidelines o all AIs on 8 January 1997 recommending ha a maximum LTV raio of 60% be adoped for luxury properies wih a value of more han HK$1 million. In he wake of he Asian financial crisis, Hong Kong s propery prices fell significanly by more han 40% in he year from Sepember 1997 o Sepember Nowihsanding he sharp fall in propery prices, he subsequen morgage delinquency raio has never exceeded 1.43%, a low level by inernaional sandards. This fac alone suggess ha he LTV policy is effecive in reducing he credi risk ha banks face and assuring he qualiy of banks morgage loan porfolios. Phase 3: From 1999 o 008 Following a number of measures implemened by he Hong Kong Governmen inended o sabilise he propery marke, he earlier 60% LTV raio 7 AIs are insiuions auhorized under he Banking Ordinance o carry on he business of aking deposis. All AIs in Hong Kong are supervised by he HKMA. 8 The Office of he Commissioner of Banking was he bank supervisory auhoriy in Hong Kong before he esablishmen of he HKMA. The HKMA was esablished on 1 April 1993 by merging he Office of he Exchange Fund wih he Office of he Commissioner of Banking. 9 See he Commissioner of Banking (1991, 199). 10 Propery prices in Hong Kong increased by 30% in he one-year period from December 1995 o December RML also increased by 1% in he same period.

7 - 7 - guidelines for he purchase of luxury properies (wih a value of more han HK$1 million) were wihdrawn by he HKMA in Ocober 001. The maximum LTV raio of 70% was hen resored. A he same ime, he HKMA allowed AIs o refinance RML for homeowners in negaive equiy up o 100% of he curren marke value of he morgaged propery. Nowihsanding his relaxaion of he rules, he HKMA reieraed ha he 70% LTV policy remained generally appropriae as a long-erm prudenial measure. Because he sharp decline in propery prices afer he Asian financial crisis was also accompanied by a significan decline in household income, here were significan obsacles for perspecive homebuyers in he housing marke, which led o coninued calls for he relaxaion of he 70% LTV policy. In 1999, he Hong Kong Morgage Corporaion (HKMC) 11 launched an MIP aimed a promoing wider homeownership in Hong Kong. Under he MIP, morgage loans of up o 90% of he LTV raio are available for homebuyers who mee cerain eligibiliy crieria. 1 The MIP is designed o proec paricipaing banks from credi losses on he porion of loans over he hreshold of he 70% LTV raio in he even of defaul by morgagors. A he same ime, he MIP avoids he poenial drawback associaed wih he LTV policy: ha some homebuyers become unable o qualify for a morgage because of subsanial down paymens, even if hey could susain loan repaymen. Since he inroducion of he MIP, he coninued increase in he usage rae from 1999 o 009 has demonsraed ha he MIP has assised a significan number of homebuyers in overcoming liquidiy consrains (Figure ). The significan use of he MIP indicaes ha he concern abou liquidiy consrains imposed by LTV policy should no be lighly dismissed. Neverheless, o he exen ha such drawback exiss, he MIP in Hong Kong is shown o be effecive in assising homebuyers in overcoming he hurdle of requiring a subsanial down paymen for he purchase of properies wihou incurring addiional credi risk in he banking sysem. 11 The HKMC was esablished in 1997 and is owned by he Hong Kong Governmen. Is primary missions include he following: (1) o enhance he sabiliy of he banking secor by offering a reliable source of liquidiy, hereby reducing he concenraion and liquidiy risk of morgage lending by banks; () o promoe wider home ownership in Hong Kong; and (3) o faciliae he growh and developmen of he deb securiies and morgage-backed securiies markes in Hong Kong. 1 These include maximum deb-o-income raio, maximum loan amoun and maximum erm of mauriy a originaion.

8 - 8 - Figure. Annual drawn down loan amoun and usage rae of he MIP in Hong Kong HK$ mn 40,000 36,000 3,000 8,000 4,000 0,000 16,000 1,000 8,000 4, % Drawn Down Loan Amoun (HK$ mn,lhs) MIP Usage Rae (rhs) Source: HKMC Noe: The MIP usage rae is defined as he raio of he morgage loan amoun drawn down under he MIP o he oal morgage loan amoun drawn down in he Hong Kong banking secor. One policy concern relaed o he MIP is ha i may reduce he effeciveness of he LTV policy because i enables households o assume higher leverage raios, which will increase he risk of morgage defauls and keep banks a risk of a maximum credi loss of 70% of propery values. However, he lower delinquency raio of he HKMC s MIP porfolio as compared o ha of he Hong Kong banking secor 13 indicaes ha wih pruden underwriing crieria, he MIP has acually improved banking sabiliy and has no reduced he effeciveness of he LTV policy. Phase 4: Afer 008 As a resul of srong capial inflows and unusually low ineres raes amid unprecedened quaniaive easing by major cenral banks since early 009, propery prices in Hong Kong have increased sharply, paricularly in he upper end of he propery marke. As a prudenial measure, he HKMA issued guidelines in Ocober 009 requiring all AIs o reduce he maximum LTV raio for properies wih a value of HK$0 million or more from 70% o 60%. In Augus 010, o furher safeguard banking sabiliy and help banks manage credi risk more prudenially, he HKMA applied he maximum LTV raio of 60% o properies wih a value a or above HK$1 million and also lowered he maximum LTV raio for properies no inended o be occupied by he owners o 60%. 13 The delinquency raio of he HKMC s MIP porfolio reached a hisorical high of 0.39% a he end of Sepember 003, whereas he raio for he Hong Kong banking secor was 1.05%.

9 - 9 - To srenghen risk managemen in RML business in he banking secor, he HKMA implemened he following measures on 19 November 010: (1) i lowered he maximum LTV raio for properies wih a value a HK$1 million or above from 60% o 50%; () i lowered he maximum LTV raio for residenial properies wih a value a or above HK$8 million and below HK$1 million from 70% o 60%, bu he maximum loan amoun is capped a HK$6 million; (3) i mainained he maximum LTV raio for residenial properies wih a value below HK$8 million a 70%, bu he maximum loan amoun is capped a HK$4.8 million; and (4) i lowered he maximum LTV raio for all non-owner-occupied residenial properies, properies held by companies and indusrial and commercial properies o 50%, regardless of propery values. In addiion o he LTV policy, here were oher policies implemened in Hong Kong during ha period ha had similar macroprudenial elemens. These included maximum deb servicing raios 14 for morgages and maximum exposure o propery lending by AIs. The deails of he developmens in hese policies and of hose in LTV policy are summarised in Annex A. III. AN ECONOMETRIC ANALYSIS OF THE EFFECT OF LTV POLICY ON BANKING STABILITY Empirical specificaions This secion examines wo imporan issues in LTV policy using economeric analyses of panel daa from 13 economies. The economies include Ausralia, Canada, Greece, Hong Kong, and Korea, Malaysia, he Philippines, Porugal, Singapore, Spain, Thailand, he US and he UK. Two economeric models are specified. Model A is specified o examine he effeciveness of LTV policy by esimaing he responsiveness of morgage delinquency raios o changes in propery prices and o macroeconomic flucuaions for wo groups of economies (i.e., hose wih and wihou LTV policies), whereas Model B is used o examine wheher MIPs have reduced he effeciveness of LTV policy. Model A: LTV policy: The following fixed effecs model is used o examine he effeciveness of 14 The deb servicing raio is defined as monhly repaymen obligaions as a percenage of monhly income.

10 ΔMD = α + α ΔP 0 1 I LTV i + α ΔP I NLTV i + α ΔGDP 3 I LTV i + α ΔGDP 4 I NLTV i + (1) α DTGDP 5 + α ΔIn 6 + μ + ε i I I LTV NLTV is a dummy variable for economies wih (wihou) LTV policy. The specificaion assumes ha he change in he morgage delinquency raio ( Δ MD ) 15 for economy i a ime is correlaed wih he growh in real propery prices ( Δ P ) and real GDP growh ( Δ GDP ). The raio of aggregae morgage deb o GDP (DTGDP) and he change in he ineres rae ( Δ In ) are included o conrol for cross-counry differences in he aggregae level of household leverage and moneary condiions, respecively. 16 Unobservable economy-specific effecs and he remainder disurbance are capured by μ i and ε i (wih zero mean and consan varianceσ ), respecively. where i and index he economy and ime, respecively. ( ) ε We hypohesise ha LTV policy reduces he responsiveness of morgage defaul risk o changes in propery prices. This implies ha he esimaed coefficiens of Δ P I LTV and Δ P I NLTV (i.e., α 1 andα respecively) should be negaive, wih he absolue value of α 1 smaller han ha ofα. Similarly, we hypohesise ha morgage defaul risk for economies wih LTV policies is less responsive o macroeconomic flucuaions han hose wihou LTV policies. Therefore, negaive esimaes for α 3 andα 4 are expeced, wih he absolue value of he former smaller han ha of he laer. The sign of he esimaed coefficien of DTGDP (i.e., α 5 ) is expeced o be posiive; higher aggregae household leverage generally indicaes higher defaul risk when oher facors are kep consan. A posiive esimae of α 6 is expeced because a higher ineres rae implies a higher deb-servicing burden for morgagors. Model B: The second model examines wheher MIPs will reduce he effeciveness of LTV policy. The model is a modificaion of Model A wih an addiional dummy variable J i included. J i is defined as one if an MIP is in place and zero oherwise. The inclusion of he addiional dummy variable allows us o examine wheher he 15 Δ denoes he change operaor. Throughou his sudy, a change is measured in a quarer o quarer difference. 16 Oher insiuional facors such as recourse rules and personal bankrupcy regulaions are likely o affec morgage defauls. The effec of such facors on morgage delinquency raio is assumed o be capured by he fixed-effec coefficiens of he counries.

11 coefficien esimaes of he economies wih boh an LTV policy and an MIP are saisically differen from hose for economies wih only an LTV policy. The model is specified as follows: ΔMD = α + ( α + γ J ) ΔP ( α + γ J ) ΔGDP α DTGDP i 1 i + α ΔIn 6 I I LTV i LTV i + π + δ i + α ΔP + α ΔGDP 4 I NLTVi I + NLTV i + () where π i and δ i (wih zero mean and consan varianceσ ε ) capure economy-specific effecs and remainder disurbance, respecively. Noe ha here are wo new coefficiens, γ 1 and γ 3, in Model B as compared o Model A. γ 1 is he incremenal sensiiviy of he morgage delinquency raio o propery prices for economies wih boh LTV policy and MIPs relaive o he economies wih only LTV policy. Similarly, γ 3 measures he corresponding incremenal sensiiviy o macroeconomic flucuaions. The oher esimaed coefficiens can be inerpreed in exacly he same way as hose in Model A. Our core ineres is in he esimaed value and saisical significance of γ 1 and γ 3. A posiive and significan esimae of γ 1 ( γ 3 ) indicaes ha MIPs will increase he sensiiviy of he morgage delinquency raio o propery prices (macroeconomic flucuaions), suggesing ha MIP will reduce he effeciveness of LTV policy. Daa for esimaions and he esimaion mehod The esimaion sample consiss of unbalanced quarerly panel daa on he 13 economies covering he period 1991 Q1 010 Q. The main descripive saisics for he daa are shown in Table 1. Daa on he morgage delinquency raio are colleced from he respecive cenral banks 17,18, whereas daa on propery prices, GDP, governmen bond yields (which is used o proxy for ineres raes) and he GDP deflaor are aken from various daabases, including he Bank for Inernaional Selemens, CEIC and he Inernaional Moneary Fund (i.e., he Inernaional Financial Saisics). Real propery prices and real ineres raes are derived from he respecive nominal variables and he GDP deflaor The only excepion is he daa for he UK, which are obained from he Council of Morgage Lenders, a non-profi making organisaion for he morgage indusry in he UK. Morgage delinquency daa for he UK and Greece are available biannually and annually, respecively. Quarerly daa for hese wo counries are derived by inerpolaing he biannual/annual series. We verified ha he empirical resuls are no sensiive o he choice of he inerpolaion mehod.

12 - 1 - Of he 13 economies, four are idenified as having adoped an LTV policy (Hong Kong, Korea, Malaysia and Singapore) according o he Bank for Inernaional Selemens (010) and based on informaion obained from he respecive cenral banks/supervisory auhoriies. Hong Kong, Korea and Malaysia are furher idenified as having implemened an MIP. 19 Models A and B are esimaed using he generalised leas squares (GLS) mehod insead of he ordinary leas squares (OLS) mehod because in heory, GLS esimaes are more efficien han OLS esimaes given he panel srucure of he daa se The corresponding insiuions are he HKMC, he Korea Housing Finance Corporaion, Cagamas Berhad for Hong Kong, Korea and Malaysia. In Malaysia, Cagamas Berhad launched is MIP in In panel daa ses, variance in cross-secional unis may be significanly differen. The OLS esimaion is saisically inefficien and can give misleading inference when he variances in he daa are unequal.

13 Table 1. Descripive saisics for unbalanced panel daa for 13 economies Change in morgage delinquency raio (%) Real propery price growh (%) Deb o GDP (%) Real GDP growh (%) Change in real ineres raes (%) Period LTV MIP Economies Mean Sd dev Mean Sd dev Mean Sd dev Mean Sd dev Mean Sd dev Ausralia No No Canada No Yes Greece No No Hong Kong Yes Yes Korea Yes Yes Malaysia Yes Yes # Philippines No No Porugal No No Singapore Yes No Spain No No Thailand No No UK No No US No Yes All economies Noes: (1) Sd dev denoes sandard deviaion # Malaysia launched a MIP in 008

14 Esimaion resuls We firs discuss he esimaion resuls for Model A, which are summarised in Table. The esimaed sensiiviy of he morgage delinquency raio o propery prices for economies wih LTV policies (i.e., α 1 ) is negaive and lower (in absolue erm) han ha of economies wihou LTV policies (i.e., α ). A 1% drop in propery prices would increase he delinquency raio for economies wih LTV policies by 0.35 basis poins, whereas here would be an increase of 1.9 basis poins for economies wihou LTV policies. The saisical resuls of he Wald es indicae ha he null hypohesis of α 1 =α can be rejeced a he 10% significance level for Model A, suggesing ha LTV policy reduces he vulnerabiliy of banking sysems o propery price shocks. Morgage defaul risk for economies wih LTV policies is also esimaed o be less responsive o macroeconomic flucuaions (i.e., α 3 ) han hose wihou LTV policies (i.e., α 4 ). All oher hings being equal, a one percenage-poin decrease in GDP growh should increase he delinquency raio by 3 basis poins for economies wih LTV policies compared o 5.1 basis poins for hose wihou LTV policies. The saisical resuls for he Wald es, however, sugges ha he difference is no significan saisically. For Model B, he esimaion resuls are similar o hose of Model A. In addiion, he esimaed coefficiensγ 1 and γ 3 are found o be saisically insignifican, suggesing ha he MIP has no reduced he effeciveness of he LTV policy.

15 Table. Esimaion resuls for Model A (Equaion 1) and Model B (Equaion ) Dependen variable: Change in morgage delinquency raio ( Δ MD ) Model A Model B Consan ( α 0 ) ** ** Δ P wih LTV policy α ) * ** ( 1 wihou LTV policy ( α ) ** ** Incremenal effec of MIP ( γ 1 ) NA Δ GDP wih LTV policy ( α 3 ) ** * wihou LTV policy ( α 4 ) ** ** Incremenal effec of MIP ( γ 3 ) NA 0.08 DTGDP ( α 5 ) ** ** Δ In ( α 6 ) Adjused R-squared Null hypohesis for he Wald Tes Chi-square Saisics (P-value) Chi-square Saisics (P-value) α 1 = α α 3 = α * (0.065) (0.443) 4.971** (0.06) 0.00 (0.960) Noe: ** and * denoe he 5% and 10% levels of significance, respecively. A simulaion exercise To furher visualise he effec of LTV policy on banking sabiliy, we conduc he following simulaion exercise for Hong Kong s banking secor. In he simulaion, we assess relaxing he maximum 70% LTV policy on propery lending may affec he losses in he banking secor resuling from a severe propery price shock. Toward his end, we consider a hypoheical scenario in which he 70% LTV policy were o have been wihdrawn a some ime before We also assume ha all banks would aggressively exploi his change o expand heir business by exending morgage loans o cover 90% of propery value (i.e., an average of 90% of he LTV raio). We hen assume a 40% drop in real propery prices 1. Wih he assumed shock, we simulae he 1 The shock is comparable o ha occurred in Hong Kong for he period of Q Q

16 movemen of oher variables (i.e., GDP, ΔIn and DTGDP) based on heir hisorical relaionships. Togeher wih he esimaed coefficiensα, α 4, α5 andα 6 in Model A, we compue he overall impac of he shock on he delinquency raio. We repea he process 100,000 imes o generae a disribuion of he delinquency raio. For comparison, anoher disribuion ha assumes an iniial value of 70% of he LTV raio is also simulaed. The disribuion is simulaed based on he esimaed coefficiensα 1, α 3, α5 andα 6 in Model A. These wo simulaed disribuions are shown in Figure 3. I is found ha if he 70% guideline had been relaxed before 1997, he delinquency raio afer he 40% decline in propery price would have increased from 0.6% o 1.71% (a he 95% confidence level). In conras, wih he 70% LTV policy in place, he delinquency raio would only have increased moderaely o 1.11%. This resul is largely consisen wih he empirical finding by Wong e al. (004). Based on he amouns of RML and he oal capial in Hong Kong s banking secor in 1997, we compue he credi losses based on he simulaion resuls (Table 3). The calculaion of credi losses ake ino accoun he effec of he drop in propery prices on he loss-given-defaul. Based on he ail risk, i is found ha if relaxaion were o occur (see column LTV 90% ), he credi loss as a percenage of oal capial would be around 1.87% (a he 95% confidence level) as compared o a level of around 0.46% for he acual maximum LTV raio of 70%. Figure 3. Simulaed disribuion of he morgage delinquency raio for Hong Kong 9,000 8,000 7,000 6,000 Maximum LTV raio of 70% Maximum LTV raio of 90% Frequency 5,000 4,000 3,000,000 1, Morgage delinquency raio (%) Source: Auhors esimaes. We follow he simulaion mehod adoped by Wong e al. (008). The model consiss of a seemingly unrelaed regression for he growh rae of GDP, ineres rae and real propery prices. For he variable DTGDP, he value is simulaed based on he simulaed growh rae of GDP and an iniial value of 50% of DTGDP.

17 Table 3. Simulaed credi losses wih and wihou relaxaion of he maximum LTV policy Credi loss (HK$ mn) Credi loss (as % of oal capial) Credi loss (as % of ier-1 capial) Saisics LTV 70% LTV 90% LTV 70% LTV 90% LTV 70% LTV 90% Mean h percenile h percenile h percenile h percenile Noe: LTV 70% refers o he case of acual policy capping he maximum LTV raio a 70%, whereas LTV 90% refers o he hypoheical maximum LTV raio of 90% IV. An economeric analysis of he effec of LTV policy on propery marke aciviies This secion assesses he effeciveness of LTV policy as a ool for sabilising propery markes. Alhough LTV policy was shown in Secion III o be effecive in enhancing he resilience of he banking sysem o propery price shocks, i remains unclear wheher LTV policy may be an appropriae ool for sabilising propery marke aciviies. On an empirical level, he experience in Hong Kong, Korea and Singapore may shed ligh on his issue. Specifically, LTV caps in hese hree economies were ighened in pas periods when here was significan concern abou he risk of overheaing propery markes. By quanifying he immediae effec of he ighening LTV caps on propery marke aciviies, we can evaluae he effec of LTV policy on propery marke aciviies. For his purpose, he following generalised auoregressive condiional heeroskedasiciy (GARCH) model is specified: n B A 0 + CbDum + Ca Dum + C3IR + θ k k = 1 Y = C Y k + e p e ~ N(0, σ ) and σ = a0 + aie 1 + b jσ 1 (3) i= 1 q j= 1 where Y is an indicaor of propery marke aciviies such ha a higher Y indicaes a higher level of propery marke aciviies. The model assumes ha he condiional mean of Y follows an auoregressive process wih a maximum lag of n: i.e., AR(n). 3 Dum is B 3 In he lieraure, using GARCH models o analyse he impac of policy inervenions is common, paricularly for exchange rae policy inervenions. Earlier work includes Baillie and Oserberg (1997), and Hillebrand and Schnabland (003). In general, including a dummy variable or a wo-period esimaion mehod can help o idenify he effec of policy acions on he financial variables concerned. Recen work such as Baba and Packer (009), Baba and Shim (010), Fung and Yu (009), and Genberg and Hui (011) also specifies he models used in a similar fashion.

18 defined as one for observaions wihin he six-monh period righ before he ighening LTV caps and zero oherwise, whereas Dum is defined as one for observaions wihin he A six-monh period righ afer he ighening LTV caps and zero oherwise. The change in real ineres raes (IR) is included o conrol for differences in moneary condiions. The error erm e is assumed o follow a condiional normal disribuion wih zero mean and ime varying varianceσ. If he ighening LTV caps reduced propery marke aciviies, he esimaed coefficienca should be significanly smaller han he esimaed coefficiencb given ha a highery indicaes a higher level of propery marke aciviy. The saisical significance of he difference beweenc andc can be examined using he Wald es. b a Three propery marke indicaors are seleced in his sudy. They are (i) he real propery price growh, ; (ii) he deviaion of acual propery prices from he P Y rend value 4 HP as a percenage of he acual level of propery prices, Y 5 ; and (iii) he number of propery ransacions (in logarihmic form), Y V. In addiion, we also evaluae he impac of ighening he maximum LTV raios on household morgage deb Lev leverage, which is defined as he raio of morgage loans o GDP, Y. Quarerly ime series Y for Hong Kong, Korea and Singapore are used for he esimaions. These daa are mainly from he panel daa used in Secion III. The sample period for he economies is presened in Table 4 along wih he saisical resuls of he augmened Dickey-Fuller (ADF) es fory and he definiion of he dummy variables P B Dum and A Dum for he economies. Overall, he ADF ess indicae hay andy Lev are non-saionary ime series, and herefore, he firs-difference form is HP used in esimaing equaion (3). In conras, Y andy V are saionary ime series, and hus he level form is used. In esimaions, he order of he GARCH model (i.e., n, p and q) is deermined using he sample auocorrelaion funcion and he sample parial auocorrelaion funcion ofy, e and e. The esimaed model is furher diagnosed by checking he Ljung-Box Q saisics e and e. 4 The rend level is derived using he Hodrick-Presco filer. 5 HP Y is a commonly used indicaor of propery price bubbles.

19 Table 4. Augmened Dickey-Fuller (ADF) uni roo es resuls of propery marke indicaors and definiions of Dum A and Dum B Hong Kong Singapore Korea Dependen variable Level Firs Diff Level Firs Diff Level Firs Diff Real propery price (Y P ) * * * Gap beween propery price and is HP filered rend (Y HP ) -5.34* -6.71* -4.94* -6.95* -4.61* -9.75* Transacion volume (in log, Y V ) -.86* -8.03* -3.69* -9.65* -3.56* -3.31* Raio of morgage loan o GDP level (Y Lev ) * * * Sample period (198 Q1 010 Q) (1981 Q1 010 Q) (1987 Q1 010 Q) Periods wih Dum = 1 B 1991 Q 1991 Q Q Q4 009 Q 009 Q Q Q4 009 Q3 009 Q4 00 Q1 00 Q 009 Q 009 Q3 Periods wih Dum = 1 A 1991 Q4 199 Q Q Q 009 Q4 010 Q Q Q 010 Q1 010 Q 00 Q3 00 Q4 009 Q4 010 Q1 Noes: - * denoes he 10% level of significance. The criical value a he 10% level of he ADF es is The lag lengh of he ADF es is deermined by he Schwarz informaion crierion. Panels A o C in Table 5 repor he esimaion resuls for Hong Kong, Korea and Singapore, respecively. The main findings are summarised as follows: (1) Empirical evidence ha ighening LTV caps would have a significan dampening effec on real propery price growh (measured byy ) is mixed across he economies. Whereas he coefficien of A Dum P (i.e., C a ) is esimaed o be smaller han ha of Dum (i.e., C b ) for he hree economies, he saisical resuls of he Wald es indicae ha he null hypohesis of C a = C b can be rejeced a he 1% significance level only for he case of Hong Kong. () Saisically, here is no clear evidence ha ighening LTV caps would lead o a lower propery price gap ( Y ). C a is esimaed o be lower han C b HP for Hong Kong and Korea, whereas C a is esimaed o be larger han C b for Singapore. Neverheless, he null hypohesis of C a = C b canno be rejeced for all of he economies, suggesing ha he mean levels ofy B HP in he six-monh periods before and afer he ighening of he LTV caps are no saisically differen. Similar empirical resuls are found when propery ransacions ( Y V ) are considered.

20 - 0 - (3) We find srong empirical evidence ha a higher LTV cap will lead o a lower level of morgage deb leverage (measured byy ). C a is esimaed o be lower han C b for all he hree economies wheny Lev Lev is used as he dependen variable. The null hypohesis of C a = C b can be rejeced a he 1% significance level for Hong Kong and Korea and a he 5% significance level for Singapore. (4) Overall, alhough here is clear empirical evidence ha ighening LTV caps will reduce household leverage, evidence ha ighening LTV caps will lead o a lower level of propery marke aciviies is mixed across he economies. These findings sugges ha he effec of LTV policy on sysemic risk may be primarily ransmied hrough effecs on he household secor leverage, wih he propery marke playing a minor role.

21 - 1 - Table 5. Esimaion resuls on he impac of ighening LTV caps on propery marke aciviies (Equaion 3) Economy Coefficien of Real propery price growh (Y P ) Dependen variable Gap beween price and rend (Y HP ) Transacion volume (Y V ) Morgage loans o GDP (Y Lev ) Panel A: Condiional mean equaion Hong Consan (C 0 ) ** 3.47** Kong Dum (C b ) 7.94** 4.30** 0.41** ** B A Dum (C a ) * IR (C 3 ) -0.59* * Condiional variance parameer Consan (a 0 ) e (a 1 ) 0.19** σ (b 1 ) 0.54** 0.86* ** Adjused R-squared Wald es for C b =C a (P-value) Panel B: Condiional mean equaion Singapore Consan (C 0 ) ** ** Dum (C b ) 5.16*.7** 0.3* ** B A Dum (C a ) 1.79** 3.1** 0.35** IR (C 3 ) * Condiional variance parameer Consan (a 0 ).55** e (a 1 ) e (a ) 0.63** σ (b 1 ) ** 1 σ (b ) Adjused R-squared Wald es for C b =C a (P-value) Panel C: Condiional mean equaion Korea Consan (C 0 ) ** Dum (C b ) ** B A Dum (C a ) ** IR (C 3 ) ** Adjused R-squared Wald es for C b =C a (P-value) Noes: - ** and * denoe he 5% and 10% levels of significance, respecively. - All p-values for he Ljung-Box es for adequacy in mean and variance equaions are larger han 10%, suggesing ha all models are adequae a an reasonable confidence level. - Esimaes for he lag erms for Y are no repored in his able. - For panel C, all ime series are found o be homoscedasic, so a simple AR model insead of a GARCH model is adoped as he final model.

22 - - V. CONCLUSION Some key issues relaed o he use of maximum LTV raios as a macroprudenial ool, including heir effeciveness and poenial drawbacks, are assessed in his paper. Boh Hong Kong s experience and empirical findings of he panel-daa economeric analyses sugges ha LTV policy is effecive in reducing sysemic risk arising from he boom-and-bus cycle of propery markes. However, he significan usage of he morgage insurance programme (MIP) in Hong Kong indicaes ha he liquidiy consrains generaed by he LTV policy may be maerial. Neverheless, empirical evidence shows ha MIPs can miigae his drawback wihou undermining he effeciveness of he ool. This finding indicaes he imporan role of MIPs in enhancing he ne benefis of LTV policy. More imporanly, poenial liquidiy consrains on homebuyers generaed by LTV policy should no be seen as a srong reason for no adoping an LTV policy o conain he sysemic risk associaed wih propery price shocks. This sudy also conribues o recen discussions of he role of LTV policy and paricularly of wheher i should be used o sabilise propery marke aciviies and address concerns regarding propery price bubbles. The empirical findings based on daa from he hree economies ha have adoped heir LTV policies sugges ha alhough here is srong evidence ha ighening LTV caps in general would reduce household leverage, evidence ha ighening LTV caps will have significan dampening effecs on propery marke aciviies is mixed across he economies. These findings sugges ha he effec of LTV policy on sysemic risk is ransmied mainly hrough impacs on he household secor raher han on propery marke aciviies.

23 - 3 - REFERENCES Baba, N., and I. Shim, 010, Policy responses o dislocaions in he FX swap marke: he experience of Korea, BIS Quarerly Review, June 010. Baba, N., and F. Packer, 009, Inerpreing deviaions from covered ineres pariy during he financial marke urmoil of , Journal of Banking and Finance, 33, Baillie, R.T., and W.P. Oserberg, 1997, Cenral bank inervenion and risk in he forward marke, Journal of Inernaional Economics, 43, Bank of England, 009, The role of macroprudenial policy: a discussion paper, available a hp:// Bank for Inernaional Selemens, 010, 80h Annual Repor. Caruana, J., 010, Sysemic risk: how o deal wih i?, Bank for Inernaional Selemens, available a hp:// Commissioner of Banking, Annual Repor, Hong Kong. Commissioner of Banking, 199. Annual Repor, Hong Kong. European Cenral Bank, 010, The role of macro-prudenial oversigh and moneary policy, available a: hp:// Financial Services Auhoriy, 009, Morgage marke review, Discussion Paper of he Financial Services Auhoriy in he UK DP09/03. Financial Supervisory Auhoriy of Norway, 010, Reningslinjer for forsvarlig ulånspraksis for lån il boligformål (Guidelines for pruden lending pracices for housing loans). Fung, L.F., and I.W., Yu, 009, Dislocaions in FX swaps and money markes in Hong Kong and policy acions during he financial crisis of 008, Hong Kong Moneary Auhoriy Working Paper 17/009. Genberg, H. and C.H. Hu 011, The crediabiliy of Hong Kong s Link from he perspecive of modern financial heory, Journal of Money, Credi and Banking, 43, Gerlach, S. and W. Peng, 005, Bank lending and propery prices in Hong Kong, Journal of Banking and Finance, 9, Hillebrand, E. T., and G. Schnabl, 003, The Effecs of Japanese Foreign Exchange Inervenion GARCH Esimaion and Change Poin Deecion, Japan Bank for Inernaional Corporaion Insiue Working Paper No. 6.

24 - 4 - Inernaional Moneary Fund, 010, Macro-prudenial policies an Asian perspecive, available a: hp:// Magyar Nemzei Bank, 010, Repor on financial sabiliy, April 010 issue. Swedish Financial Supervisory Auhoriy, 010, Morgages capped a 85 percen as of 1 Ocober, available a: hp:// -percen-as-of-1-ocober/?mode=prin Swiss Naional Bank, 010, A changing role for cenral banks?, available a: hp:// Wong, J., K. F. Cho and P. W. Fong, 008, A framework for sress-esing banks credi risk Journal of Risk Model Validaion, (1), 3-3. Wong, J., L. Fung, P. W. Fong, A. Sze, 004, Residenial morgage risk and loan-o-value raio Hong Kong Moneary Auhoriy, Quarerly Bullein, December 004.

25 - 5 - Annex A: Summary of he hisory of he LTV policy in Hong Kong Year Before 1991 Major developmens "Residenial morgage" was defined in he Third Schedule of he Banking Ordinance as a morgage where, among oher hings, "he principal sum does no exceed 90% of he purchase price or he marke value of he propery, whichever amoun is he lower" The maximum LTV raio of 70% was adoped by he banking indusry in November 1991 and has since been fully endorsed by he Commissioner of Banking as a pruden measure adoped by banks agains over-exposure o he propery marke. Source: hp:// A 40% guideline for propery lending was inroduced a he beginning of 1994 when propery lending was rising rapidly. I advised ha AIs whose propery exposure as a percenage of loans for use in Hong Kong was above he average for he indusry as a whole (abou 40%) should seek o sabilise or reduce ha percenage. Source: hp:// The Governmen confirmed a a Legislaive Council meeing ha he 70% LTV raio should be adoped as a long-erm regulaory policy. Source: hp:// The HKMA recommended ha a maximum LTV of 60% should be adoped for luxury propery wih a value of more han HK$1 million. Source:hp:// All AIs were required o have a clearly defined and documened policy o assess he repaymen capabiliy of residenial morgage borrowers. This should include he use of a deb servicing raio (DSR) es. The DSR is defined as he monhly repaymen obligaions of he borrower as a percenage of monhly income. The raio should be no higher han 50-60% of income, hough he upper end of his range should be confined o higher income earners. Source:hp:// The "40% guideline" for propery lending on he propery exposure of auhorized insiuions in Hong Kong was wihdrawn. Source: hp://

26 - 6 - Year Major developmens 001 While he 70% LTV guideline remained generally appropriae as a long-erm prudenial measure, and coninued o apply o new RMLs, he HKMA did no objec if AIs ha judge i commercially desirable o do so choose o depar from he 70% LTV guideline in he case of refinancing RMLs in negaive equiy. However, such loans should no exceed 100% of he curren marke value of he morgaged propery. The 60% LTV guideline for he purchase of "luxury" propery (wih a value of more han $1 million) had been wihdrawn. The maximum LTV raio for such loans was resored o 70%. Source: hp:// Oc 009 Aug 010 Nov 010 All AIs were required o reduce he maximum LTV raio for properies wih a value of HK$0 million or more from 70% o 60%. Source:hp:// The HKMA furher implemened a se of prudenial measures for RML: 1. Applying a maximum LTV raio of 60% o properies wih a value a or above $1 million. For properies valued below $1 million, he 70% LTV guideline coninued o apply, bu he maximum loan amoun will be capped a $7. million;. Lowering he maximum LTV raio for properies which are no inended o be occupied by he owners o 60%. Banks should require morgage applicans o declare wheher hey inend o occupy he morgaged propery; and 3. Sandardising he limi on DSRs of morgage applicans o 50%, insead of he curren range of 50% o 60%. In addiion, banks should sress-es morgage applicans' repaymen abiliy, assuming an increase in morgage raes of a leas wo percenage poins, and limi he sressed DSR o a cap of 60%. Source: hp:// To srenghen risk managemen in RML business of he banking secor, he HKMA implemened he following measure: 1. Lowering he maximum LTV raio for properies wih a value a HK$1 million or above from 60% o 50%;. Lowering he maximum LTV raio for residenial properies wih a value a or above HK$8 million and below HK$1 million from 70% o 60%, bu he maximum loan amoun is capped a HK$6 million; 3. Mainaining he maximum LTV raio for residenial properies wih a value below HK$8 million a 70%, bu he maximum loan amoun is capped a HK$4.8 million; and 4. Lowering he maximum LTV raio for all non-owner-occupied residenial properies, properies held by a company and indusrial and commercial properies o 50%, regardless of propery values. Source: hp://