Macro-Prudential controls on Loan-to-Value and Debt-Service-to-Income ratios are the hot topic in banking supervision at the moment. The IMF, for instance, has been pushing these policies as a means for reigning in housing markets. The premise is that banks are incapable of assessing credit risk on a deal-by-deal basis, and therefore it falls to the banking regulator to impose lending guidelines based on specific LTV and DSTI criteria, without exception, in the name of ‘prudent lending’.
Consider the following set of facts concerning two potential borrowers, Mr Smith and Ms Wong.
Mr Smith wants to borrow $700,000 to buy a property. He has income of $150,000 per year and just enough to pay the 30% deposit on the house. His net asset position is $300,000.
Ms Wong wants to borrow $700,000 to start a business. Initially, she will have no wage income. Nevertheless, she owns 5 houses outright which she can pledge as collateral. Her net asset position is $5million.
Who gets the loan approval?
From a pure credit perspective, it would appear that Ms Wong is by far the worthiest borrower, since in the event of default she would have more than $5million worth of assets to cover a $700,000 liability. But in a world with macro-prudential controls, wage income becomes the central focus with DSTI determining the borrower’s eligibility. Mr Smith, despite having limited asset base, qualifies on the DSTI criterion while Ms Wong’s application gets rejected.
This is a case of ‘one bird in the bush being worth more than 10 in the hand’. The notion that uncertain future income is more valuable than existing assets is incredulous to the extreme. Not only does it encourage banks to lend to weaker credits, but it also locks up potentially productive capital that can be used for investments such as Ms Wong’s business venture.
The astounding aspect of this policy push is that it is gaining traction without the slightest hint of opposition. Everyone nods when the proponents use the word ‘prudential’, implying safe practice, but this is a misnomer. If they called it a ‘low grade credit and weaker growth policy’, which it is, then I am sure it would not be as well supported.