Managing Housing Market Risks in the United Kingdom

IMF Blog, July 28, 2014

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House prices are rising rapidly in the UK at an annual rate of 10.5 percent.
House price inflation is particularly high in London (20 percent per year), and it is gradually accelerating in the rest of the country.
The current UK housing cycle raises two important questions: What is driving the rise in house prices? And how should macroeconomic policies respond?
Macroeconomic policies should tackle two crucial issues in the housing market: (i) mitigating systemic financial risks during upswings in house prices and leverage; and (ii) encouraging an adequate supply of housing in order to safeguard affordability.

The current cycle differs from past UK episodes: aggregate mortgage credit growth has been relatively weak (only 1 percent over the past year), as has gross disposable income (0.5 percent growth in 2013), yet house prices have been steadily increasing.
Accelerating prices are explained in large part by a structural undersupply of housing in areas where demand is high, compounded by pent-up demand as credit conditions ease and consumer confidence returns.
Some households are taking larger loans relative to their incomes; the increase in the number of high loan-to-income (LTI) mortgages is more pronounced in London and among first-time buyers.
An increasing number of households are vulnerable to negative income and interest rate shocks.

UK authorities have strengthened banks’ buffers against housing market exposures by:
- applying more stringent mortgage risk weights;
- increasing the provisioning of forborne retail mortgages.
Underwriting standards have been tightened, for example by verifying the income of new borrowers.
The Funding for Lending Scheme was refocused toward business by making household lending no longer eligible for borrowing allowances.
The government has recommended a cap on mortgages with high loan-to-income ratios, while allowing lenders flexibility to allocate the risk of their mortgage portfolios.
The 2014 UK Article IV Staff Report finds that caps on debt-to-income (DTI) and on loan-to-value (LTV) ratios are potent tools to dampen mortgage credit growth and to mitigate financial stability risks; their effectiveness is enhanced when used simultaneously with additional macroprudential measures.
Countries tend to implement macroprudential policies gradually, possibly due to uncertainty of the transmission mechanism of those policies.
If macroprudential measures prove insufficient, the Bank of England might consider an interest rate hike to tighten financial conditions, weighing immediate costs in terms of growth and employment against the effects of increased financial risks associated with the housing market.

Recent trends in house prices ultimately reflect an imbalance between demand and supply: demand—measured by the volume of transactions—has recovered to pre-crisis levels, while housing supply—measured by housing completions per capita—is lagging.
Micro- and macro-prudential policies can affect the demand for housing but will not influence housing supply and consequently affordability in the medium and long term.
Recent reforms in the planning system are contributing to a gradual increase in house building from recession lows, but more is needed to remove unnecessary constraints and regulations on development.
Further reforms to the tax system could:
- encourage a more efficient use of land;
- provide economic incentives to local councils to grant more building permits, for instance by better linking local fiscal revenues with the development of local projects.
It is crucial to further develop the private rental market sector in the UK, which currently accounts for approximately 16.5 percent of households.

Financial authorities have employed new measures to control potential financial risks arising from the housing market.
To ensure long-run affordability and address financial stability risks, more will likely be needed on the supply side in addition to demand-side and macroprudential measures.
Ultimately, enabling more housing where needed will require political and social consensus.

Source: Managing Housing Market Risks in the United Kingdom (IMF blog post, Ruy Lama, July 28, 2014).