Macro prudential instruments for the German mortgage market

It is without question that regulations are necessary in the banking system, but regulators should be more patient and analyse the outcome of regulations in greater detail, says the IW Institute's real estate expert Michael Voigtländer in a guest commentary for Market Insights & Updates.

When it comes to banks, nowadays most voters and politicians predominantly think of the financial crisis. Thus, the main goal is to make banks more robust to prevent taxpayers from once again having the obligation of bailing-out banks from financial misery. Seemingly without alternative, more and more waves of regulation have emerged since 2008. Most important is the Capital Requirements Directive (CRD) IV, which sets rules to enforce more capital and which demands better liquidity management. Moreover, the Mortgage Credit Directive (MCD) has been implemented which sets incentives for more prudential lending by protecting borrowers from "irresponsible lending". Also, banks are for example affected by Solvency II and they have to pay special taxes as a consequence of the financial crisis. In Germany, the introduction of macro prudential instruments for mortgage lending is planned.

Until now the effects of all regulation projects are still uncertain. Most new rules are still in a period of introduction and although, in most cases, each rule can be justified, the outcome in practice is insecure. Especially, no one can estimate the outcome of the interplay of regulations as the financial system is very complex and innovative. As the robustness of banks is the focus, the logical view seems to be more regulations will result in more financially sound banks. However, banks play a very important role in promoting investment and growth in a country. Lending money to households and entrepreneurs is not only a means to make profits, but it is a necessity for modern economies to prosper. Therefore, there has to be a balance between the robustness of banks and their ability to lend. Unfortunately, this balance seems to be uneven and the newly planned macro prudential rules for mortgage lending are an example here.

According to the planned new legislation, banking supervision will be enabled to cap the loan-to-value ratio, debt-to-income ratio and debt-service-to-income ratio. Also, requirements for amortisation can be enforced. Such rules are used in a number of countries, like in the UK. However, Germany is a special market with a traditional prudential lending culture. In order to assess the impact on households, the Cologne Institute for Economic Research has analysed the Household Finance and Consumption survey provided by the European Central Banks. The analysis shows that in Germany, more households than expected have LTVs above 90 percent, but that these are predominantly households with higher wealth Macro Prudential Instruments for the German Mortgage Market and higher incomes. Hence, the probability of credit defaults is low since high income groups are less often affected by over-indebtedness. What is more, most households have low debt-service-to-income (DSTI) ratios, 75 percent of all households with a mortgage have a ratio of less than 19 percent. In France, the corresponding value is 24 percent, in Spain it is 30 percent. The median DSTI for Germany is only 12 percent while it is 18 percent for France or 20 percent for Spain (see chart). In addition, only 1 percent ofall households with mortgages have an LTV of more than 90 percent and a DSTI of more than 30 percent. Thus, risks for the financial system seem manageable.

While the contribution of caps on mortgages on financial robustness seem minor, the effects on banks and customers are significant. First of all, such caps are a strong intervention in the principle of contractual freedom, which is an important device in a market economy. Households with less capital but high incomes are restrained from buying homes. Because of ultra-low mortgage rates, purchasing homes is superior to renting for almost all regions and cities, but with even more restrictions on lending only a small number of households can benefit from this advantage. At least, a good justification is needed for such a form of intervention. Secondly, restrictions on lending pose an additional burden on banks’ profits given that low interest rate revenues on lending are small and mortgages are one of the more profitable business cases. Especially by demanding risk premia for higher LTV, the profitability increases. Of course, risks should be manageable, but the data proves that in most cases only households which are able to take higher LTVs have received such loans. By capping LTVs for all customers, banks are not only disempowered with regards to risk assessment, they also lose a source of profits. In this context it should be emphasized that profits do not only serve the interests of shareholders but are needed to build up the capital required under CRD IV. The Deutsche Bundesbank is worried about the profitability of German banks as this is the main source of building up capital. Consequently, the macro prudential instruments might even counteract the aim of financial robustness.

Finally, Germany has had a high current account surplus over a long period of time. German households save a lot of money which is not invested in Germany. As a consequence, other European countries are lenders, which results in more imbalances in the Eurozone. Hence, regulations which hinder domestic investment spur further imbalances.

It is without question that regulations are necessary in the banking system, but regulators should be more patient and analyse the outcome of regulations in greater detail. Before introducing even more rules, the effects of CRD IV or the MCD should be assessed. Hence, now is not the time to introduce macro prudential instruments for the German mortgage market.