Beyond the LTV Ratio: Lending Standards, Regulatory Arbitrage, and Mortgage Default

Booming house prices are historically correlated with loose lending standards. Nonetheless, in Spain the loan-to-value (LTV) ratio failed to capture imbalances during the last housing boom. Using loan-level data from millions of mortgages we show that inflated collateral valuations, used by banks as a mechanism to circumvent regulation, distorted the informative value of LTV, and masked the accumulation of risk. We identify that regulation relying upon a single measure is more prone to suffer from regulatory arbitrage, and that the optimal policy mix varies over the financial cycle. Overall, our study provides useful insights for the implementation of borrower-based measures.