Developments in the real estate market are influenced by, and in turn, can have a major impact on, the financial system and the macro-economy. For example, construction spending has a direct impact on economic activity and employment. Increases in housing prices directly affect personal wealth which could influence consumption spending. Persistently strong increases in housing prices are invariably followed by reversals which could pose a threat to the stability of the financial system, especially where real estate loans make up a significant portion of the loan portfolio of financial institutions.
Rapid economic growth, led by buoyant energy prices, has again led to a boom in the real estate market (See Tables 7 and 9). The question that arises in this context is whether there is a high probability of financial stress as a result of exposure to the real estate market.There are two main vulnerabilities in the present mortgage market. The first is the excessive dependence on short-term deposits for funding mortgages. In the commercial banks, this creates a serious mis-match between long-term assets and short-term liabilities. This risk is compounded by the recent tendency of commercial banks to hold on to their mortgage loans rather than sell them in the secondary market. The second vulnerability is that the prolonged rapid rise in housing prices is outstripping the growth of incomes. Under these circumstances, the ratio of mortgage loans outstanding to income has been increasing. This raises the possibility that in the event of an oil shock that impacts personal incomes, some debtors could have difficulty meeting their mortgage obligations.
Of course, there have been several changes over the last decade which should serve to make the financial system more resilient than it was during the first oil shock.
Firstly, the evidence suggests that greater prudence in the operations of the financial institutions, combined with improvements in regulatory and supervisory practices, has reduced the potential risks of financial stress caused by a collapse in the mortgage market. For example, mortgage loans as a proportion of total loans of the financial system now stand at 15.5 per cent compared with an average of around 40 per cent in the period 1985-88. In general, banks’ prudential indicators (such as regulatory capital, provisions and non- performing loans) are significantly more robust now than they were in the 1980s. Non-performing loans, for example, are now about 2.5 - 3.0 per cent of total loans compared with 33 per cent at the end of 1988.
Secondly, competition in the mortgage financing market has forced banks to hold the lid on mortgage interest rates. Thus mortgage interest rates now average between 8 and 9 per cent. This compares with rates averaging 12 - 13 per cent in the mid-to-late 1980s. The lower mortgage rates are being cross-subsidized by higher rates on some business loans. At the same time, excess liquidity is serving to restrain increases in deposit rates, helping to maintain banks’ interest margins.
The potential risks of financial stress induced by setbacks in the mortgage market have been further reduced by the upgrading of financial legislation and the strengthening of financial practices. As regards the latter, bank supervisors now pay special attention to banks’ management of risks associated with mortgage lending. Stress testing, which has become an important tool in the Central Bank’s supervisory arsenal, now suggests that the banking system is well-equipped to withstand reductions in property values of up to 30 per cent.