Withdrawal of the FPC's affordability test Recommendation

Overview

1. The Financial Policy Committee (‘the FPC’ or ‘the Committee’) introduced two Recommendations in 2014 to guard against a loosening in mortgage underwriting standards which could lead to a material increase in aggregate household debt and the number of highly indebted households: the ‘LTI flow limit’ which limits the number of mortgages that can be extended at loan to income (LTI) ratios at or greater than 4.5; and the ‘affordability test’ which specifies a stress interest rate for lenders when assessing prospective borrowers’ ability to repay a mortgage.

2. The FPC reviews these Recommendations regularly, and in its latest review the Committee concluded that the Recommendations continue to guard against a loosening in underwriting standards and a material increase in household indebtedness, which could amplify an economic downturn and increase financial stability risks.

3. But the FPC noted some concerns with how the affordability test has operated. In particular, the stress rate encapsulated in the test has remained broadly static, reflecting stickiness in reversion rates despite the fall in average quoted mortgage rates. This demonstrates that there is considerable uncertainty about how the stress rate encapsulated in the affordability test might move in future, and in turn about the effect the test could have.

4. The FPC also examined the potential effect of both Recommendations in a scenario of rapidly rising house prices, where, absent policy measures, the risks from excessive household indebtedness would increase sharply. When comparing the effect of each Recommendation in isolation, the FPC’s analysis suggests the LTI flow limit is likely to play a stronger role than the affordability test in guarding against an increase in aggregate household indebtedness and the number of highly indebted households when house prices rise rapidly, and that the additional insurance provided by the affordability test would be small.

5. Reflecting these factors, the FPC judges that, on current evidence, the LTI flow limit, without the FPC’s affordability test Recommendation, but alongside the wider assessment of affordability required by the Financial Conduct Authority’s (FCA’s) Mortgage Conduct of Business (MCOB) responsible lending rules,^{footnote [1]} ought to deliver an appropriate level of resilience to the UK financial system, but in a simpler, more predictable and more proportionate way.

6. The FPC has therefore decided to maintain the LTI flow limit Recommendation, but has decided to consult on withdrawing its affordability test Recommendation.

7. The subject of this consultation is the FPC’s proposal to withdraw its affordability test Recommendation. The FPC published its full conclusions from the latest review of its mortgage market Recommendations in the December 2021 Financial Stability Report (FSR) and the accompanying Technical annex, including analysis of trends in the UK housing market and of the role that the FPC’s measures may have played in shaping the overall market and particular segments.

8. Irrespective of the outcome of this consultation, the FPC will continue to monitor risks related to household indebtedness and the mortgage market. The FPC is also ready to act in future if these risks were to build in a way that could adversely impact UK financial stability, and would consider recalibrating existing measures or introducing new measures to manage these risks.

Responses and next steps

9. All responses should be emailed to FPCMortgageMarketConsultation@bankofengland.co.uk.

10. By responding to this consultation, you provide personal data to the Bank of England. This may include your name, contact details (including, if provided, details of the organisation you work for), and opinions or details offered in the response itself. The response will be assessed to inform our work as a regulator and central bank, both in the public interest and in the exercise of our official authority. We may use your details to contact you to clarify any aspects of your response. Where respondents provide a response which includes information to be treated as confidential, they should clearly indicate the information provided which should be treated as such. If a request for disclosure is subsequently received, in accordance with access to information regimes under the Freedom of Information Act 2000 or the Data Protection Act 1998, respondents’ indications will be taken into account, but no assurance can be given that confidentiality can be maintained in all circumstances. An automatic confidentiality disclaimer generated by a respondent’s IT system on emails will not, of itself, be treated as constituting notice that the respondent regards any information supplied as confidential.

11. The consultation will close on 6 May 2022. In the event of deciding to withdraw its affordability test, the FPC would expect to formally withdraw its Recommendation within 12 months of making the decision.

12. The FPC intends to provide its summary of and response to feedback received during this consultation later in 2022. This response will include a summary of responses to this consultation but will not identify any individual respondents nor include any information that could be connected or attributed to an individual respondent.

Background

Rationale for the FPC’s mortgage market measures

13. The mortgage market can be a source of risk to the UK financial system and the economy. The FPC has identified two channels through which build-ups of excessive mortgage debt, such as those typically coinciding with periods of rapid house price growth, have historically been a source of risk to UK financial stability and the broader economy:

• The borrower resilience channel – in an economic downturn, the evidence from previous recessions is that highly indebted households are more likely to cut spending sharply. In the past, this has amplified downturns, increasing the risk of losses to lenders on all forms of lending and reducing incomes throughout the economy.
• The lender resilience channel – highly indebted households are more likely to face difficulties making repayments on mortgage and other consumer debt during a downturn. This can lead to losses for lenders and test their resilience.

14. Risks could be exacerbated when house prices fall during a downturn. Highly indebted borrowers are less likely to be able to borrow against the value of their house to support consumption if it has decreased in value. And if borrowers do default on their mortgages during a downturn, banks are likely to recover a smaller proportion of the outstanding loan from selling the property used to collateralise the mortgage.

15. The FPC introduced two Recommendations in 2014 to guard against the risks associated with aggregate household indebtedness and the number of highly indebted households:

• The LTI flow limit, which limits the number of mortgages that can be extended at LTI ratios at or above 4.5 to 15% of a lender’s new mortgage lending.
• The affordability test, which builds on the FCA’s MCOB framework and specifies a stress interest rate for lenders when assessing prospective borrowers’ ability to repay a mortgage.

16. The LTI flow limit and the affordability test (collectively ‘the measures’) primarily target the borrower resilience channel by helping to guard against a deterioration in underwriting standards which could lead to a significant increase in aggregate household indebtedness and the number of more highly indebted households, especially when house prices are growing rapidly.

17. By reducing aggregate household indebtedness and the share of highly indebted households, the measures can also help to reduce the proportion of borrowers who face repayment difficulties on their mortgages during a stress, partially helping to mitigate risks to lender resilience. As such, they are a complement to a range of other measures including the capital framework for banks and the Bank’s stress-testing framework.

Rationale for withdrawing the affordability test Recommendation

18. Since 2014, the FPC has been able to learn how the measures have operated in practice and has benefited from new analysis and an expanding evidence base. The FPC has noted some concerns with how the affordability test has operated. In particular, the stress rate encapsulated in the test has remained broadly static reflecting stickiness in reversion rates despite the fall in average quoted mortgage rates. This demonstrates that there is considerable uncertainty about how the stress rate encapsulated in the affordability test might move in future, and in turn about the effect the test could have.

19. The FPC has examined the potential effect of both measures in a scenario of rapidly rising house prices, where, absent policy measures, the risks from excessive household indebtedness would increase sharply. When comparing the effect of each individual Recommendation in isolation, the FPC’s analysis suggests the LTI flow limit is likely to play a stronger role than the affordability test in guarding against an increase in aggregate household indebtedness and the number of highly indebted households when house prices rise rapidly, and that the additional insurance provided by the affordability test would be small. A framework without the FPC’s affordability test Recommendation would therefore be simpler and more predictable. It would also reduce the impact on a small proportion of borrowers, while the wider assessment of affordability required by the FCA’s MCOB responsible lending rules would remain as an appropriate affordability check.

Details of the FPC’s proposal

History and legal framework

20. In June 2017, the FPC made the following Recommendation (17/Q2/1), revising a similar Recommendation from June 2014:

‘When assessing affordability, mortgage lenders should apply an interest rate stress test that assesses whether borrowers could still afford their mortgages if, at any point over the first five years of the loan, their mortgage rate were to be 3 percentage points higher than the reversion rate specified in the mortgage contract at the time of origination (or, if the mortgage contract does not specify a reversion rate, 3 percentage points higher than the product rate at origination). This Recommendation is intended to be read together with the FCA requirements around considering the effect of future interest rate rises as set out in MCOB 11.6.18(2). This Recommendation applies to all lenders which extend residential mortgage lending in excess of £100 million per annum.’

21. At its September 2017 meeting the FPC confirmed that the affordability test Recommendation did not apply to any remortgaging where there is no increase in the amount of borrowing, whether done by the same or different lender.

22. This Recommendation built upon an earlier Recommendation (13/Q4/1) to the FCA, made in November 2013 and implemented in May 2014, that:

‘The Financial Conduct Authority (FCA) should require mortgage lenders to have regard to any future FPC recommendation on appropriate interest rate stress tests to use in the assessment of affordability.’

FPC proposal

23. The FPC is consulting on withdrawing its June 2017 Recommendation on affordability testing (17/Q2/1).

24. In the event of the FPC withdrawing this Recommendation, affordability would still continue to be assessed according to the FCA’s MCOB rules on responsible lending. These rules set out standards that mortgage lenders must meet when assessing affordability. They cover the assessment of income and expenditure and, in relevant cases, the effect of future interest rate rises.^{footnote [2]} In coming to a view as to likely future interest rates, a mortgage lender must have regard to market expectations and any prevailing FPC Recommendation on appropriate interest rate stress tests. A lender must also assume that interest rates rise by a minimum of 100 basis points during the first five years of the mortgage. In the event that the FPC decides to withdraw its affordability test Recommendation, MCOB rules on responsible lending would continue to apply. The only change would be that, for lenders considering the effect of future interest rate rises, there would be no prevailing FPC Recommendation on interest rate stress tests to have regard to.

Cost-benefit analysis

25. The proposal to withdraw the affordability test Recommendation aims to allow the FPC to achieve its objectives of guarding against the risks associated with aggregate household indebtedness and the share of highly indebted households, but in a simpler, more predictable, and more proportionate way.

26. Certain features mean that affordability testing, when implemented as macroprudential regulation, can introduce unwarranted complexity and potential unpredictability in the FPC’s macroprudential framework. For example, and as has been seen since 2014, the link to lenders’ reversion rates introduces uncertainty about how the stress rate encapsulated in the FPC’s affordability test might move in future. The Committee therefore considers that withdrawing its affordability test Recommendation would simplify its macroprudential regulatory framework and make it more efficient.

Impact on lenders and borrowers

27. The precise effect of withdrawing the affordability test Recommendation will depend on the behaviour of lenders and borrowers.

28. When the FPC introduced the affordability test Recommendation, the 300 basis point buffer over reversion rates was in line with prevailing lender practices at the time. And the FPC notes that many mortgages where the initial rate is fixed for five years or more are stressed with a 300 basis point buffer, despite being out of scope of the FPC’s affordability test Recommendation and the FCA requirement to consider the effect of future interest rate rises. If the Recommendation were withdrawn, lenders may choose to retain similar risk management practices and keep stress buffers at or close to 300 basis points. The FPC would welcome feedback from lenders on their likely responses and the factors that would influence their decisions.

29. Without the FPC’s Recommendation in place, lenders’ affordability assessments would still be subject to the FCA’s MCOB rules on responsible lending. Under these rules, unless a mortgage’s interest rate is fixed for five years or more from the expected start of the mortgage term (or for the duration of the contract, if less than five years), mortgage lenders must, in relevant cases, take into account the impact of likely future interest rate increases on affordability. Lenders must have regard to market expectations in deciding the appropriate interest rate stress, but must assume a minimum stress buffer of 100 basis points. Within this framework, lenders may potentially be able to lower their stress rates while keeping within the minimum required by the FCA. In order to model a potential upper bound on the impact of withdrawing the affordability test, the FPC’s modelling assumed all lenders use 100 basis points buffers in the absence of the FPC’s Recommendation.

30. In practice, the approach to affordability testing in the absence of the FPC’s Recommendation may vary across lenders, depending on their risk appetite and strategy for certain parts of the mortgage market.

31. There is also uncertainty around the number of borrowers currently affected by the test and the extent to which they would have taken out larger mortgages in its absence. Bank staff analysis suggests that the affordability test could have caused around 6% of borrowers (roughly 30,000 per year) to take out smaller mortgages than they would have been able to in its absence. Most of the mortgagors that we estimate to have been constrained by the FPC’s affordability test took out mortgages with LTI ratios of under 4.5. If all of those mortgagors immediately chose to take out the maximum mortgage they could afford in the absence of the affordability test Recommendation, the share of the flow with an LTI of 4.5 or higher could rise slightly from around 10% to around 11%. But, in practice, not all borrowers would have chosen to borrow up to the maximum amount allowed.

32. The FPC also considered the potential impacts of withdrawing the affordability test on mortgage market access. Bank staff analysis published in the December 2021 FSR and Technical annex showed that the vast majority of renters that are unable to buy the median-valued first-time buyer home in their area are constrained by factors other than the FPC’s Recommendations. The analysis shows that 83% of renters currently lack the savings to raise a 5% deposit themselves. A further 6% would currently be able to raise a deposit, but are not currently able to meet affordability assessments that would apply under the FCA’s MCOB framework and an assumed LTI ratio cap of 5.5, even without the FPC’s affordability test Recommendation. Around 1% of the remainder would not currently be able to meet the FPC’s affordability test. Depending on the response of lenders, the FPC’s proposal could potentially reduce this figure. However, there is uncertainty about the magnitude of this impact and whether it could potentially feed back to a rise in house prices relative to incomes, which could partially offset any impact on market access.

33. The FPC undertook sensitivity analysis to test the robustness of its conclusions on the impact of withdrawing the affordability test Recommendation. Even under extreme assumptions that increase the impact of withdrawing the affordability test, withdrawing the test and relying on the LTI flow limit would still deliver a large share of the benefits delivered by both measures together.^{footnote [3]}

Implications for the FPC’s financial stability objective

34. The main potential cost of the FPC’s proposal could be a loss of resilience in the UK financial system, which could threaten financial stability and therefore the FPC’s ability to achieve its primary objective.

35. But the FPC has judged that the LTI flow limit, without its affordability test but alongside the wider assessment of affordability required by the FCA’s MCOB responsible lending rules, ought to deliver an appropriate level of resilience to the UK financial system.

36. The FPC has considered how each of the Recommendations has individually contributed towards reducing risks, by assessing how indicators of household indebtedness – namely aggregate household debt (excluding student loans) to income, and the share of highly indebted households – could evolve over the medium term in a scenario of rapid house price growth where, absent policy measures, risks would increase sharply.

37. Currently, the aggregate household debt to income ratio and the share of households with mortgages at ‘high’ LTI ratios (at or above 4.5) are around 125% and 10% respectively. In a scenario of rapid house price growth, in the absence of both measures, these are projected to increase significantly to over 200% and 31% respectively by the end of 2030. Maintaining either of the measures materially mitigates both of these increases. Relying only on the LTI flow limit by withdrawing the FPC’s affordability test (with the wider assessment of affordability required by the FCA’s MCOB responsible lending rules remaining in place) would result in a smaller reduction in resilience than withdrawing the LTI flow limit. Whereas withdrawing the LTI flow limit and relying on the FPC’s affordability test alone would lead to a larger reduction in resilience (Table A).

38. The FPC’s analysis suggests the LTI flow limit is likely to play a stronger role than the affordability test in guarding against an increase in aggregate household indebtedness and the number of highly indebted households when house prices rise rapidly, and that the additional insurance provided by the affordability test would be small. Therefore the FPC judges that the LTI flow limit, without the FPC’s affordability test Recommendation, but alongside the wider assessment of affordability required by the FCA’s MCOB responsible lending rules, ought to deliver an appropriate level of resilience to the UK financial system.

39. Further details on this analysis and the scenario underpinning it are set out in Section 3 of the Technical annex to the December 2021 FSR.

Additional FPC considerations

HM Treasury’s remit and recommendations letter

40. This section sets out the factors outlined in the FPC’s remit and the Chancellor of the Exchequer’s remit and recommendations letter of 2 March 2021 that are relevant to the FPC’s proposal to withdraw its affordability test Recommendation.

41. The Committee's primary objective is to exercise its functions with a view to contributing to the achievement by the Bank of the financial stability objective. The Committee is neither required nor authorised to exercise its functions in a way that would in its opinion be likely to have a significant adverse effect on the capacity of the financial sector to contribute to the growth of the UK economy in the medium or long term. The FPC’s analysis suggests that in a scenario of rapid house price growth and in the absence of the affordability test Recommendation, the LTI flow limit would continue to guard against an excessive increase in overall household indebtedness and the share of highly indebted households.^{footnote [4]}

42. Subject to its primary financial stability objective, the FPC has a secondary objective of supporting the Government’s economic policy, including its objectives for growth and employment. The FPC has had due regard to its secondary objective, taking into account the Chancellor’s remit and recommendations letter. While the aim of this proposal is to deliver an appropriate level of resilience in a simpler, more predictable and more proportionate way, the FPC has also considered how it would interact with the Government’s economic policy. The aspect of the Government’s economic policy most relevant to the FPC’s proposal to withdraw its affordability test Recommendation is in relation to first-time buyers looking to access the mortgage market. The proposal to drop the affordability test is not expected to have an adverse impact on first-time buyers looking to access the mortgage market. At the margin, there may be a small improvement in access. Bank staff analysis of household survey data suggests that around 1% of renters could be unable to meet the FPC’s affordability test when buying the median-valued first-time buyer home in their region. As context, this analysis also shows that raising a deposit is by far the biggest constraint faced by prospective first-time buyers.^{footnote [5]}

Impact of the proposal on the advancement of the Prudential Regulation Authority’s (PRA’s) objectives and the FCA’s operational objectives

43. The FPC must, so far as it is possible to do so while complying with its own objectives,^{footnote [6]} seek to avoid exercising its functions in a way that would prejudice the advancement by the PRA of its objectives or the FCA of its operational objectives. The FPC has co-ordinated closely with the PRA and FCA on its proposal and judges that the proposal would not prejudice the advancement by the PRA of its objectives or the FCA of its operational objectives.

Equality and diversity considerations

44. When reviewing its Recommendations, the FPC must have due regard to the public sector equality duty and consider the impact of its proposal on those with protected characteristics. The Recommendations are not directly linked to any protected characteristics, but the FPC notes there may be a correlation between age and home ownership, which is discussed in Section 1 of the Technical annex. Nonetheless, there is limited data available on the full set of mortgagors’ protected characteristics, so the FPC would welcome responses to this consultation with further information on the impact of the proposal to withdraw the affordability test Recommendation on groups with protected characteristics.