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Or, build more houses

14 January 2016
Richard Kemmish

House prices went up by 10% in Sweden last year. This is the most, but by no means the only extreme price move in Europe. Whereas we might remember similar price rises in previous bubbles (I’m British so have plenty of experience of those) they were usually in the days when there was general price inflation. A 10% increase in house prices when the prices for every thing else is more or less static is truly extreme. 

The two main causes of the problem are obvious enough: demographics are a constant source of increased demand, whereas Europe’s population might be stable in terms of total numbers we increasingly want to live in the same places as each other: Copenhagen, Stockholm and, inexplicably, London and in smaller family units.

The ECB’s interest rate policy (and therefore by necessity the interest rate policies of nearby central banks) is the other big driver of house price appreciation. It did slightly annoy me recently when the ECB (in their financial stability review) suggested that excessive house price inflation was an unintended consequence of their monetary policy. Abnormal changes in market prices are the point of the policy, not an unintended consequence of it.

Setting aside for now the two obvious drivers of house price appreciation I think there is insufficient attention paid to two other factors: housing policy and regulation of the banking system. Fiscal incentives to becoming a home owner as an instrument of housing policy I’ll leave to another time. But banking policy has a very complex relationship with house prices and this really is an unintended consequence.

Many banking regulators have introduced measures to reduce both mortgage lending and its riskiness – loan to value, debt service and loan to income ratios have all been subject to restrictions in an effort to contain the problem.

But whilst the vast increase in regulatory capital requirements for banks in recent years has shown that systemic stability is a more important policy outcome than lending to the real economy, the pressure on banks to lend more – including financial incentives to do so - has shown exactly the opposite. Inevitably this has pushed banks to hit their ‘increased lending’ targets in the way which uses least regulatory capital.

Needless to say that is not lending to, say, small and medium sized enterprises as policy makers would prefer.

Looking at the risk weights of residential mortgages on bank balance sheets, particularly those banks who are allowed to use their own internal models to determine capital needs, they are clearly too low. Too low for the riskiness of the asset class in a ‘10% per year increase’ scenario. Too low for the desired policy outcome of lending to SMEs rather than stoking up house prices.

An increase in the risk weight of residential mortgages and restrictions on those capital markets instruments which attempt to arbitrage the risk weight rules might be unpopular but they will surely be effective in achieving the desired policy outcome.

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