The key chart
The key message
In its latest “Financial Stability Review” (November 2021), the ECB calls for a policy shift away from short term support measures towards “mitigating risks from higher medium term financial stability vulnerabilities, in particular emerging cyclical and real estate risks.”
This is a welcome development given the extent to which (unorthodox) policy measures have fuelled growth in the “wrong type of lending” to date, and the negative implications this has for future growth, leverage, financial stability and income inequality.
Macroprudential instruments include capital measures (e.g. higher risk weights) and borrower-based measures (e.g. LTV limits). Their adoption varies across the euro area currently, with six economies adopting a combination of both instruments, nine economies adopting borrower-based measures alone, and four economies having no measures in place (Germany, Spain, Italy and Greece).
Further tightening of existing instruments may be required in several economies where RRE vulnerabilities are continuing to build up, but Germany stands out given current house price and lending dynamics, the extent of RRE overvaluation and the absence of targeted macroprudential measures.
“Enough is enough”
Over the past two years, I have been highlighting the hidden risk that unorthodox monetary policies in the euro area (and elsewhere) were fuelling growth in the “wrong type of lending”. From this, I have argued that the resulting shift from productive COCO-based lending towards less-productive FIRE-based lending (see chart below) has negative implications for leverage, growth, financial stability and income inequality in the future.
Earlier this month, I also argued that it was appropriate, therefore, to expect new macroprudential measures for residential real estate soon. The ECB agrees (finally). In their latest “Financial Stability Review” (November 2021), the ECB is calling for a policy shift away from short-term support towards mitigating risks from higher medium-term financial stability vulnerabilities including residential real estate (RRE) risks.
The ECB’s analysis includes three key risk factors:
- First, nominal house prices grew at 7.3% in 2Q21, the fastest rate of growth since 2005 (see key chart above)
- Second, house price and lending dynamics have been much stronger in many countries with pre-existing vulnerabilities. For example, despite above average degrees of over-valuation pre-pandemic (ie, >4% estimated overvaluation), RRE prices grew at above-average rates (ie, >7% YoY) in Luxembourg, the Netherlands, Austria, Germany, and Belgium in the year to end 2Q21 (see chart above)
- Third, there is evidence of a progressive deterioration in lending standards, as reflected in the increasing share of loans with high LTV ratios. The share of new loans with LTVs above 90% reached 52% in 2020 compared with only 32% in 2016 (see chart below)
The ECB also notes “high and rising levels of HH indebtedness”, but this is less of a risk, in my opinion, given that the HH debt ratio of 61% GDP is well below the BIS’ threshold of 85% GDP.
Macroprudential instruments include capital measures (eg higher risk weights) and borrower-based measures (eg, LTV limits). Their adoption varies across the euro area with six economies adopting a combination of both instruments (green bubbles in chart below), nine economies adopting only borrower-based measures (orange bubbles in chart below), and four economies having no measures in place – Germany, Spain, Italy and Greece (red bubbles in chart below, although Greece not shown).
Further tightening of existing instruments may be required in several economies where RRE vulnerabilities are continuing to build up, but Germany stands out given the combination of house price and lending dynamics, the extent of overvaluation and the lack of macroprudential measures.
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.