Evolution of 70% loan-to-value policy

inSight

04 Jun 2009

Evolution of 70% loan-to-value policy

This industry initiative has served Hong Kong well for nearly two decades.

Readers may be interested in how the policy of regulating residential mortgage lending by banks to within 70% of the value of a property came about. An interesting aspect of this is the high degree of co-operation between the banking community, mainly through the Hong Kong Association of Banks, and the regulator. Banking supervisors obviously pay close attention to all significant areas of risk exposure of the banking system and are keen that these risks are prudently managed. Residential mortgage lending has always been one of the largest areas of risk exposure. Property prices have historically exhibited cyclical behaviour that, if not properly managed, could undermine banking stability. But the fact that the banking community in Hong Kong also appreciates this, from a macro, systemic-stability perspective rather than just from the micro, profitability perspective is quite impressive. This co-operation between the banking industry and the supervisor has made banking supervision more effective and served Hong Kong well. It also provides a good foundation for introducing the macro-prudential approach to banking supervision in Hong Kong - an approach that, as a result of the current financial crisis, is considered by banking supervisors in other jurisdictions to be essential to the maintenance of banking stability.

The interaction between the banking community and the banking supervisor leading to the adoption of the 70% loan-to-value (LTV) policy dates back to 1991. At that time, "residential mortgage" was defined in the Third Schedule of the Banking Ordinance as a mortgage where, among other things, "the principal sum does not exceed 90% of the purchase price or the market value of the property, whichever amount is the lower". This had been a matter of concern to us, since the law prescribed a favourable capital weighting for residential mortgages even when their LTV ratios were as high as 90%. The arrangement effectively encouraged the banks to lend up to 90% of the value of a property, which appeared to us to be excessively risky. We had intended to amend the Third Schedule to lower the 90% LTV threshold to 70% and issue a guideline advising banks to adopt a 70% LTV ratio for residential mortgage lending.

We consulted the banks during 1991 on these intentions. They were very co-operative, offering to adopt the 70% LTV policy voluntarily, removing the need to amend the Third Schedule. I believe they shared our concern about the potential systemic risks of residential mortgage lending, but I also suspect that they wanted to retain some flexibility to avoid being required by law to apply a higher risk weight in case they lent more than 70% of the value of a property. To make a long story short, the banks' proposal was adopted and the 70% LTV policy was an industry initiative.

But the continuing buoyancy of the residential property market in the early 90s led us to feel that the 70% LTV policy should be more tightly observed by the banks. Over the next four years the HKMA incorporated it into its supervisory policy. We wrote to the Hong Kong Association of Banks in 1992 asking the banks to "avoid making too many exceptions to this rule, even for specially regarded customers", and on 2 November 1995 the Government confirmed at a Legislative Council meeting that the 70% LTV policy should continue to be adopted as a long-term regulatory policy.

Under the new Basel II capital-adequacy framework, the Banking (Capital) Rules provide an even lower capital charge for residential mortgages with LTV ratios of not more than 70% (under the Standardised Approach, which is adopted by a majority of authorized institutions in Hong Kong). This more favourable capital requirement is a recognition of the effective credit controls practised by the industry in upholding the 70% LTV policy over the years.

Joseph Yam
4 June 2009

Click here for previous articles in this column.

Document in Word format

Latest inSight
Last revision date : 04 June 2009