Minutes of the CNB Bank Board meeting on financial stability issues on 25 November 2021

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

The meeting opened with a presentation given by the Financial Stability Department on the main conclusions of the publication Risks to financial stability and their indicators. This publication focused mainly on the position of the Czech economy in the financial cycle, the evolution of the financial sector in the course of the pandemic, risks to the domestic financial sector going forward, the resilience of the banking sector and the CNB’s macroprudential policy response to risks associated with mortgage lending.

The Bank Board first discussed the countercyclical buffer (CCyB) rate and the capital buffers needed to cover the accumulated and newly emerging risks in the balance sheets of the domestic banking sector. It also debated the possible use of the sectoral systemic risk buffer, which the CNB may now introduce if necessary. It also evaluated the pilot version of a banking sector stress test focused on the impact of climate change-related risks. The Bank Board then dealt in detail with the mortgage market and residential property market and decided on the settings of macroprudential tools targeted at related risks. 

The part of 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 been in an expansionary phase of the financial cycle this year. The previously accepted cyclical risks in the banking sector’s balance sheet had remained elevated and the taking on of new risks had meanwhile intensified against the backdrop of favourable financial conditions. The methods used by the Financial Stability Department as a guide to setting the CCyB rate implied a necessary rate of as high as 2.25% as from January 2023. However, the Financial Stability Department took into account possible methodological distortions caused by decreasing risk weights and recommended that the Bank Board increase the rate to 2% with effect from 1 January 2023.

In the following discussion, the board members agreed that the financial sector had increased its resilience in the course of the pandemic, but banks’ vulnerability to significantly adverse developments was still elevated. The Bank Board therefore supported the proposal to raise the CCyB rate to 2%. The board members regarded the rate increase primarily as a signalling step, made taking into account the current macroeconomic uncertainties, which may lead to potentially greater risk materialisation in the future. There was a consensus that, given their current capitalisation, banks had substantial lending capacity and that raising the CCyB rate would not create credit supply constraints. The opinion was expressed that in a standard environment some restriction of the supply of loans in response to the CCyB rate increase would be desirable, but that this was not very likely given the high capital surpluses and relaxed standards.

There followed a debate on how to react to the rising risk of concentration of bank loans in the purchase and construction of residential and commercial property. In the Czech Republic, as in many other European countries, these exposures were the dominant component of banks’ loan portfolios. Almost two-thirds of bank loans to the private non-financial sector were currently linked with property one way or another. The implicit risk weights of portfolios of housing loans (accounting for half of all bank loans to the private non-financial sector) derived on the basis of banks’ internal models were meanwhile currently at historical lows. The weights might not fully reflect the increasing systemic risk associated with the relevant portfolio. Some European countries had already responded to this risk by setting minimum risk weights for the housing loan portfolio by means of a procedurally complex measure based on Article 458 of the CRR. The Financial Stability Department stated that since the start of October, following the recent transposition of CRD V, the CNB had had the power to prescribe a specific capital buffer – the sectoral systemic risk buffer (sSRB) – to cover this structural risk. The advantage of the sSRB was that, unlike the CCyB, it did not have a generalised impact and the composition of specific banks’ balance sheets could be taken into account when setting it. The Bank Board agreed that if the vulnerability of the housing loan portfolio were to increase despite the macroprudential and monetary policy actions taken, it would be legitimate to apply the sSRB, even though there was no established practice in this case in the EU. The method for setting the cap on the sum of the structural buffer rates (O-SII and SRB) in EU law represented something of a barrier to applying the sSRB. The CNB therefore supported the proposals to amend this framework in the context of the ongoing review of the EU’s macroprudential rules. The Bank Board also supported the actions taken by the Financial Market Supervision Department to prevent an excessive decrease in housing loan risk weights in individual banks by means of modifications to banks’ internal models.

In its discussion, the Bank Board also focused on the results of a pilot stress test addressing the potential impact of climate risks on the resilience of the domestic banking sector. There was a consensus that it would be possible to publish the first version of this stress test in June 2022 in Financial Stability Report 2021/2022, after the methodology for creating scenarios incorporating climate risks and for calculating the impact of those scenarios had been finalised.

The second – and this time more important – part of the Bank Board’s meeting was focused on risks connected with mortgage lending and the residential property market. According to the presentation given by the Financial Stability Department, the movement up the spiral between debt financing of property purchases and rising property prices had intensified in the course of this year. The estimated overvaluation of apartment prices for a median-income household had increased slightly in this period to an average of 25%, while in selected localities with a high share of investment apartments it might be in excess of 30%. The CNB’s projection prepared for stress-testing purposes assumed that the year-on-year growth in house prices would continue in 2022 but would start to weaken appreciably due to rising interest rates on housing loans, base effects and the CNB’s macroprudential measures. Genuinely new mortgage loans (excluding refinanced and refixed loans) had reached very high levels in the course of this year. This was due not only to growth in the average loan size, but also to a substantial increase in the number of loans. Credit standards had meanwhile been getting more lax. According to the data for January to August, mortgage lenders had been compliant with the recommended 90% LTV limit. In the case of the DTI and DSTI ratios, however, they had often not abided by the levels representing increased risk according to the CNB. As a result, the amount of significantly risky loans had increased since the start of 2021. In the second quarter of 2021, banks had provided over 48% of loans with a DSTI of over 40%, 26% of loans with a DSTI of over 45%, and 10% of loans with a DSTI of over 50%. Similar tendencies could be seen for the DTI ratio. These trends had intensified in July and August 2021. In light of the growing systemic risks, the Financial Stability Department recommended that the CNB Bank Board react to this situation by tightening the LTV limit and reintroducing DTI and DSTI caps. Specifically, it proposed to set, in accordance with the amended Act on the CNB, an LTV cap of 80%, a DTI cap of 8.5 times the applicant’s net annual income and a DSTI cap of 45% of the applicant’s net monthly income with effect from 1 April 2022. Under the amended Act on the CNB, banks would have the option of applying higher limits to applicants under 36 years of age: an LTV cap of 90%, a DTI cap of 9.5 and a DSTI cap of 50%. 

In the following discussion, the board members agreed that the continuing growth in house prices and new mortgage loans represented a source of systemic risk. There was broad agreement with the Financial Stability Department’s estimate that both variables were highly likely to slow in the coming quarters, due in part to the CNB’s monetary and macroprudential policy actions. A majority of the board members favoured the Financial Stability Department’s proposal to lower the basic LTV limit to 80% and introduce DTI and DSTI caps of, respectively, 8.5 times the applicant’s net annual income and 45% of the applicant’s net monthly income. Some of the board members said that given the record-high levels of new mortgage loans and house price growth, they could imagine even tighter limits on the income ratios. There was a consensus that slightly looser caps for loan applicants under 36 years combined with a 5% volume exemption should prevent the measures from causing excessive regulatory hardship. There was also a consensus that the caps should be largely stable over time. The Bank Board supported the Financial Market Supervision Department’s endeavours to react in targeted fashion to the excessively relaxed credit standards of certain lenders by means of supervisory tools within the SREP. It also agreed that banks should start to apply the new measures without delay, irrespective of their formal date of effect.

In a discussion of house prices, some of the board members emphasised that the CNB’s primary role as macroprudential authority was to ensure that the banking sector was sufficiently resilient to adverse shocks. The positive side-effects of introducing credit ratio caps were that they might reduce the vulnerability of recipients of new mortgage loans and reduce the conditions for further substantial growth in house prices. However, a much more important role was played here by other sorts of economic policies conducted by authorities other than the central bank. The Bank Board also debated the concept of house price overvaluation. The Financial Stability Department said that this was the term used in the analytical community, but it would be more correct to refer to “the percentage misalignment of current house prices from the historical norm”. In June of this year, the CNB had published a cnBlog article explaining to the public how this indicator should be interpreted. 

Following the presentation of the publication Risks to financial stability and their indicators and the subsequent discussion, the Bank Board decided to increase the countercyclical capital buffer rate for exposures located in the Czech Republic to 2% with effect from 1 January 2023. The Bank Board set upper limits on mortgage ratios by means of a provision of a general nature for the first time. The LTV cap was set at 80%, the DTI cap at 8.5 times the applicant’s net annual income and the DSTI cap at 45% of the applicant’s net monthly income. Banks will have the option of applying higher limits to applicants under 36 years of age: an LTV cap of 90%, a DTI cap of 9.5 and a DSTI cap of 50%.

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