Minutes of the CNB Bank Board meeting on financial stability issues on 26 November 2020

Present at the meeting: Jiří Rusnok, Marek Mora, Tomáš Nidetzký, Vojtěch Benda, Oldřich Dědek, Tomáš Holub, Aleš Michl.

The meeting opened with a presentation of the autumn update of Financial Stability Report 2019/2020, the main part of which is the publication Risks to financial stability and their indicators (pdf, 1.5 MB). The latter focused mainly on risks to the future stability of the Czech financial sector linked with the economic decline caused by the COVID-19 pandemic, on sources of banking sector vulnerability, on the behaviour of the economy in the recessionary phase of the financial cycle, and on changes in the risks associated with mortgage lending following the relaxation of credit ratios in spring 2020. After the opening presentation, the Bank Board discussed the countercyclical capital buffer (CCyB) rate, banks’ ability to withstand a continuation or escalation of the adverse situation without disruptions to lending to the real economy, and risks associated with the rapid growth in mortgage loans and rising residential property prices.

The Financial Stability Department’s presentation on the CCyB emphasised that, according to the aggregate financial cycle indicator and other indicators, the domestic economy had remained at the start of the recessionary phase of this cycle this year and the downward cyclical movement could be expected to continue given the adverse economic developments seen in the second half of this year. The total cyclical risks accumulated in banks’ balance sheets remained high, but their materialisation had been reduced by supportive economic policy measures. Loan impairment losses remained low for now and implicit risk weights had decreased further. However, they were likely to go up gradually on the back of an expected rise in the default rate. The methods used as a guide to setting the CCyB rate implied a rate of 0.75%–2.25%. According to the Financial Stability Department, the reduction of the CCyB rate to 0.5% this year had nonetheless been the appropriate response to the expected economic downturn.

In the following discussion, the board members agreed that the economy remained at the start of the recessionary phase of the financial cycle even after three quarters of adverse economic developments. It was said repeatedly that this was due in part to loan moratoria and large-scale government measures, which had limited and delayed the materialisation of credit risk. Without these factors, the downshift in the financial cycle would have been stronger. In the discussion of the appropriate rate level in the present situation, it was said that the relatively high CCyB rate (as high as 2.25%) calculated on the basis of analytical methods reflected risks that had built up in the expansionary phase of the cycle. In normal conditions, those risks then materialise in the recessionary phase of the cycle, to which the CNB as macroprudential authority should react by reducing the CCyB rate. That the economy was behaving differently in the current crisis due to the wide range of government measures did not alter the fact that lowering the CCyB rate to 0.5% in the spring had been the right forward-looking response and was fully consistent with the methodological framework used to set the CCyB. It was also said that in the present situation it was sensible to indicate that the next rate change could be in either direction depending on economic developments. The CNB was currently communicating the monetary policy outlook in similar fashion. Macroprudential policy and monetary policy were thus well aligned not only in terms of instrument settings, but also as regards communication of potential future changes. It was also said that not only the banking sector, but also insurance companies and funds, had remained resilient during the crisis, as evidenced by the fact that these institutions were capable of managing their liquidity themselves and had no need to use the CNB’s liquidity facilities. Those facilities, however, were still an important safeguard. The opinion was also expressed that the weak growth in loans to non-financial corporations might constitute a minor credit crunch and that this could be weighing on economic activity.

In support of leaving the CCyB rate at 0.5%, it was said that domestic banks had entered the coronavirus crisis in a very robust position and had been able to maintain it thanks in part to economic policy measures. Another supporting argument for keeping the CCyB rate unchanged was the high uncertainty surrounding the EU authorities’ approach to the payment of dividends in 2021. It would be necessary to wait for the decisions scheduled to be made by the ESRB and other authorities at the end of this year. Only then would it be possible to define a general approach to setting macroprudential buffers, including the CCyB, for the period ahead. The issue of what signals would be sufficient to commence a CCyB rate-increasing cycle was also discussed. With reference to previous communications and published methodological documents, the Financial Stability Department would consider clear signals of an economic recovery to be sufficient. The CCyB rate should then be moved relatively quickly to the level covering the usual cyclical risks, which according to CNB analyses is 1%.

The board members went on to discuss the implications of the decline in implicit risk weights. They agreed that a further decline was not desirable, as in some banks the overall level of risk weights could fall below the approved regulatory threshold set to become binding in a few years’ time. Microprudential supervision would respond to risk on a case-by-case basis in the process of approving banks’ internal models. The CNB had so far responded to the cyclical decline in risk weights on a sector-wide basis by means of the CCyB. If the trend of recent years were to continue, it would be appropriate to consider deploying other instruments, such as a lower bound on risk weights following the example of some Scandinavian countries.

Part of the discussion was devoted to the implications of the minimum leverage ratio requirement scheduled to become binding on banks in the EU on 28 June 2021. The actual leverage of domestic banks was relatively low by international standards, but banks’ high risk-free exposures to the CNB were adversely affecting the calculated leverage ratio. However, the interpretation of the amendment to the relevant EU regulation approved this summer, which had been meant to resolve this issue, remained ambiguous on certain points. The prevailing view in the discussion was that even after the amendment, the rules were probably deficient from the Czech Republic’s perspective. The CNB would therefore actively promote an additional regulatory revision of the leverage ratio calculation in EU structures.

The second part of the meeting focused on risks connected with mortgage lending and the residential property market. According to the presentation given by the Financial Stability Department, there had been renewed movement up the spiral between debt funding of property purchases and property price growth. The estimated overvaluation of house prices had edged up to 17% on average in the second half of 2019. In selected localities with a high share of investment apartments, property may be overvalued by as much as 25%. Although a downturn in household income growth could be expected, the year-on-year rate of growth of housing prices was likely to remain positive and affordability would not improve significantly. However, there was undoubtedly potential for prices to decrease in the event of further adverse macroeconomic shocks. The economic downturn and gradually worsening labour market situation had yet to be reflected in the mortgage market either. On the contrary, genuinely new loans had been at a record high in the first nine months of 2020. Here again, it could be expected that the impacts of the coronavirus epidemic would manifest themselves in the longer run and lending for house purchase would weaken. In the first half of 2020, mortgage lenders had mostly been complying with the CNB’s Recommendation and taking into account the risky levels indicated for credit ratios, for which numerical limits are not currently set. Nonetheless, some lenders had taken on increased risk, especially in the second quarter of 2020, primarily in terms of growth in the share of loans with a DSTI ratio of 45%–50%.

In the following discussion, the board members agreed that the robustness of house price growth and new mortgage loans was surprising to some extent. They also agreed with the Financial Stability Department’s estimate that the growth of both variables was highly likely to slow in the coming quarters. The opinion was expressed that mortgage loans were currently a key product for banks as regards profitability, and banks’ efforts to expand their loan portfolios in this category was to have been expected. At the moment, it was sufficient to respond to the increased risk-taking by certain banks with microprudential instruments. Macroprudential measures should only be taken in the event of across-the-board growth in risks. The Bank Board nonetheless regarded it as necessary to continue systematically pointing out to lenders that loans can usually be regarded as highly risky above certain thresholds (a DTI of eight times net income and a DSTI of 40% of net income). Financial institutions should therefore provide such loans only to applicants who are highly likely to repay without problems.

Some of the board members commented that the financial stress associated with the second wave of the pandemic was encouraging prudent behaviour by mortgage lenders. One of the board members emphasised that materialisation of the CNB forecast – in terms of a decline of inflation towards the target and stabilisation of inflation expectations – would be a major factor for mortgage loans and the property market going forward. As regards demand for apartments, other board members referred to the importance of the perception of property as a safe haven and to persisting supply-side problems. They also stressed the need to monitor carefully whether credit standards were being collectively relaxed as lenders competed for market share. If this were to start happening, it would probably be necessary to return to stricter LTV, DSTI or DTI ratios and possibly also to set conditions for the provision of mortgage loans that are very probably being used to finance purchases of property as an investment.

There was also a debate about whether it would be appropriate to apply one of the capital buffers for real estate exposures in the event of a rise in systemic risk associated with a spiral between debt funding of property purchases and property price growth and with a parallel decline in mortgage loan risk weights. EU regulatory rules will newly allow a sectoral systemic risk buffer to be applied to banks. Unlike the CCyB, this is not an across-the-board approach and allows authorities to respond to systemic risks that banks may take when providing mortgage loans. It is therefore possible to consider using this instrument in the future even though there is currently no established practice in this case.

Following the presentation of the update of the Financial Stability Report and the subsequent discussion, the Bank Board decided to leave the countercyclical capital buffer rate for exposures located in the Czech Republic at 0.5%. The Bank Board also confirmed the LTV limit at 90%.

Author of the minutes: Jan Frait, Executive Director, Financial Stability Department