Mortgage markets and monetary policy: a central banker’s view
Speech by Otmar Issing, Member of the Executive Board of the ECB,
European Mortgage Federation Annual Conference,
Brussels, 23 November 2005
It is a great pleasure for me to speak here at the Annual Conference of the European Mortgage Federation. This is, of course, an organisation that represents the interests of lenders that provide one of the most important financial products in an individual’s life, i.e. the mortgage. The English politician and chief justice Sir Edward Coke (1552-1634) once famously remarked that “A man’s house is his castle”. You, as mortgage lenders, help many households to realise their dream of building their castle, and thereby play a crucial role in the European financial system and economy.
The quote by Sir Edward underlines the fact that housing cannot be regarded just like any other asset in the portfolio of households. The decision to acquire property to make one’s home (or castle) to realise this aspiration is a crucial moment for most people. In many cases, the mortgage contract that households enter into represents the single most important financial commitment and the acquired property the single most important asset in household balance sheets.
By maintaining an environment of stable prices, we, as central bankers, also make our contribution to help people realise their long-term ambitions and facilitate life-time planning. An environment of price stability also puts you, as mortgage lenders, in the best position to provide the most effective financial intermediation. Price stability is an important precondition for a well-functioning financial system. High and variable inflation, by contrast, undermines confidence in long-term planning for savings and investment decisions far into the future. As empirical evidence shows, long-term nominal contracts, in particular, tend to be curtailed – or disappear altogether – in high-inflation environments.
In my speech today, I shall first look at why mortgage markets matter to central banks. Then I shall turn to the current situation of mortgage markets as well as to expected future developments in these markets. I shall do this by analysing several processes, namely, banking competition, financial integration and financial innovation. Clearly, these processes are largely market-driven and are key elements of any vibrant market economy, with outcomes and consequences anything but easy to predict. In this context, we – as a central bank – have an obligation to encourage financial integration while carefully monitoring its consequences for monetary policy.
2. Mortgage markets matter to a central bank
There are several good reasons for the European Central Bank to take a close interest in mortgage markets and their interrelationship with housing markets and the wider economy. Mortgage markets are a key element in the overall functioning of the financial system, not least in relation to the depth and liquidity of markets on the funding side of banks.
In general, well-developed financial markets enhance the diversification of risk and enable an efficient allocation of savings, thus contributing to economic growth. In recent years, a growing branch of economic literature has focused on the relationship between financial structure and the real economy. An important finding of these studies is the existence of a causal link between financial development and economic growth. The main reasons for this link are twofold. First, a developed financial system allocates funds to their most profitable uses. Second, a more advanced financial system creates additional investment opportunities for investors. Clearly, this allows individuals to reduce their financial risk as they are able to diversify their investments more effectively.
Within the financial system, developments in mortgage markets are of crucial importance for a central bank from the perspective of both financial stability and monetary policy. I would like to focus today on the monetary policy perspective, by giving you an overview of the current monetary policy transmission mechanism and the pivotal role of banks in it.
The cost of financing is one of the main determinants of borrowers’ financing and investment decisions. For this reason, it is not surprising that at the ECB we study very carefully the interest rate pass-through from interest rate decisions to market rates across the maturity spectrum as well as to bank lending rates. As you know, central banks exert a dominant influence on money market conditions and thereby steer money market interest rates. Changes in short-term interest rates, in turn, affect market interest rates with longer maturities and retail bank interest rates. Clearly, a quicker and fuller pass-through of official and market interest rates to retail bank interest rates strengthens monetary policy transmission.
In addition to this traditional interest rate channel, there are a number of other mechanisms through which monetary policy might affect output and inflation. Going back to Irving Fisher’s analysis of debt deflation in the context of the Great Depression in the 1930s, there has been a rich tradition in economics emphasising the role of financial factors. An example of this is the role played by the balance sheets of corporations and households in the business cycle. In this tradition, monetary policy has an effect in addition to its direct influence on the market interest rates. In this respect, the net wealth of economic agents and, in particular, the availability and value of collateral can affect how monetary policy changes impact on consumption and investment. Likewise, because banks are special institutions which operate as the main channel for the distribution of credit from savers to borrowers, the situation of the banking sector will also play a major role in the transmission of monetary policy. In this context, the analysis of money and credit conditions can provide valuable additional insights to monetary policy-makers, not least in conjunction with asset price developments.
3. European mortgage markets today and in the future: competition, integration and innovation
Let me now address briefly a number of processes which are currently shaping, or more precisely, reshaping, the structure of the European mortgage markets. We also expect these processes to be important determinants of the specific ways in which mortgage markets will operate in the future.
The first one is the substantial increase in the level of competition in mortgage markets in Europe compared with five or ten years ago. Indeed, mostly due to increased competition in European mortgage markets and a relatively favourable credit risk outlook in recent years, mortgage lending margins have narrowed substantially. Also, the ongoing introduction of new mortgage products – that is, the process of financial innovation – may be indicative of the high competitive pressure in mortgage markets.
I would like to emphasise that competition in mortgage markets seems to have increased and lending margins have declined. At the same time, these margins have remained substantially different across the EU. Thus, it seems that, in particular, competition within national mortgage markets has increased, while cross-border competition and market entry appears to be much more limited.
This brings me to the second process that I would like to discuss: the ongoing process of financial integration in Europe, which is closely related to developments in competition. It is clear that we at the ECB have a keen interest in enhancing further the integration of financial markets and services in Europe. As you may know, this is one of the strategic intents of the Eurosystem, which comprises the ECB and the national central banks of the 12 countries that have adopted the euro. In this respect, efforts towards further integration of mortgage markets in Europe should be welcomed.
The most recent ECB report on “EU banking structures”, which was published last month, highlighted that significant structural differences and barriers prevail across the EU countries’ mortgage markets. It goes without saying that it may not be easy to eliminate some of these barriers but, wherever possible, further integration of mortgage markets in Europe should be encouraged. As a prominent example, our analysis indicates that the dispersion of mortgage interest rates in the euro area is relatively low when compared to the dispersion of interest rates in other segments of retail lending – most notably for consumer loans – although it is still higher than the intra-regional dispersion of these rates in the United States.
The last determinant of current and future developments in European mortgage markets is the process of financial innovation. Financial innovation refers to the introduction of new financial instruments and practices in financial markets. In general, financial innovation stimulates the completeness of financial markets, enhances market efficiency and reduces costs.
With respect to mortgage markets, financial innovation applies to both mortgage loans and funding mechanisms. Regarding the former, in the past few years, we have seen the introduction of quite a number of new products with floating rate and mixed fixed/floating rate characteristics in numerous EU countries, the greater use of second mortgages and foreign currency-linked mortgages. There are also relatively new practices in mortgage lending, such as the adoption of higher “loan-to-value” ratios and enhanced refinancing possibilities. In terms of new funding mechanisms, mortgage providers have increasingly resorted to other sources than the traditional retail and wholesale funds in the form of various deposits and loans. Indeed, financial innovation on the funding side has enabled a greater diversification of funding possibilities in more EU countries, most importantly in the form of mortgage bonds and mortgage-backed securities.
It would go beyond the scope of my presentation here today to address these developments in detail, but let me highlight one issue, which is the fast growth of the use of securitisation in European mortgage markets. According to figures from the European Securitisation Forum, in the first half of 2005, overall issuance in the European securitisation market reached a record level. This was significantly driven by issuance of mortgage-backed securities, which in the first half of this year was up by 35% compared with the same period in 2004, to 95 billion euro.
4. Monetary policy impact
The three processes that I have described here should, of course, not be seen in isolation, as they are mutually interdependent. For example, progress in banking competition may enhance financial integration and vice versa. Given these interactions, it will not be surprising that the dynamic interplay of these processes is being monitored with great interest by the ECB.
First, greater competition in European mortgage markets may influence the speed and degree of the pass-through from changes in central bank interest rates and market rates to mortgage lending rates. This effect may be strengthened further by changes to the regulatory framework such as the introduction of Basel II and the implementation of the new International Accounting Standards, which may intensify competitive conditions in mortgage lending markets. The ultimate effect of increased competition in mortgage markets on monetary policy, though, is somewhat difficult to assess.
In the euro area, we have found that banks generally adjust their interest rates broadly in line with market interest rate developments. However, this pass-through process is not immediate and differs across the different segments of the retail bank markets in the euro area. Available evidence suggests that since the introduction of the euro, the speed of transmission from market to bank lending rates has significantly increased. The extent and speed of the pass-through is only one element in the transmission chain, which may indeed be largely related to market competition, even if the presence of long-term relationship lending could also contribute to a sluggish pass-through mechanism.
Furthermore, progress in the financial integration of national mortgage markets in Europe will enhance the smooth and effective transmission of the ECB’s monetary policy actions throughout the euro area. The higher the degree of financial integration, the more effectively this transmission will work in practice. Generally speaking, advances in financial integration may enhance risk sharing among the countries involved, improve the allocation of capital and stimulate economic growth. In Europe, it seems fair to say that important progress has been made in the integration of money and bond markets, but further progress may be achieved, particularly in retail banking services, including mortgage lending.
The impact of financial innovation in European mortgage markets on the monetary transmission mechanism runs via both mortgage products and mortgage funding. On the mortgage side, increased financial innovation has given borrowers a wider choice of mortgage possibilities. These include fixed, floating and a wide array of mixed products including features of the two. This process is of course led by market forces and at this juncture it is too early to say what form of borrowing is going to become predominant. Overall, the impact of innovation on the use of fixed versus floating interest rate contracts is not obvious a priori, but may carry important monetary policy implications. Clearly, floating rate mortgages, where the interest rate is reset frequently in line with market rates, would translate into a faster response of disposable income to changes in monetary policy. Thus, these variable rate loans effectively establish an important channel through which interest rate changes affect consumer spending. At the same time, this type of mortgage loan carries the risk that the borrower will attach excessive importance to the current level of interest rates, even though the majority of mortgage loans have a longer-term maturity.
Another factor which could have a significant monetary policy impact is the legal possibility of refinancing outstanding fixed rate mortgages at a lower cost. When interest rates decrease, there is an incentive for existing borrowers to refinance. The impact of refinancing would depend on the associated costs, which are normally in the form of early repayment fees. Early repayment regimes vary widely across EU Member States, thereby contributing most likely to a heterogeneous transmission of monetary policy in the euro area.
A final impact of financial innovation related to mortgage products on monetary policy transmission may be the increased use of housing equity withdrawal in Europe. Because this practice involves households extracting equity from the value of their houses to finance consumption or other expenditures or to invest in financial assets, household consumption may increase, generating additional effects on output and inflation.
On the funding side, overall, securitisation may have altered the impact of changes in monetary policy interest rates on the economy somewhat. It has to be said, however, that existing empirical evidence for the euro area is rather tentative and further analysis is required.
Overall, a stronger housing-mortgage market nexus and a higher responsiveness of consumption to interest rates via the housing market channel could, no doubt, enhance the potency of monetary policy transmission, but it may also contribute to more pronounced housing market cycles and macroeconomic volatility. By contrast, mortgage finance systems that shield households from interest rate risks would appear to be more conducive to stability. However, it is not up to central bankers to promote a particular financial environment that makes their job easiest or their policy instruments most efficient. Instead, as central bankers, we are fully committed to support efficient markets through competition, innovation and integration and to take the outcome of these processes into account in the best possible way in the pursuit of our task.
5. Concluding remarks
To conclude, let me re-emphasise the reasons why the ECB, as a central bank, has a major interest in mortgage market developments in the euro area.
First, the spectacular process of financial innovation that has taken place in the mortgage markets in the EU could contribute significantly to more efficient financial markets. We believe that a fully developed financial system will raise the potential for economic growth and the capacity of the economy to withstand economic shocks. At the same time, regulatory authorities have the task of offering a suitable framework for competition and innovation that operates in a stable manner. It is also important that the process of financial innovation reaches all euro area countries in order to reduce possible asymmetries in the transmission of monetary policy impulses.
Second, connected with this, the process of financial integration in the mortgage markets has advanced noticeably over the past years, particularly on the funding side. Yet a lot remains to be done. Mortgage markets in Europe have remained largely fragmented along national lines.
In this respect, the ECB supports the initiatives by the European Commission to encourage financial integration. We believe that these initiatives have the potential to bring considerable economic benefits to European consumers. At the same time, changes in mortgage market characteristics – such as those discussed earlier – may have consequences which are difficult to predict. Thus, initiatives in this field, whether regulatory or market-led, need to be well designed. In particular, their possible implications for monetary policy and financial stability need to be carefully assessed and monitored.
In my view, the most important contribution that the ECB can make to the further completion of the European mortgage markets is to guarantee its commitment to maintaining price stability. If market participants are convinced that the ECB will deliver results in terms of a low and stable rate of inflation, inflationary expectations should remain subdued and interest rate fluctuations modest. Without such an environment, further progress in market competition and financial integration would be very difficult to achieve. Without low and stable inflation, innovative forces would be thwarted in their quest to realise benefits for both consumers and investors.
The French writer Marguerite Yourcenar – who by the way was born in Brussels – put the following words in the mouth of the Roman emperor Hadrian: “Bankers are among the best judges of men. We try to make use of these special qualities”. I am sure that these wise words will be fully reflected in the contributions to this conference.
 This literature has its roots in the 1960s and early 1970s (see R. Goldsmith (1969), Financial Structure and Development, Yale University Press). However, it has regained prominence over the last decade. For a review of the literature linking financial and economic development, see for instance R. M. Stulz (2000), “Does financial structure matter for economic growth?”, World Bank Conference on Financial Structure and Economic Development, Washington D.C., 10-11 February.
 This is what we call the broad credit channel; see M. Iacoviello (2005), “House prices, borrowing constraints and monetary policy in the business cycle”, American Economic Review, 95, 3, pp. 739-64, June.
 This is what we call the bank (or narrow credit) channel of monetary policy (see S. J. Van den Heuvel (2002), “Does bank capital matter for monetary transmission?”, Federal Reserve Bank of New York Economic Policy Review, 2, pp. 259-65, May).
 The monetarist tradition in economics has emphasised, in particular, the potential spillover effect of excess money holdings on the prices of other assets such as bonds, equity and property.
 See ECB (2003), “Structural factors in the EU housing markets”, March.
 See ECB (2005), “EU Banking Structures”, October.
 See “The Strategic Intents of the Eurosystem”, which are part of the Eurosystem Mission Statement.
 See ECB (2005), “EU Banking Structures“, October.
 This may be partly explained by methodological differences.
 See also D. Cass and A. Citanna (1998), “Pareto improving financial innovation in incomplete markets”, Economic Theory, 11 (3), pp. 467-94. Also, in more efficient markets, prices will adjust more quickly in response to market changes and risk premia may be reduced (see W. S. Frame and L. J. White (2004), “Empirical studies of financial innovation: Lots of talk, little action?”, Journal of Economic Literature, Vol. 42, pp.116-44, March).
 See G. Tumpel-Gugerell (2004), “Capital markets and financial integration in Europe”, speech given at the European Mortgage Federation Annual Conference, Geneva, 23 November.
 European Securitisation Forum (2005), “ESF Securitisation Data Report”, summer.
 See ECB (2005), “EU Banking Structures”, October.
 For example, in parallel with the increased competition in European banking, there has also been an increase in the degree of concentration in the banking sector in recent years. Empirical research has shown that, ceteris paribus, the transmission to bank lending rates may become increasingly sluggish as concentration increases in the market for mortgage loans, which could offset some of the benefits of enhanced competition. See S. Corvoisier and R. Gropp (2001), “Bank concentration and retail interest rates”, ECB Working Paper No 72, July.
 See L. Be Duc et al. (2005), “Financing conditions in the euro area”, ECB Occasional Paper No 37, October, and G. de Bondt (2005), “Interest rate pass-through: Empirical results for the euro area”, German Economic Review, 6 (1), pp. 37-8.
 L. Baele, A. Ferrando, P. Hördahl, E. Krylova and C. Monnet (2004), “Measuring financial integration in the euro area”, ECB Occasional Paper No 14, May.
 D. Miles (2003), “The UK mortgage market: Taking a long-term view”, HM Treasury.
 G. H. Sellon (2002), “The changing U.S. financial system: Some implications for monetary transmission”, Federal Reserve Bank of Kansas City Economic Review, pp. 5-35, first quarter.
 See also G. Debelle (2004), “Household debt and the macroeconomy”, BIS Quarterly Review, pp. 51-64, March.
 ECB (2003), “Structural factors in the EU housing markets”, March, and G. Debelle (2004), “Macroeconomic implications of rising household debt”, BIS Working Paper No 153, June.
 A. Estrella (2002), “Securitisation and the efficacy of monetary policy”, Federal Reserve Bank of New York Economic Policy Review, 8 (1). See also J. W. Kolari, D. R. Fraser and A. Anari (1998), “The effects of securitisation on mortgage market yields: A cointegration analysis”, Real Estate Economics, 26 (4), pp. 677-93.
 M. Yourcenar (1951), Memoirs of Hadrian, edition The Noonday Press/Farrar, Straus and Giroux, New York, 1999.