At the March 2004 meeting in Rome, Forum members considered the risks to financial stability arising from increased household indebtedness and real estate lending in many jurisdictions.

Overall, members formed the view that increased household indebtedness is not likely, in and by itself, to pose a serious threat to the stability of financial intermediaries. A more serious risk from increased household indebtedness, however, could stem from its potential to amplify shocks to the macroeconomy coming from other sources, especially those that affect household incomes (notably via unemployment) and wealth (notably via house prices).

Members noted that even in those jurisdictions where household debt to income ratios have risen the most and where debt servicing ratios are around or above historical highs and/or are likely to increase further, severe stress test assumptions about movements in interest rates and disposable incomes would be required to affect the household sector to levels that have been associated with previous episodes of household financial distress. Moreover, a weakened household sector’s ability to service debt obligations would not necessarily result in increasing mortgage defaults, although this would be much likelier if the weakening was accompanied by a substantial fall in house prices. In any event, members noted that, in the main, financial intermediaries, notably banks, appear to have the resources to withstand substantial deterioration in retail credit - be it secured lending or unsecured lending (e.g., credit cards) - under severe stress scenarios. The analysis underpinning this assessment is, however, subject to some caveats and limitations, notably the lack of adequate micro-level data, and the relative simplicity of the stress tests typically used, including the short time-horizon considered.

Nonetheless, members recognized that the rise in household indebtedness that has occurred in many jurisdictions over the past two decades and the resulting larger stock of debt may have important macroeconomic implications that could manifest themselves independently of financial stability problems. As inflation rates have fallen, the associated decline in nominal borrowing rates has allowed a greater number of households to borrow and/or increased the average level of debt for a given limit on debt service. Moreover, if inflation remains at its low present levels, the real value of the debt (which is fixed in nominal terms) will not be eroded as fast as in the past. As a result, the household sector is not only currently more exposed to shocks, but is likely also to remain so for a longer period than hitherto.

Members noted that the macroeconomic implications of greater household indebtedness depend on national circumstances, such as the characteristics of mortgage contracts, composition of borrowers (for example, whether they are owner-occupiers or buying-to-let), and the distribution of the debt across the household sector. Ceteris paribus, in jurisdictions in which mortgage debt is mainly contracted at adjustable interest rates, where liquidity constraints have lessened the most (for example, where loan-to-value ratios are higher), and where housing equity withdrawal has played a significant role in boosting consumption, household responses to unexpected rises in interest rates, weaknesses in the economy, and a fall in house prices may have larger macroeconomic implications. In these circumstances, a balance sheet consolidation by households would have a substantial negative impact on the real economy that may ultimately affect the health of financial intermediaries via weaknesses in the corporate sector. A slowdown or reversal of the housing equity withdrawal process (i.e., the increased borrowing by existing mortgage holders against their house equity), which may result from a deceleration in house prices, could also have a substantial impact on the real economy, as suggested by the experience of some jurisdictions in the recent past.

Although members viewed this type of risk as relatively small, they also recognized that the scale and significance of household debt in certain jurisdictions are such that they have moved into somewhat uncharted territory, affecting household historical behavioural patterns in potentially important ways and making risk assessment more difficult.