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 that 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. In its latest review, published in the December 2021 Financial Stability Report (FSR), the Committee announced that it intended to consult on withdrawing the affordability test Recommendation. The FPC judged 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, ought to deliver the appropriate level of resilience to the UK financial system, but in a simpler, more predictable and more proportionate way.
3. In its February 2022 Consultation Paper the FPC sought views on its proposal to withdraw the affordability test Recommendation and on the potential impact this might have on the mortgage and housing markets.
Summary of responses
4. The consultation received 27 responses, including from four trade bodies that collectively represent the majority of mortgage providers and intermediaries in the UK mortgage market. This also included a number of responses from individual organisations, including major lenders, several smaller lenders, building societies and some third sector organisations, and responses from members of the public.
5. The majority of responses – including those from all four trade bodies – were supportive of withdrawing the affordability test, and agreed with the FPC’s assessment that the LTI flow limit and the FCA’s MCOB framework ought to provide the appropriate level of resilience. Some respondents noted that the LTI flow limit was the more appropriate instrument for macroprudential policy. The consultation feedback did not provide any evidence to suggest that removing the affordability test would have a significant impact on the mortgage or housing markets.
Decision
6. Following this consultation, the FPC has decided to withdraw the affordability test Recommendation with effect from 1 August. The withdrawal of the FPC affordability test Recommendation does not place any requirement on lenders to take action, as existing affordability assessment practices are subject to the FCA’s MCOB framework and will remain so. It will be up to individual lenders as to whether they wish to make any changes to their own lending practices and to determine the timing of any such changes after this date.
7. The FPC judges that a notice period of six weeks appropriately balances the desirability of giving lenders notice ahead of the change in policy and the desirability of minimising the risk of borrowers delaying purchases due to uncertainty about how reversion rates and the stress rate might move in future.
8. This paper sets out the background and rationale for the FPC’s decision. It also sets out the FPC’s response to the feedback received and how this feedback has been factored into its decision.
FPC mortgage market Recommendations
Background and legal framework
9. The Financial Services Act 2012, amending the Bank of England Act 1998 (the 1998 Act), introduced legislation to put the FPC on a statutory footing. The primary responsibility of the FPC is ‘protecting and enhancing the resilience of the UK financial system’. This responsibility relates chiefly to the identification of, monitoring of, and taking of action to remove or reduce systemic risks. The legislation identifies ‘unsustainable levels of leverage, debt or credit growth’ as one of these systemic risks.
10. But the FPC’s task is not to achieve resilience at any cost. Its actions must not, in the language of the legislation, 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 legislation provides that, subject to achieving its primary objective, the FPC must support ‘the economic policy of Her Majesty’s Government, including its objectives for growth and employment’. In the latest remit letter, this included supporting first-time buyers looking to access the mortgage market.
11. The FPC has two main powers under the 1998 Act. It can make Recommendations to anybody, including to the Prudential Regulation Authority (PRA) and FCA. It can also give Directions to those regulators to implement specified macroprudential measures to further the FPC’s objectives.footnote [1]
12. In June 2014, the FPC made the following Recommendation, addressed to the PRA and FCA, on mortgage lending at high LTI ratios:
‘The PRA and the FCA should ensure that mortgage lenders do not extend more than 15% of their total number of new residential mortgages at loan to income ratios at or greater than 4.5. This Recommendation applies to all lenders which extend residential mortgage lending in excess of £100 million per annum’.
13. This was accompanied by a Recommendation addressed to mortgage lenders on affordability testing, which was revised in June 2017:
‘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’.
14. 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.
15. The rationale behind these Recommendations is to guard against a loosening in mortgage underwriting standards that could lead to a rapid increase in aggregate household debt and the number of highly indebted households. An excessive build-up and rapid growth in mortgage debt, often associated with rapid increases in house prices, has historically been a significant source of risk to the UK financial system and to the economy.
16. In an economic downturn, the evidence from previous recessions is that highly indebted households are more likely to cut spending sharply, and countries with rapid increases in credit growth were more likely to see sharper falls in consumption. 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 (see December 2021 FSR and Technical Annex).
17. In addition, by moderating aggregate household indebtedness, household credit growth and the share of highly indebted households, the Recommendations can also help to reduce the proportion of borrowers who face repayment difficulties on their mortgages during a stress. 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 the proposed change in policy
18. The FPC has reviewed the role and impact of its Recommendations regularly since their introduction. The FPC has been able to observe how the measures have operated in practice and has benefited from new analysis and an expanding evidence base.
19. The FPC has noted some concerns with how the affordability test has operated. In particular, the stress rate required by the test has remained broadly static, reflecting stickiness in reversion rates despite past falls in average quoted mortgage rates.
20. 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. In addition, analysis suggests that the additional insurance provided by the affordability test is 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. The FPC therefore decided to consult on withdrawing the affordability test Recommendation.
FPC decision
21. Following consultation, the FPC decided to withdraw the affordability test Recommendation with effect from 1 August 2022. The LTI flow limit remains in place and continues to guard against a deterioration in underwriting standards that could lead to a material increase in aggregate household debt and the number of highly indebted households by limiting lending at high LTI ratios.
22. The FPC notes that the consultation feedback indicated that a period of two to three months might be needed for lenders to operationalise any changes that they may choose to make to their affordability testing. However, the FPC also notes that the withdrawal of its affordability test Recommendation does not place any new requirement on lenders to take action, as existing affordability assessment practices are already subject to the FCA’s MCOB framework and will remain so. If lenders choose to adjust their lending practices in response to the FPC’s withdrawal of the affordability test Recommendation, feedback from the consultation suggested that any system or process changes were unlikely to be material to implement.
23. Mortgage reversion rates have risen since the consultation was launched in February and there is a market expectation for further rises in Bank Rate. A longer notice period could strengthen incentives for prospective borrowers to delay applying for a mortgage.
24. Following the withdrawal of this Recommendation, affordability will continue to be assessed according to the FCA’s MCOB rules on responsible lending (see Box A for further summary). 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 over a period of five years from the expected start of the mortgage. 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. Even if this assessment suggests that rates will go down or rise by less than 1% over the period, the lender must assume that interest rates rise by a minimum of 100 basis points during the period.
25. The FPC will continue to monitor the level of household debt and the share of highly indebted households. The FPC reviews its measures regularly and retains the power to make a future Recommendation in this space, for example in the event of a significant decline in underwriting standards or increase in household indebtedness that threatens UK financial stability.
Box A: FCA Mortgage Conduct of Business (MCOB) rules
1. Background to the FCA’s responsible lending rules and MCOB rules
After the 2007 financial crisis, the regulator (the Financial Services Authority) carried out the Mortgage Market Review, which resulted in a major overhaul of the responsible lending requirements for mortgages. The new rules that came into effect in April 2014 covered three key elements:
A robust affordability assessment: MCOB rules require lenders to demonstrate that the mortgage is affordable, taking into account the borrower’s income (net of income tax and national insurance) and, at a minimum, the borrower’s committed expenditure and basic household expenditure. This spelled the end of self-certification mortgages.
An interest rate stress test: as part of the assessment of affordability, the MCOB rules require lenders to assess the impact of likely future interest rate increases, where relevant. This includes taking into account market expectations and any FPC Recommendations on appropriate stress tests when coming to a view on likely rate rises.
Specific interest-only rules: the affordability assessment is based on capital and interest, unless there is a clearly understood and credible alternative source of capital repayment.
The FCA’s interest rate stress-test requirement is set out in the following terms within MCOB:
‘MCOB 11.6.18R
1. … in taking account of likely future interest rate increases for the purposes of its assessment of whether the customer will be able to pay the sums due, a mortgage lender must consider the likely future interest rates over a minimum period of five years from the expected start of the term of the regulated mortgage contract (or variation), unless the interest rate under the regulated mortgage contract is fixed for a period of five years or more from that time, or for the duration of the regulated mortgage contract (or variation), if less than five years.
2. In coming to a view as to likely future interest rates, a mortgage lender must have regard to:
a) market expectations; and
b) any prevailing Financial Policy Committee recommendation on appropriate interest rate stress tests;
and must be able to justify the basis it uses by reference to (a) and (b).
3. For the purposes of this rule, even if the basis used by the mortgage lender in (2) indicates that interest rates are likely to fall, or to rise by less than 1%, during the first five years of the regulated mortgage contract (or variation), a mortgage lender must assume that interest rates will rise by a minimum of 1% over that period’.
The effect of MCOB 11.6.18R 2(b) is that lenders, when assessing the affordability of relevant mortgages, also have regard to the current FPC Recommendation to stress affordability should mortgage rates be 3 percentage points higher than the contractual reversion rate.
2. Existing guidance on applying market expectations in MCOB
To assist firms with the requirement to ‘have regard to market expectations’ the FCA Handbook includes the following guidance:
‘MCOB 11.6.19G
In relation to MCOB 11.6.18R (2):
1. An example of market expectations is the forward sterling rate published on the Bank of England website. A mortgage lender should not use its own forecast; and
2. A mortgage lender should not link its determination to market expectations without considering the likely effect of rate changes in accordance with the market expectations on the specific regulated mortgage contract in question’.
The FPC notes that an example of a relevant forward sterling rate published by the Bank of England is the UK instantaneous nominal forward curve (overnight index swaps), with a focus on the peak implied interest rate over the next five years.
The FCA has communicated on its website and to trade bodies that if, following consultation, the FPC do decide to withdraw their affordability test Recommendation, the MCOB rules on responsible lending would continue to apply. It has also confirmed that when conducting the required assessment, firms should take into account the variable interest rates that would take effect during the first five years of the mortgage contract, including reversion rates, if applicable.
Under MCOB, a lender’s responsible lending policy should include the approach it takes to likely future interest rate rises when assessing affordability. The requirement for this policy is set out as follows:
‘MCOB 11.6.20R
A firm must put in place, and operate in accordance with, a written policy (which may be contained in more than one document), approved by its governing body, setting out the factors it will take into account in assessing a customer's ability to pay the sums due. The policy must address the following matters [including]… how future interest rates are taken into account when assessing affordability…’.
Lenders are also expected to monitor the effectiveness of the assessments they make. The requirement for this is set out in the following terms:
‘MCOB 11.6.22R
A firm must put in place, and be able to demonstrate that it has, robust systems and controls (including the use of management information and key performance indicators) to monitor the effectiveness of its affordability assessments, including in preventing payment difficulties’.
FPC response to the consultation
26. The consultation received 27 responses, including from four trade bodies that collectively represent the majority of mortgage providers and intermediaries in the UK mortgage market. This also included a number of responses from individual organisations, including major lenders, several smaller lenders, building societies and some third sector organisations, and responses from members of the public.
27. The majority of responses – including those from the four trade bodies – supported the FPC proposal. Many of these responses noted that the LTI flow limit and the FCA’s MCOB rules would remain in place and provide appropriate resilience. Some respondents also noted that the LTI flow limit is a more appropriate macroprudential tool than the affordability test because it targets lenders and the wider market, not individuals.
28. A minority of respondents opposed withdrawing the test given concerns about the macroeconomic environment and the risk that borrowers could take on mortgages that were not affordable, increasing indebtedness. Concerns about the timing of withdrawing the test were also expressed by some of those who were in favour of the FPC’s proposal.
29. The FPC notes that the LTI flow limit will remain in place alongside the FCA’s MCOB rules which provide a framework for firms’ assessment of affordability to ensure a borrower only takes on a mortgage they can afford. The FPC notes that as part of this framework the MCOB rules require lenders to take into account market expectations for future rate rises (where relevant and subject to a 100 basis points minimum stress over reversion rate). Recent evidence also indicates that lenders are being prudent and factoring cost of living increases into their assessment. Furthermore, the FPC’s analysis in the December 2021 FSR suggests that 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 in a scenario where house prices rise rapidly. The additional protection provided by the FPC affordability test would be small.
30. Some respondents agreed with the FPC assessment that there was a lot of overlap between the measures, but argued that the LTI flow limit should instead be withdrawn, with the affordability test remaining in place to guard against excessive leverage. Another respondent proposed moving to a measure that limited debt service ratios at origination rather than the flow of high LTI lending.
31. The FPC reviewed the LTI flow limit as part of its 2021 review and concluded it was performing as intended. The FPC notes that at a stress rate of around 7%, the affordability test is broadly equivalent to an LTI ratio of around 4.5, allowing for some variation in mortgage terms. However the FPC is concerned that the affordability test is subject to additional uncertainty, particularly in the current environment in which there is uncertainty about the extent to which rising interest rates may be passed through to reversion rates, which in turn would tighten the affordability test. In contrast, the FPC considers that the LTI flow limit is simpler and more predictable through economic and interest rate cycles, allowing the FPC to achieve its financial stability objective in a more proportionate way.
The impact of the affordability test to date
32. The majority of respondents agreed with the FPC judgment that the affordability test had had a limited impact to date. Some identified marginal impacts on some first-time buyers, including through longer mortgage terms or longer fixed periods, which were likely to increase overall mortgage costs.
33. Three respondents suggested that the FPC analysis might have understated the impact on first-time buyers by not taking sufficient account of the role played by gifted deposits, which can help households with low levels of savings to raise a deposit.
34. The FPC has considered the role of gifted deposits in its analysis published alongside the December 2021 FSR. Allowing for a higher level of gifted deposits than were assumed in this analysis reduces the constraint on first-time buyers associated with raising a deposit. But even accounting for this, the FPC considers that the affordability test is only likely to restrict a small proportion of prospective buyers over and above other constraints such as lenders’ restrictions on income and LTV for some high LTI products and the FCA’s MCOB rules.footnote [2]
35. Several respondents pointed to the benefits of the affordability test Recommendation in embedding stronger underwriting standards and ensuring a consistent and transparent approach across lenders and expressed concerns that removing the test might result in a weakening of underwriting standards or a reduction in transparency.
36. The FPC agrees with the view that underwriting standards have improved since the financial crisis, in part due to regulatory intervention by the FPC, PRA and FCA. The FPC considers that the LTI flow limit, together with MCOB responsible lending rules and ongoing PRA and FCA supervisory activity, will continue to maintain appropriate underwriting standards. The FCA’s responsible lending rules should continue to ensure a consistent and transparent approach to affordability assessments is adopted across the industry.
The response of lenders to withdrawing the affordability test Recommendation
37. Most of the respondents who addressed this point thought that lenders would take the opportunity to adopt a more tailored approach to affordability testing, rather than loosen uniformly. Some pointed to the fact that although five-year fixes are exempt, most lenders still apply an affordability stress buffer of 300 basis points on these products and some apply more stringent tests in certain segments of the market.
38. Some respondents voiced concerns about a deterioration in underwriting standards due to competitive pressures, if some lenders loosened the stress rates used in affordability assessments. There was a concern that this could weaken overall standards of affordability. However, one respondent noted that the fact that some lenders need to securitise their loans, together with scrutiny from funders, could act as a constraint and stop lenders from deviating too far from the market norm.
39. The FPC has considered a hypothetical scenario in which all lenders reverted to the 100 basis points minimum stress rate required by MCOB.footnote [3] As set out in the December 2021 FSR, the FPC considers that in a scenario of rapid house price growth, the LTI flow limit and the FCA’s MCOB rules would work together to limit the growth in the share of highly indebted households and deliver the appropriate level of resilience to the UK financial system.
40. Some respondents raised concerns about uncertainty and inconsistency in the approach to affordability testing and requested further clarity on the FCA’s MCOB rules. This feedback has been noted to the FCA. One respondent was concerned that an inconsistent approach could potentially mean that some borrowers would have fewer options for remortgaging when they reached the end of their initial term.
41. The FPC notes that the FCA’s MCOB rules and guidance provide detail on the approach that lenders should take to ensuring the affordability of lending, including the interest rate stress test where applicable (see Box A). The FPC also notes that both the FCA and PRA will continue to take into account the robustness of affordability testing in their supervisory activities. This can be monitored through mortgage loan-level data, known as the Product Sales Database, which is submitted by firms to the FCA, and asks firms to report the stress rates used in lending decisions. The FPC highlights the importance of these regulatory data in monitoring mortgage market activity, and the importance of firms submitting accurate and timely returns to the FCA.
The potential impact on the mortgage and housing markets
42. The majority of respondents thought that the impact of withdrawing the affordability test would be small. Among those that provided more detail, most thought that first-time buyers and some marginal buyers with weaker credit histories would be more likely to benefit. However one respondent suggested that wealthier home-movers and older buyers who might previously have been less able to extend their mortgage term were more likely to benefit.
43. However some respondents expressed concerns that withdrawing the Recommendation could lead to house price growth, making it more difficult for first-time buyers to access the market.
44. The FPC notes that most of the feedback is consistent with its assessment that the affordability test is currently having a limited impact, but that withdrawing it could result in some improvements in access, consistent with the FPC’s secondary objective. The FPC also notes that since the consultation opened, mortgage interest rates have risen and the market expectation is for Bank Rate to rise further. While there is uncertainty about how reversion rates could respond, this could mean that stress rates could reach close to end-2021 levels within the next 12–18 months, even if lenders were to apply only the minimum stress rate of 100 basis points over reversion rates specified within MCOB rules. This suggests that the short-term impact on market access and house prices could be limited.
Equality and diversity considerations
45. 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. However, there is limited data available on the full set of mortgagors’ protected characteristics.
46. One trade body responded that they did not think that the change would have any impact on the ability of those with protected characteristics to access the mortgage market. The response also noted that firms have risk monitoring in place to ensure all groups are fairly treated. However one respondent thought that withdrawing the test could lead to an increase in prices that could disadvantage those on lower incomes including minority ethnic households.
47. The FPC considers that removing the test will have a limited impact on access to the mortgage market and on house prices. Consistent with other consultation feedback, the FPC considers that there may be some small benefits for younger and lower-income borrowers. To the extent that this is correlated with other protected characteristics, the FPC does not consider that these groups will be adversely impacted by the change.
Other feedback
48. The consultation also received additional feedback on issues outside of the scope of the consultation. This feedback was not relevant to the specific proposal and so was not factored in to the FPC’s decision on the withdrawal of the affordability test Recommendation. However, the FPC is grateful for the feedback received and will keep it under consideration as part of its regular reviews of its mortgage market measures.
In April 2015 Her Majesty’s Government gave the FPC powers of Direction over the PRA and FCA in relation to loan to value and debt to income limits in respect of owner-occupied lending. These powers of Direction have not been exercised to date. See Statement of Policy.
In the analysis set out in the December 2021 FSR, it was estimated that the majority of renters were constrained by deposit size, rather than the affordability test Recommendation. Using the ONS Wealth and Asset Survey, less than 1% of renters had a large enough deposit to afford the median property in their region and enough income to pass MCOB requirements but not the FPC affordability test. The December 2021 Technical Annex ran a sensitivity that found that even if the number of renters able to afford a deposit is scaled up to account for about one third of first-time buyers receiving support from other sources, like gifts from family members, the number constrained by the affordability test, over and above other regulatory requirements, remains small at around 1.5%. One consultation submission suggested that closer to around 60% of eventual buyers might have had access to other sources of funds. This does not mean that 60% of all renters have access to other sources of deposit. But nonetheless, applying this assumption suggests around 3% of renters would be able to afford a deposit but be unable to meet the affordability test Recommendation.
The FCA’s MCOB rules would continue to require firms to have regard to market expectations when coming to a view of likely future rate rises, which may be greater than the 100 basis points minimum specified in MCOB.