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MMR: Lenders to stress test interest rates

Lenders will have to stress test borrowers’ affordability in different interest rate scenarios under proposed regulation.

Sarah Davidson, 18 December, 2011

The Mortgage Market Review paper published today sets out the Financial Services Authority's expectations for a stress test and ditches the idea that the FSA should set a single rate for lenders to benchmark.

The paper said: "We agree that it would not be appropriate for the FSA to set a single rate for lenders to use.

"We propose instead to require lenders to undertake stress-testing of interest rates with reference to market expectations for interest rates over the next five years.

"Lenders cannot make their own forecasts about this – they must be able to justify the stress test applied by reference to an independent published source of market expectations, such as the forward sterling rate published on the Bank of England's website."

Where interest rates are expected to fall or to rise by less than 1%, lenders must assume a minimum rate increase of 1% over the five-year period.

"Our intention is for lenders to use the expected interest rate curve as a clear interest rate scenario within which to frame their approach – rather than derive a universal stress rate," said the FSA.

"This approach is designed to give lenders flexibility to set the rate used in a way that reflects their customer base and products, allowing them to retain control and plan ahead while testing the impact of interest rate rises on affordability for each mortgage application.

"This, to a large extent, also reflects current good market practice."

The regulator estimates applying an interest rate stress test on top of the affordability assessment today would impact on an additional 0.25% of borrowers.

This is based on an assumption that 90% of lenders are already applying a stress test.

If no lenders were stressing in line with the proposal today, the impact would be significantly greater at 3% of borrowers.

In the boom period, the FSA assumed that no lenders applied a stress-test and in this period estimated that an additional 4% of borrowers would be affected.

Within this small group of affected borrowers, the FSA indicates that there is a fairly uniform impact across the different borrower types. The addition of an interest rate stress test increases the proportion of borrowers affected in each group (such as first-time buyers, self-employed, credit impaired) by about 0.3% in subdued conditions and between 6-8% in a boom period.

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