Property lending

Guideline No. 5.9.1

Property lending

This letter provides further guidance on the HKMA's Policy on property lending.

I previously wrote to your Association on 18 February 1994 to set out some guidelines on property lending. The HKMA has recently reviewed its policy on property lending, taking into account practical experience of the operation of its guidelines and the views of both individual market participants and the Banking and Deposit-taking Companies Advisory Committees (the committees). It has also had regard to the results of the survey on residential Mortgages in Hong Kong carried out for the Informal Group on Secondary Mortgage Market chaired by the HKMA and included in the report of the Informal Group.

Our discussions with the Committees revealed that the application of what has become know as the 40% guideline is causing, some Complications of interpretation. The guideline as contained in the letter of 18 February 1994 which, inter alia, stated that:

those institutions whose property lending (as defined above) accounts for a larger than average share of their loans for use in Hong Kong, say 40% or more, should consider how that percentage can be stabilized and, if necessary, reduced

This guideline was intended to slow down and in some cases reverse growth in property lending as a percentage of domestic loans. It has however come to be seen as imposing an upper limit of 40% on property exposure, which was not the intention. Moreover, as members of the Committees have pointed out, the guideline does not distinguish between different types of property lending, Including lending on residential mortgages on which, as the above Survey has shown, the loan loss experience in Hong Kong is very low. As. at end-September 1994, the amount of loan default/delinquency (defined as loan repayments overdue for more than 60 days) was only 0.43% of the outstanding loan amount.

In the light of these difficulties of interpretation and measurement, the HKMA wishes to clarify its policy on property lending, with particular reference to the 40% guideline. Equally, it wishes to restate, in the light of recent comment on the subject, that it continues to support the 70% ceiling in respect of loan to value ratios.

HKMAs policy on property lending

It is important to stress that the basic thrust of the HKMA's policy on property lending has not changed. This policy is based on an acknowledgement that the Hong Kong property market has certain special characteristics. In particular, the supply of land is relatively limited and this has tended to cause land values to rise in the long-term. Also, Hong Kong has seen a heavy demand for private residential accommodation and hence mortgage finance in recent years. The absence of non-bank financial institutions (such as building societies) means that the supply of mortgage finance is channelled largely through the banking system, producing levels of property exposure which are high by international standards. But, as already noted, the loan default and delinquency rates in the mortgage portfolio have been low.

Having said this, property lending does involve certain risk which need to be carefully considered by institution. First, property lending is generally long-term in nature and the funding of this involves running a maturity mismatch. Even though the. average life of residential mortgages in Hong Kong is much shorter than the contractual maturity, such loans are still a: relatively illiquid asset.

Second, property lending involves a concentration risk of a special kind. Notwithstanding the long term trend in Hong Kong, the property market is cyclical in nature and may be influenced by factors over which individual institutions have no control, such as the general level of interest rates. The market may also be affected by over-supply produced by the collective lending decisions of individual institutions. These factors mean that individual property loan which were good in isolation can turn bad because of a change in external market circumstances.

Both these issues have been addressed in the Report of the Informal Group which has considered ways in which the secondary mortgage market in Hong Kong might be improved, thereby reducing the liquidity and concentration risks.

While the recommendations in the Report should bring long-term benefits in risk reduction, the HKMA believes that institutions should continue to adopt a cautious approach towards property exposure and, within the special circumstances of Hong Kong, should aim for a balanced loan portfolio. More specifically, the HKMA expects that all institutions which are involved in property lending should adhere to the following guidelines:

• Institutions should have written policies on property lending which are approved by the board of directors in the case of locally incorporated institutions and by head office in the case of branches of foreign banks.
• The policy should set out the institutions general strategy and objectives in relation to property lending, including the types of exposure which it is prepared to undertake and the customers with whom it is willing to deal.
• Institutions should place a cap on the overall, level of property exposure with sub-limits for the various types of exposure (e.g. residential mortgages, property development, property investment etc.)
• Institutions should have regard to their property exposure (as defined below) as a percentage of loans for use in Hong Kong. The industry average of 40% should be regarded as a benchmark rather than an upper limit. It is accepted that some institutions (particularly those with large residential mortgage portfolios) may have percentages in excess of 40%. However, such institutions should generally exercise additional restraint and caution in expanding their property lending. This will apply particularly to those institutions where property exposure is high, and capital is less adequate, in relation to their immediate peer group.
• Institutions should adopt prudent loan to value ratios in relation to all types of property lending. In particular, the HKMA continues to support the maximum 70% loan to value ratio which has become the industry standard for residential mortgage lending. As the Report of the HKMA's Informal Group makes clear: the lower the loan to value ratio, the lower the risk of default.
• Institutions should not however place undue reliance on the value of collateral when making loans. The first consideration should be the ability of the borrower to service the debt. Institutions should therefore apply prudent limits for the maximum amount of loan repayments (principal and interest) in relation to the income and/or cash-flow of the borrower.
• Institutions should address the funding aspects of properly lending, e.g. the extent to which the various types of property exposure should be supported by customer deposits or by funding with a longer-term contractual maturity such as certificates of deposit.

Most institutions should already have lending policies in place which cover these points. The HKMA will continue to monitor the property exposure of individual institutions on the basis of the above guidelines, taking account of the level of, and growth in, each institution's property exposure compared with its peer group and the industry benchmark. The HKMA's principal definition of property lending will continue to be the following loans reported in the quarterly Return of Loans and Advances and Provisions:

This should not preclude institutions adopting a broader definition for their own internal purposes.

We have also considered whether exposure in property lending should be measured in relation to the total loan book. The conclusion is that measurement in relation to loans for use in Hong Kong continues to provide the best common denominator for banks in general. The industry average of 40% is considered an appropriate benchmark for triggering consideration of the need to exercise additional restraint and caution. The ratio of the industry's property lending to total loans, which is at around 15%, is too low a benchmark for this purpose, particularly in relation to the local banks. However, in considering the need for additional restraint and caution, the HKMA will also have regard to the size of the institution's property exposure in relation to its total loan book. The HKMA will take a more relaxed view where the institution's property lending does not account for a significant portion of the bank's total loan book. This would apply particularly in the case of branches of foreign banks.

Given that the letter is largely a clarification of existing policy, we would not expect to see institutions adopting a much more expansionary lending policy as a result of it.

I would be grateful if you would circulate this letter to the members of your Association.

I am writing in the same terms to the Chairman of the Deposit-taking Companies Association.