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Prudential Supervision of Residential Mortgage Lending

In supervising banks' residential mortgage activities, the Hong Kong Monetary Authority (HKMA) has always emphasised on the importance of adequate risk management. With residential mortgage loans constituting 36% of the banks' total loans for use in Hong Kong, sound and prudent credit approval criteria and proper risk management are key to preventing credit risks due to deterioration in asset quality of residential mortgage loans. Over the past decade or so we have seen how devastating can be the effects of volatility in the property market and the bursting of asset-price bubbles on the financial system, the community, and the world as a whole. The huge decline in the Hong Kong property market after the Asian Financial Crisis in 1997-98 left a large number of properties in negative equity and placed the Hong Kong economy under intense pressure. Recently, we have also witnessed the triggering of the global financial crisis by the sub-prime mortgage problem in the US. These examples tell us that the risks associated with mortgage lending must be vigilantly managed. We are of the view that banks should strictly comply with the following principles in their risk management: (1) Risk assessment should be through-the-cycle, taking into account possible changes during each economic cycle; (2) Avoid placing undue reliance on historical data and conduct comprehensive assessment of potential shifts in market environment, to ensure that banks remain resilient even in worst-case scenario. These two principles have become increasingly accepted as important basic principles in international discussions on financial regulatory reforms.

Continued large capital inflows into Hong Kong recently have increased the risk of an asset bubble. The HKMA has therefore stepped up its supervisory efforts on residential mortgage lending and introduced a series of measures to enable banks and the general public to better manage the risks associated with mortgage lending. These measures include lowering the loan-to-value ratio from 70% to 60% for residential mortgages on properties valued at $20 million or more; requiring banks to set mortgage rates prudently, such as by making reference to the long-term average spread between the prime rate and HIBOR; assessing thoroughly the repayment ability of borrowers and computing debt servicing ratio and property valuation prudently; and evaluating the potential impact on the borrowers' repayment ability carefully when the exceptionally low interest rates return to normal in future. The HKMA is also conducting a round of on-site examinations to ensure the banks abide by the supervisory requirements and implement measures to follow best practices in residential mortgage business.

Recently there have been signs of intensified competition in the residential mortgage market. There are concerns that the mortgage rates offered by some banks might be too close to or even below a level that is sustainable in the long run. This trend, if continues or deteriorates, might threaten banks' risk management and long-term stability. The HKMA has therefore recently held meetings with banks again to understand more about their mortgage-rate pricing strategies. Our focus is whether banks' pricing decisions have taken into consideration only the current credit costs and ignored the potential adverse impact of future increases in funding costs or delinquency level on their financial soundness. Through these meetings we shared with banks our internal analyses on pricing framework for residential mortgage products, and the need for bank's pricing framework to include a reference level computed after taking into account a number of factors such as banks' existing capital charges, expected credit costs, fixed and variable administrative expenses, amortisation of mortgage incentives such as cash rebates offered by the banks, and assumptions on delinquency levels. We hope that this systematic analytical framework will help remind banks that they should adopt prudent pricing strategies and manage risks properly.

In addition, banks should note that the low level of bad and doubtful loans of Hong Kong banks' mortgage portfolio during the property market correction after the Asian Financial Crisis was attributed not only to prudent risk management. Declining interest rates during the time had significantly reduced borrower's repayment burden and possible default. However, the declining interest rate environment is an exogenous factor that might not repeat itself when the next decline in property market takes place. Banks therefore should not place undue reliance on historical data in calculating their credit costs but should take into consideration potential property market adjustments that might be triggered by a surge in interest rates, in which case default risk could be much higher due to swelling repayment burden of borrowers. In fact, the sub-prime mortgage problem in the US has demonstrated that undue reliance on risk management models built on historical data is not necessarily prudent.

Apart from the risks faced by the banks, the HKMA is also mindful of the risks faced by potential home-buyers and would like to remind them that they should carefully assess their mortgage repayment ability. The current lower-than-average interest rates will not last forever. Borrowers should therefore not overstretch themselves. They should be alert to the adverse impact on their repayment ability if interest rates return to normal. Home-buyers will also be able to manage their financial risks more effectively when banks adopt prudent and sustainable mortgage rates.

Arthur Yuen
Deputy Chief Executive
2 March 2010

Last revision date: 1 August 2011
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