Opening address by Chief Economist, Gabriel Fagan, to the 2nd Sunday Business Post Property Summit

01 December 2015 Speech

‘Property Markets and Financial Stability1


Good morning, Ladies and Gentlemen.  I would first of all like to congratulate the organisers for setting up this seminar.  The topics which are on today’s agenda are of fundamental importance to property market participants, to policy makers and to the public at large.  I am sure that your discussions will provide valuable insights for both market participants and policymakers. I am most grateful for the opportunity to participate today.

In my remarks, I will concentrate on the interrelationship between property markets and financial stability.  Although housing policy, and property market policy more generally, is outside the remit of the Central Bank, we are the supervisor of the Irish financial system and, as the designated macroprudential authority for Ireland, we have a key responsibility to maintain financial stability in Ireland.

Developments in property markets play a central role in our analysis and in the policies that we pursue, both in terms of micro and macro-prudential regulation.

Why is this the case?  For an Irish audience, given the experience of the past 20 years, the answer seems obvious.  We are all fully aware of the damage that can be inflicted on the financial system and the broader economy by credit-fuelled property booms and busts.  Although the scale of the problem was large in comparative terms, the Irish experience, is far from unique.  It has been well documented[2] that credit fuelled property booms played a major role in the major banking crises in advanced economies between 1970 and 2006.  Moreover, the recent Global Financial Crisis has its roots in unsound mortgage lending practices in the US, the effects of which were transmitted to the broader global financial system as a consequence of securitisation, cross-border sales of securitised assets and interconnectedness between financial systems.

Why are property markets so important for financial stability?  There are at least four reasons:

First, property ownership is widespread throughout the economy and property comprises a large proportion of the asset side of the private sector’s balance sheet.  In the case of Irish households, for example, the data from our Household Finance and Consumption Survey (HFCS) shows that residential property amounts for 55% per cent of household gross assets in Ireland[3].  The predominance of property in private sector portfolios gives rise to a situation where movements in property prices generate substantial wealth effects, which affect consumption, investment and the economy more generally.  More generally, the construction sector is a large, labour-intensive source employment. In contrast to other sectors of the economy, the proportion of output which has a domestic content – i.e. which ends up as domestic incomes –   is large.  Hence, changes in construction can have large impacts on the broader economy, impacting in turn on the financial system.

Second, property acquisition has traditionally been financed by borrowing and property is a major component of the collateral used in the economy.  The resulting high leverage of property buyers renders their financial positions vulnerable to declines in property prices, raising the risk of loan default.  The close links between property, collateral and bank lending also raises the risk of “financial accelerator effects”, by which economic shocks lead to falls in asset values and reduced collateral value.  This in turn leads to tighter credit conditions and weaker economic activity.  This feedback loop exacerbates problems both in the property market and in the banks.

Third, banks have played a dominant role in the financing of real estate purchases.  Across advanced economies, this role has increased sharply over the last 50 years.[4]  The structure of banks’ balance sheets means that they are highly vulnerable to adverse shocks.  Banks are highly leveraged institutions: in Europe capital typically amounts to around 5% of total (unweighted) assets. They are characterised by a “maturity mismatch” since they typically rely on short-term funding (such as deposits) to finance longer term assets.  These features of bank balance sheets render them vulnerable to adverse developments in borrower repayment capacity.  Adverse movements in property markets can thus generate both liquidity and solvency problems for banks. Deterioration in banks’ health, due for example to a rise in non-performing loans or withdrawal of wholesale funding, in turn forces banks to take corrective actions, e.g. by tightening credit availability.  This has spillover effects on the economy, which feeds back to the property market and to the financial position of the banks.  In this regard, international evidence suggests that Commercial Real Estate (CRE) exposures have led to greater losses for banks.[5]  And, in the Irish case losses on CRE loans transferred to NAMA amounted to circa €21billion on the profit and loss accounts of banks in 2010.

Fourth, property is the durable good par excellence.  Properties are long-lived assets, with an associated low depreciation rates[6].  One implication of this is that construction investment is more volatile than other components of output.  If there is an “overinvestment” in property it is not easily and quickly corrected since the overhang of excess properties is likely to persist for a long time.  Thus construction investment is characterised by long cycles of large amplitude. (Contrast this with what happened in the US following the Dotcom bubble.  In this case excessive information technology infrastructures were quickly absorbed by the high depreciation hence leading to a shorter downturn.)

The combination of these four elements give property markets their starring role in the emergence of risks to financial stability.  If these risks are too large and actually materialise, then the economy will likely experience a banking crisis. 

The Irish Crisis

As memories fade with the passage of time, it is worth reminding ourselves of what such a crisis looks like.  In this context it is useful to briefly recall the impact of the collapse of the credit-fuelled property bubble in Ireland on the property market, the banking system and the wider economy (Slide 3).  The salient facts are:

Peak-to-trough falls of 50% and 67% in residential and commercial property prices, respectively;
Over 300,000 residential mortgages in negative equity;
A peak of 13% in mortgage arrears and a peak in the banks’ non- performing loan ratio of 27%;
Severe macroeconomic impacts: a peak rise in the unemployment rate of over 10pp and peak-to-trough falls in private consumption and construction output of 8.6% and 62%, respectively, and 
A dramatic deterioration in the public finances, with the debt-to-GDP ratio rising from 24% to 120%.
The sheer magnitude of these effects is staggering.  According to available evidence, the Irish banking crisis was among the most severe on record post WWII[7].

Yet, while the scale differs, the Irish experience is not unique (Slide 4).  Even before the latest Global Financial Crisis, a number of advanced economies experienced severe financial crises linked to boom and busts in property markets.[8]

This evidence is a salutary lesson.  The sheer costs of credit-fuelled property booms and busts impose an obligation both on property market participants and policymakers to act in ways which avoid a repetition of such deleterious outcomes.

A change in the relationship between property markets and financial stability?

Past experience, both in Ireland and abroad, clearly shows that substantial financial stability risks have emanated from property markets.  Looking ahead, is this likely to be more or less the case than in the past?  There are four reasons for believing that the link between property markets and financial stability will be somewhat weaker than in the past.

First, one would expect that, following a crisis of the magnitude we have experienced, agents – banks, investors, households – would adjust their risk-taking behaviour.  We have seen substantial falls in both commercial and residential property prices.  The collateral value of assets previously considered “safe” has fallen by substantial amounts and we have observed unprecedented rates of loan default.  In short, investment in property and lending on the basis of property can no longer be considered as “safe as houses”.  Widely popular pre-crisis notions such as: “house prices cannot fall” or “people don’t default on their mortgages” are clearly no longer tenable.  It is therefore comforting that the academic literature[9] provides strong evidence that investors reduce risk taking behaviour after suffering large losses (e.g. in the stock market) and this impact persists for a long time.  In Ireland today we also see some evidence of this phenomenon.  For example, bank lending practices in relation to commercial property and development loans are much more cautious now compared to the pre-crisis period: the era of development loans with 100% LTVs is clearly past. Similar, albeit less dramatic, changes were also evident in respect to residential mortgage lending - even before the adoption of the recent macroprudential measures.  This more cautious behaviour, in and of itself, diminishes risks to financial stability emanating in the property market.  However, the evidence also suggests that memories fade with the passage of time as a new generation, which has not experienced crisis, comes on stream[10].  As the saying goes, “you can’t put an old head on young shoulders”.  Hence, though more cautious behaviour by market participants is important, it would be unwise to rely on enduring changes to behaviour to avoid future risks to financial stability.

A second reason for optimism in this regard is the fact that more and better information is now available to both policymakers and market participants, potentially reducing future risks to the system.  For example, the new Credit Register due to be operational by 2017 should help to avoid some of the more egregious lending mistakes which occurred in the pre-crisis era.  That said, serious information gaps still remain, and this is especially true in relation to the commercial property market.

Third, the financing of property transactions appears to be changing towards safer and more resilient forms of finance, many of which will be discussed later in this conference.  The essential feature of this is a greater role for equity-type financing and a lesser role for debt financing.  This is particularly evident in the commercial and development sectors with the rise to prominence of low-leveraged institutional investors, foreign investors and REITS[11]and the concomitant decline in reliance on bank loans.  If this pattern proves to be an enduring feature of the market, it will help to greatly diminish risks to domestic financial stability emanating from the property market.  Similarly, on the residential side, higher down-payment ratios for mortgage loans diminish financial stability risks.

As regards the residential sector, in principle, a greater role for rental market as against owner-occupied housing can reduce risks to financial stability.  For example, comparing experience in 18 countries, the former Deputy Governor of the Central Bank[12]  has showed that higher owner-occupancy rates have been associated with more severe output declines during the recent crisis.  However, there are caveats.  First, it is not clear that the share of private rented accommodation can remain at current levels, much less increase, given the large number of “accidental landlords” and the expressed desire of many landlords to exit the market as soon as possible[13].  Again this is an issue which will be discussed later at this conference.  Financial stability would certainly be served by a higher share of rented accommodation provided by non-leveraged institutional investors, such as insurance companies and real estate investment trusts (REITS).  However, the current situation in Ireland is that the supply of private rented accommodation is dominated by small-scale buy-to-let landlords who fund their property portfolio by bank loans.  Many of these landlords are encountering financial difficulties: evidence from our household survey shows that buy-to-let borrowers are more leveraged than owner occupiers and have a higher incidence of negative equity (54% compared to 32%).  And, as is well known, these borrowers have higher default rates than owner-occupier mortgages.  Thus, unless the funding model underlying the private rental sector changes significantly, it is not at all clear that a higher share of rented accommodation would in itself contribute to a greater degree of stability in the financial system.

Last, but by no means least, policymakers at home and abroad have learned much from the crisis experience and important initiatives have been taken to strengthen the stability and resilience of the financial system.  These (sometimes radical) changes affect both micro-prudential policy, which focuses on the stability of individual financial institutions, and macroprudential policy, which is orientated to preserving the stability of the financial system as a whole and mitigating systemic risk.

As regards micro-prudential policy, the Central Bank (within its role as part of the Single Supervisory Mechanism (SSM) system of prudential supervision) now carries out a much more intensive and intrusive supervision of banks.  This includes focusing inter alia on new lending activities and the sustainable resolution of banks’ non-performing loan (NPL) portfolios.  With respect to new lending, the Central Bank and the SSM have a clear focus on the appropriateness of bank’s Risk Appetite with respect to new lending and would review and challenge limits and metrics on a regular basis for appropriateness and monitoring purposes.  In addition, the Central Bank and SSM supervise banks’ new lending in respect of risk profile and portfolio level concentrations with a clear focus on grade profile, alignment with the bank’s strategy and contribution to business model profitability.

While NPL levels (both nominally and as a percentage of gross loans) have been declining over the past 18 months, overall NPL levels remain elevated and therefore present systemic risks to the Irish banking sector.  Consequently, NPL resolution continues to be central to our (and the SSM's) supervisory focus.  The Central Bank continues to drive banks to sustainably resolve distressed loans (both commercial and retail) via an intensive supervisory programme which includes inter alia challenging bank management on their strategies, operational effectiveness and the pace of progress.  Furthermore, supervisory focus and challenge also centres on ensuring the adequacy of bank's financial resources including adequate provisioning practices.

Following the crisis there has been a renewed focus on using macroprudential policies to mitigate systemic risk.  These policies can be expected to diminish risks to financial stability emanating from the property market[14].  A number of such instruments have been made available to the Central Bank as the macroprudential authority both through European legislation and the domestic legal framework.

Under European legislation, the Central Bank is required to set a countercyclical capital buffer rate and to identify and, if needed, set additional capital buffers for Other Systematically Important Institutions (OSII).  The countercyclical buffer aims to increase resilience of the banking system to excessive credit growth and the build-up of credit imbalances by requiring higher capital ratios when credit growth is determined to be excessive.  It should also have the beneficial effect of reducing the incentives for excessive credit expansion.  This buffer rate can vary over time depending on the evolution of credit conditions.  The OSII capital buffer is designed to ensure that banks which are identified as systemically important in domestic market are in a better position to absorb shocks without posing risks to the overall financial system.  Work on preparing these two instruments is well underway and the outcome will be announced in the course of December.

At the end of January this year, on the basis of the domestic legislative framework, the Central Bank introduced loan-to-value (LTV) and loan-to-income (LTI) ratios for residential mortgage lending.  The aim of these measures is to “increase the resilience of the banking and household sectors to the property market and to reduce the risk of bank credit and housing price spirals from developing in the future.”  Clearly, these measures address directly financial stability risks emanating from the property market and they are designed to be a permanent feature of the Irish financial landscape.

The measures have attracted considerable public interest and debate over the past 12 months.  One regularly reads that adverse developments in the property market are “due to the measures” while less adverse developments are said to occur “despite the measures”.  Such judgments are premature.  It is far too early to judge the effectiveness of the measures taken last January.  First, the measures only came into effect in February and the bulk of new mortgage lending in the first half of the year (some 80% of mortgage drawdowns) was exempt since these loans had been approved prior to the adoption of the measures.  Second, during the period since the measures were introduced a number of other factors were impacting on the property market: an example is the phasing out of the capital gains tax exemption for property bought between late 2011 and 2014.  Third, the measures have a medium term orientation and it is difficult to judge success or failure on the basis of very short-term developments in the market.  In view of these considerations, it will be mid 2016 at the earliest before we can make an initial assessment of the impact and effectiveness of the measures.  That said, tentative evidence suggests that the measures have had a positive effect of removing “froth” from property prices, particularly in the Dublin residential market.  This is confirmed by the slowdown in price dynamics and evidence from the Central Bank survey of the house price expectations of property market professionals.


All of the factors which I have listed suggest that, going forward, the risks to financial stability emanating from the property market are likely to be less acute than was the case in the past.  The risks could be reduced still further by changes in the market which are on the agenda of this conference.  Of particular relevance here are proposals to increase the role of equity as against debt finance in the property sector, both commercial and residential.  While the situation looks promising, it is important to avoid falling into the trap of thinking “this time is different”.  Market participants and policymakers alike need to continuously monitor the risks building-up in the market and be ready to take appropriate and timely action to forestall the materialisation of those risks.

As far as the Central Bank is concerned, we are committed to do everything possible within our power to meet our mandate of maintaining financial stability in Ireland.  If we succeed, we will contribute to an environment in which the property industry, along with the rest of society, will have the opportunity to thrive and prosper without having to repeat the bitter experiences of the last decade.


1 I would like to thank Maria Woods and Darren Greaney for help in preparing this speech. I also thank Philip Lane and Jill Forde for helpful comments.

[2] See, for example, Reinhart and Rogoff (2010), “This time is Different” and Crowe et al (2014), “How to deal with real estate booms: Lessons from country experiences”, Journal of Financial Stability, 9(3).

[3]See, Lawless et al (2015), “The Financial Position of Irish Households”, Central Bank of Ireland Quarterly Bulletin, January 2015.

[4] Jorda et al (2014), “The Great Mortgaging”, NBER Working Paper 20501.

[5] For evidence on this point, see Drees and Pazarbasiouglu (1998) ‘‘The Nordic Banking Crises: Pitfalls in Financial Liberalization’’, Occasional Paper No. 98/161, International Monetary Fund.

[6] For a comparison of depreciation rates across assets, see Nadiri and Prucha (1996), “Estimation of the depreciation rate of physical and R&D capital in the US total manufacturing sector”.

[7] See, for example, Laeven and Valencia (2013), “Systemic Banking Crises Database”, IMF Economic Review, (61) June.

[8] See Woods and O’Connell (2012), “Ireland’s Financial Crisis: A Comparative Context”, Central Bank of Ireland Quarterly Bulletin, Q4.

[9] See, for example,  Ampudia and Ehrmann (2014), “Macroeconomic experiences and risk taking of Households”, ECB Working Paper No. 1652  and Malmendier and Nagel (2011), “Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?”  Quarterly Journal of Economics, 126(1).

[10] See Nakov and Nuno (2014), “Learning from Experience in the Stock Market”, Journal of Economic Dynamics and Control, (52c).

[11] See, the Central Bank’s Macro-Financial Review for evidence on this point.

[12] Gerlach (2015), “Making rental markets work for financial stability” available at the Central Bank’s website.

[13] See, PRTB/DKM (2014), “Future of Private Rented Sector: Final Report”

[14] For an overview of the available instruments, see, Grace, Hallisey and Woods (2015), “The Instruments of Macroprudential Policy”, Central Bank of Ireland Quarterly Bulletin Q1. Hartmann (2015), ”Real estate markets and macroprudential policy in Europe”, ECB Working Paper No. 17925 also provides an overview with a specific focus on the European case.