By MeeRoo Kim and YoonHae Oh,  Fellow at KDI

※ This article is part of KDI Journal of Economic Policy, August 2021

This study aims to analyze whether the credit risk of borrowers can decrease when supply regulations on bank mortgages are relaxed. In South Korea, there are housing finance regulations that restrict mortgage loan amounts. The LTV (loan to value ratio, since 2002) and DTI (debt to income ratio, since 2006) was introduced to secure macro-prudential stability and applied to the financial institutions (e.g., banks, savings banks, insurance companies). These regulations have played roles in promoting the macro-stability of the financial industry and stability of the real estate market.

On the other hand, there is a skeptical perspective on such regulations. If the degree of regulation is far higher than an appropriate level, it can constrain the best source of funding, which is inexpensive and offers long-term maturity. Thus, such regulation can deteriorate the debt structure and increase the debt repayment burden. For example, in the words of the Deputy Prime Minister when relaxing the LTV and DTI ratios of bank mortgage loans in July 2014: “Total household debt will increase due to deregulation of real estate, but the credit risk will decrease as the household loan structure improves.” The rationale for this claim is that bank mortgages are the best loan product from a borrower’s standpoint. Therefore, relaxing housing finance regulations may reduce debtors’ credit risk.

Furthermore, the decreased repayment burden caused by LTV and DTI deregulation can be even more substantial for borrowers with low credit scores. There are two possible explanations for this. First, the interest rates of unsecured loans are much higher for borrowers with lower credit scores. Thus, the burden of interest by borrowers who have used unsecured loans due to LTV and DTI limits on bank mortgages would be much more significant for those with low credit ratings. Second, while variations in interest rates in bank mortgages are not notable, the interest rates of non-bank mortgages (e.g., savings banks, capital companies, and credit card companies) rise when a borrower’s credit score decreases. Accordingly, the interest expense for borrowers with low credit ratings may increase further due to LTV restrictions.

Therefore, we analyze whether the relaxation of the LTV and DTI limit on bank mortgages reduces the credit risk of borrowers and whether the effect is more substantial among low-credit borrowers with extensive CB data. To understand the detailed mechanism, we also analyze the impact of the relaxation of housing finance regulations on the share of high-cost loans (the share of loans other than bank mortgage loans) and the repayment burden (Debt Service Ratio(DSR): repayment of principal and interest of all loans relative to annual income). Finally, we assess changes in the debt structure that could reduce the repayment burden considering the reduced credit risk.

LTV limit was relaxed to 70% in all financial institutions in August 2014. Since the LTV limit in the banking sector was 50-70% in the Seoul metropolitan area and 60-70% in other regions before the deregulation, the degree of the deregulation is differential between Seoul metropolitan area and other regions. We use this differential degree of deregulation as an identification strategy based on the difference-in-difference method to find the effect of the deregulation on borrowers’ debt structure and credit risk. Since the LTV limit of bank mortgage was increased more in the Seoul metropolitan area than in other regions, borrowers in Seoul metro area are classified as a treatment group.

According to our analysis, the probability of delinquency among borrowers in the Seoul metropolitan area is lower than in other areas. This effect was pronounced in borrowers with low incomes and low credit scores. Concerning this decline in credit risk, the debt structure of borrowers was changed, reducing their repayment burden via improved access to bank mortgage loans. This result suggests a need to vary LTV and DTI regulations according to the characteristics of borrowers.

The composition of this chapter is as follows. Section 2 introduces the literature in this area and the housing finance regulatory policy. Section 3 provides the data and research hypotheses. Section 4 presents the estimation results. Finally, Section 5 concludes the paper with a summary and policy implications.