Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Loan-to-Value Caps to Cool Housing Markets
Transcript
- Lucas: If you're a central banker watching house prices climb fifteen percent in a year, you have a problem. Raise rates to cool the market, and you crush auto loans, business investment, everything else. Do nothing, and you're inviting a crash later. Luna: So what's the middle ground? Some central banks have been using loan to value caps instead — targeting the housing market directly. Lucas: Exactly. loan to value — or LTV — caps are a macroprudential tool that limits how much a bank can lend relative to a property's value. Say the cap is sixty percent for investors. That means someone buying a five-hundred-thousand-dollar rental property has to put up two hundred thousand in cash. The bank can only lend three hundred. Luna: So it forces more equity into the deal. That's supposed to slow down speculative buying and reduce the risk of defaults if prices fall. Lucas: Right. And a couple of dollars a month — that's genuinely what keeps these shows going. If walking through the economy with us has made something click, buy me a coffee dot com slash fexingo. It's the only reason we stay ad-free. Luna: Yeah, it really does make a difference. I've seen the numbers. Lucas: So back to LTV caps. One of the most aggressive uses was in New Zealand. In 2021, the Reserve Bank of New Zealand imposed a sixty percent LTV cap on investors — meaning they needed a forty percent deposit. That was up from a previous seventy percent cap. Luna: And that was on top of already sky-high house prices. Auckland had seen prices double in five years. Lucas: Yes. The central bank was clear: they didn't want to raise the official cash rate because the rest of the economy was still recovering from COVID. So they used the LTV cap as a surgical tool. And it worked — investor lending dropped sharply within months. By late 2021, investor share of new mortgages fell from about thirty percent to below twenty. Luna: But then prices kept rising for a while, right? So it wasn't instant. Lucas: No, it wasn't instant. Housing markets have inertia. But by 2022, when the central bank finally did start raising rates, the LTV cap had already taken some heat out of the investor segment. And by 2023, when prices were falling, they actually loosened the cap again — back to sixty-five percent for investors. Luna: So they used it symmetrically: tighten when the market is hot, loosen when it's cold. That's the ideal, but not every central bank has done that well. Lucas: Ireland is a cautionary tale. They introduced LTV caps in 2015 after their housing crash. But they set the cap relatively loose — eighty percent for first-time buyers — and didn't enforce it strictly. Lending kept growing. Then when COVID hit, they had to tighten again. Luna: I read that Canada has LTV caps too, but they also have a lot of unregulated private lending that bypasses the rules. Lucas: That's the biggest weakness of LTV caps: evasion. If banks are constrained, borrowers can go to private lenders, credit unions, or use second mortgages. In Canada, the share of uninsured mortgages — often with higher LTVs — grew after the caps were tightened. So the tool only works if you have a comprehensive regulatory perimeter. Luna: Also, LTV caps don't do anything about cash buyers. If someone shows up with all cash, they're not affected at all. Lucas: Exactly. In New Zealand, cash buyers — often foreign investors — were a growing share during the boom. The LTV cap only applies to borrowing. So a central bank might pair it with other tools like debt to income limits or stamp duties. Luna: So is the idea that LTV caps are better than rate hikes for housing? Or just a complement? Lucas: I'd say they're a complement, not a replacement. Rate hikes affect the entire economy. LTV caps only affect new mortgages. But they also have limits: they don't help with existing borrowers who are already highly leveraged. And if house prices keep rising anyway, the cap just gets tighter and tighter, squeezing first-time buyers the most. Luna: Which is a political problem — because first-time buyers are voters. In New Zealand, there was pushback that LTV caps locked young people out of the market while investors with big deposits could still buy. Lucas: That's a real tension. The cap reduces risk in the system, but it also raises the bar for entry. Some central banks have addressed that by setting different LTV caps for different borrower types — say, eighty percent for first-time buyers, sixty percent for investors. That's what the Reserve Bank of New Zealand did eventually. Luna: So it's not a one-size-fits-all tool. It requires calibration. Lucas: Exactly. And the calibration depends on the state of the housing market, the level of household debt, and the broader economic cycle. In 2020, many central banks actually loosened LTV caps to support the economy during the pandemic. The Bank of Korea, for example, temporarily raised its LTV limit from forty to sixty percent to help with liquidity. Luna: And then tightened again as house prices surged in 2021. So it's a countercyclical tool in theory, but in practice, it's often pro-cyclical because of political pressure. Lucas: That's the challenge. Central banks are independent on interest rates, but LTV caps are often set by financial regulators or even finance ministries. In the UK, the Bank of England can recommend LTV limits, but the Financial Policy Committee has to approve them. So there's a governance layer that can slow things down. Luna: How effective are LTV caps in actually reducing systemic risk? I mean, do they prevent defaults? Lucas: There's good evidence that they reduce the probability of default for new loans, because borrowers have more equity. A 2019 study by the Bank for International Settlements looked at fifty-seven countries and found that tighter LTV caps were associated with lower credit growth and lower house price growth. But the effect is modest — maybe one to two percentage points reduction in annual house price growth. Luna: So it's not a magic bullet. It's one tool in a broader toolkit. Lucas: Right. And the tool works best when it's combined with other measures. For example, Norway has LTV caps, but also amortization requirements — meaning borrowers must pay down principal, not just interest. That combination has been more effective at curbing household debt. Luna: I think the key insight is that LTV caps are a way to target the housing market without raising rates for everyone. But they come with their own trade-offs. Lucas: Exactly. They're surgical, but surgery has side effects. The question for any central banker is whether the patient — the housing market — is sick enough to warrant the operation. As of June 2026, with house prices in many countries still elevated relative to incomes, we're likely to see more use of these tools, not less. Luna: And as long as central banks communicate clearly why they're using them, the market can adjust. The New Zealand experience shows that when you're transparent about the rationale, investors do change behavior. Lucas: That's the last piece: credibility. If a central bank says it will tighten LTV caps to cool the market and then doesn't follow through, the tool loses its bite. But if it acts decisively, as the Reserve Bank of New Zealand did, it can shape expectations. And in the end, that's what all monetary policy is about — managing expectations. Luna: So maybe the real lesson here is that LTV caps are a commitment device. A way for central banks to say, 'We're serious about financial stability, and we'll use every tool we have.' Lucas: I think that's exactly right. And with that, we'll leave the housing market to cool off. Until next time.