Financial institutions have until the end of the month to put in place new systems to assess applications for home loans. Such is Central Bank concern at the rapid expansion of private sector credit that it has told banks and building societies to tighten up their criteria for advancing mortgages.

For some time the Central Bank has "stress-tested" financial institutions to ensure their lending policies allow room to withstand sudden shocks, such as a downturn in a specific sector or in the economy. Now the Bank has told the financial institutions to apply specified stress tests to their own mortgage customers to ensure they could repay their loans if interest rates increased.

Overall private sector borrowing rose by 20.9 per cent over the 12 months to January - compared to a rise of 21.3 per cent to December 2000 - according to Central Bank monthly statistics. Lending by Irish credit institutions increased by P1.12 billion to P112.3 billion in January.

Overall borrowing includes overdrafts, term loans, hire purchase and lease agreements, credit card accounts and other loans to retail and business customers as well as residential mortgages.

Within the overall private sector credit figure, personal credit, or lending to private individuals/households, has been rising steadily - up 20 per cent in 1997 and 1998 and 26 per cent in 1999.

According to Central Bank figures to 1999, the annual percentage rise in personal credit has exceeded the increase in personal disposable income in every year except 1996. Personal credit as a percentage of personal disposable income has risen from 26 per cent in 1980 to 69 per cent in 1999.

Residential mortgages are the second biggest category of loans after term/revolving loans and make up a substantial portion of personal debt (74 per cent in 1999). The adjusted annualised rate of growth in mortgage lending was 24.1 per cent in January, down marginally from 24.3 per cent in December and from an average annual growth rate of 25.3 per cent last year.

In the month of January, residential mortgage lending increased by P273 million or 0.9 per cent, marginally less than the January 2000 rise of 1 per cent. Outstanding residential mortgages accounted for 26.4 per cent of total outstanding credit at the end of January.

The rate of increase in Irish borrowing was just over double the average credit growth in the euro zone. It compares with credit growth across the euro zone of 9.1 per cent over the 12 months to the end of January, down from 9.5 per cent to the end of December.

While the growth in Irish credit is on a lower base than the euro zone and outstanding borrowing here is still below the euro zone average as a proportion of gross domestic product, the Central Bank is concerned that, if the rate of increase is sustained, Irish indebtedness will rise to the top of the euro zone table. Irish private sector credit has been increasing by more than 20 per cent a year for the last number of years.

"At this point, outstanding borrowing by the private sector in Ireland as a proportion of GDP is coming close to the euro area average. If we continue to expand at an exceptional rate over some years ahead, we may well run ahead of the average," Central Bank governor Mr Maurice O'Connell has warned.

But Mr O'Connell said the Bank was almost powerless to halt the rise in borrowing. He recently told the Oireachtas Joint Committee on European Affairs that the Bank "is concerned about the rapid expansion of credit" but "does not have authority to impose ceilings".

Imposing ceilings would just discriminate against local lending institutions as "borrowers are free to do business with outside lenders and more and more outside credit institutions with no base here are prepared to offer their services here", he said.

Mr O'Connell said the Bank continued to monitor lending practices carefully to insist that banks looked at their ability to cope with an economic downturn. The Bank writes regularly to the institutions it supervises, updating criteria for prudent lending.

Under the latest criteria for home loans, financial institutions will have to verify the income and future income prospects of prospective borrowers, ensure that the deposit portion of cost of the house is not borrowed and stress test the ability of the borrower to repay at interest rates higher than the initial rate on the loan.

Verifying Income: Lenders will have to get documentary evidence on the amount and sustainability of the prospective borrower's income. Where the borrower is an employee, a Revenue P60 form giving proof of earnings will be required. As well as their current P60, borrowers will be asked for forms covering the previous two years. Pay slips or verification letters from employers will no longer be acceptable on their own.

A borrower who is self-employed must supply audited accounts for the last three years.

Source of Deposit: Lenders will have to verify the source of funding for the deposit to ensure that this cash is not borrowed. Borrowers will have to supply bank or other statements to show that the funds came from their savings/investment accounts. To ensure that money is not just moved around from another loan in the weeks/ months before the mortgage is approved, the savings/investment account records will have to go back over three years. Where the deposit is provided by parents, bank statements showing the transfer of the funds and verification of the parents ability to provide the funds will have to be supplied.

Stress Test: Lenders will have to test the ability of the borrower to repay the loan at a minimum of two percentage points above the lending rate. For example, if the loan is advanced at an interest rate of 6.25 per cent, the lender will have to ensure the borrower could make the repayment at a rate of 8.25 per cent.

Affordability Interview: After the stress test, lenders will have to carry out affordability interviews with borrowers at which the results of the test are discussed and the terms of the loan and the implications of taking on the level of borrowing are explained. A full report on the interview must be written up, signed by the lender and the borrower and kept on the borrower's file for inspection by the Central Bank.

Financial institutions will have to keep documentary evidence of compliance with all of these lending criteria on each individual borrower's file for inspection at any time by the Central Bank. These criteria apply to home loans only but the Central Bank stressed that general guidelines applied to all lending by financial institutions.

"Lenders are required to implement good prudent lending practices at all times and to ensure that borrowers are in a position to repay," a spokesman said.

Against a background of rising borrowing levels, there is some concern about the impact of special rate discounted mortgages, which are used by lenders to attract new borrowers in a competitive market - generally by offering low rates for an introductory period. Borrowers stretched to repay at special rates will have little or no leeway when the lending rate comes up to normal and could be in serious trouble if market rates rise.

And, as is to be expected in a competitive battle for savers under the new Special Saving Incentive Scheme between deposit takers and investment institutions, some institutions maintain that savers who put their money in deposits will only fuel more growth in credit. They argue that money placed on deposits will be used by the financial institutions to increase the amount they can lend out.