Minutes of the CNB Bank Board meeting on financial stability issues on 30 November 2022

Present at the meeting: Aleš Michl, Eva Zamrazilová, Marek Mora, Karina Kubelková, Oldřich Dědek, Tomáš Holub, Jan Frait.

The meeting opened with a presentation given by the Financial Stability Department on the main conclusions of Financial Stability Report – Autumn 2022. The presentation focused mainly on the position of the Czech economy in the financial cycle, developments in the banking sector in recent months, risks associated with the provision of consumer loans secured by residential property, house prices, and the need for a CNB macroprudential policy response. The Bank Board first discussed the countercyclical buffer rate and the capital buffers needed to cover the accumulated and newly emerging risks in the balance sheets of the domestic banking sector, with new risks arising primarily as a result of sharp growth in foreign currency loans to non-financial corporations. It then assessed the mortgage market and residential property market in detail and discussed the settings of the LTV, DTI and DSTI credit ratios.

The countercyclical buffer (CCyB) rate

In the part of the Financial Stability Section’s presentation dealing with the CCyB rate, it was said that according to the aggregate financial cycle indicator and other indicators, the domestic economy was just past the peak of the financial cycle in mid-2022. Quantitative approaches to determining the CCyB rate implied a need to set it at 1.75%, but the Financial Stability Department recommended leaving it at 2.5%. Its key argument was the greatly increased volume of previously accepted cyclical risks in the banking sector’s balance sheet, which had yet to be reflected significantly in credit losses or growth in the risk weights on credit exposures. It was also said that the expected economic downturn and strong geopolitical and macroeconomic uncertainties were creating the potential for large-scale materialisation of credit losses. Another argument was the potential cyclical risk associated with the strong growth in foreign currency loans to non-financial corporations.

The board members agreed it was not desirable to lower the CCyB rate below the pending 2.5% rate at the moment. Despite the subdued housing loan market, additional risks were entering banks’ balance sheets via relatively rapid growth in foreign currency loans provided to non-financial corporations. There was also a consensus that it was necessary to take into account the current geopolitical and macroeconomic uncertainties, which were creating room for sudden and strong materialisation of previously accepted risks. Traditional methods were unable to fully capture these uncertainties, due to their specific nature. In the discussion, opinions were expressed that the growth in foreign currency loans might already be, or had the potential to become, a source of systemic risk. There was a consensus that foreign currency loans needed to be closely monitored and assessed and measures taken at the microprudential level. If the related risks were to become systemic, it would be appropriate to use other available tools in addition to the CCyB where appropriate to mitigate those risks at the macroprudential level.

Governor Aleš Michl said that at a time when the CNB’s primary objective was to reduce inflation substantially, macroprudential policy also had to be relatively tight and it was not desirable to lessen the requirements imposed on banks and their clients. It was therefore appropriate to confirm the current CCyB rate. It was helping to maintain the stability of the financial system and contributing to the achievement of monetary policy objectives by slowing growth in loans and the quantity of money in the economy. Aleš Michl considered the growth in corporate loans in euros to be a significant risk. He said that this risk was already being addressed intensively by the Supervisory Department. The situation needed to be further monitored, and banks and clients had to be alerted to the associated risks. Deputy Governor Eva Zamrazilová saw the phenomenon of increased foreign currency borrowing as a systemic risk. In her opinion, the present situation was creating a risk of dual currency circuits in the economy reducing the effectiveness of monetary policy. She expected banks to remain active in providing such loans, partly because of competitive pressures. The CCyB rate could not be lowered in such a situation. Deputy Governor Marek Mora warned of the risk of potential spillover of the problems in the domestic and foreign real economy into the domestic financial sector and agreed with keeping the CCyB rate at its current level. He recommended waiting for signals of risk materialisation before releasing the buffer. He did not view foreign currency loans as an immediate source of systemic risk, but recommended monitoring and possibly limiting them using appropriate instruments. Karina Kubelková emphasised that in the present situation, tight monetary policy should be accompanied by tight macroprudential policy. Keeping the CCyB rate unchanged could be effective in countering the accumulated risks, which she regarded as very high in the current economic conditions. Banks were counting on an increase in the CCyB rate and it should not come as a negative shock to them. She did not consider the growth in foreign currency loans to be an immediate systemic risk and, in her view, this interpretation was supported by the conclusions of the opinions of the Monetary and Supervisory Departments. Oldřich Dědek said that although quantitative methods were indicating a lower CCyB rate, he considered the uncertainty about further developments in the economy and the risks relating to foreign currency loans to non-financial corporations to be arguments in favour of keeping the CCyB rate at the proposed level. He also said that given banks’ capitalisation and profitability, a CCyB rate of 2.5% would not pose a problem for them. He regarded growth in foreign currency loans as a natural risk in the EU internal market and considered gradual “euroisation” of the economy to be an inevitable process. He saw microprudential supervision as the focus as regards limiting any macroeconomic risks, but did not rule out the use of macroprudential tools in the future. Tomáš Holub was in favour of leaving the CCyB rate at 2.5% also because of the current strong capital position of banks. Given the results of quantitative methods implying a lower CCyB rate, he nonetheless recommended communicating a readiness to ease if the risks materialised. He did not consider the growth in foreign currency loans to be an immediate systemic risk, but he pointed to its significant macro-financial overlap. He was therefore also inclined to take the view that the CNB should monitor it closely and respond with appropriate instruments where necessary. Jan Frait supported the proposal to leave the CCyB rate at 2.5%, even though some sub-indicators were now pointing to a possibility of lowering it. He felt that in the current situation, we were facing similar issues as in monetary policy decision-making. Historical experience and economic theory associates recessions with higher default rates and credit losses. However, most countries’ fiscal policies and central banks’ monetary policies had been disrupting these traditional patterns during the pandemic and were continuing to do so now. Alongside the methodological and theoretical frameworks created in historically different conditions, it was therefore necessary to put an emphasis on broader expert assessment. Also, the IFRS 9 provisioning framework had turned out to be no more acyclical than previous accounting standards, so it was appropriate to release the CCyB only after credit losses materialised, i.e. when banks actually started to move loans to Stage 3. He warned that the domestic banking sector’s current robust capital position could weaken in the future. In view of the significant uncertainties, the regulatory requirements, including Pillar 2, were now at a conservative level, and the MREL was meanwhile starting up. This might be counteracted by the fact that banks may find it more difficult and expensive to raise capital and resources in an environment of higher interest rates. This was evidenced by the emergence of some pressure from the industry to soften the capital requirements. Nevertheless, in the current difficult situation, the CNB had to remain resistant to these pressures. He agreed that the implications of the trend in the risk weights on the banking sector’s individual loan portfolios would need to be addressed, especially in the case of mortgage loans. He felt that the growth in foreign currency loans was having a negative impact on monetary policy transmission. In his view, however, the growth in these loans was not an immediate source of systemic risk for now, but from a macro-financial point of view it had the potential to become one. He added that CNB supervision had already launched a series of steps that should lead to an improvement in the system for managing related risks in the banking sector and thus reduce the potential risks.

The board members agreed that it was vital, as in the past, to respond flexibly to changes in market conditions. Should the economic situation worsen and the domestic banking sector incur significant credit losses, the Bank Board will therefore be ready to lower the CCyB rate or release the CCyB fully to support banks’ ability to lend to the real economy without interruption.

In their broader discussion of the CCyB rate and banks’ capitalisation, the board members also debated the risks to financial stability stemming from the growth in government debt. Deputy Governors Eva Zamrazilová and Marek Mora, and Jan Frait, emphasised the need for further analysis of the possible financial stability implications of the rising government debt and the potentially strengthening links between the state and the financial sector.

Deputy Governor Marek Mora and Tomáš Holub said that the tighter monetary policy was so far not having fundamental negative effects on firms and households as a whole. In their view, the concerns that the tighter monetary policy would lead to increased systemic risks to financial stability had not been confirmed.

Part of the Bank Board’s discussion was devoted to the results of the Adverse Scenario of the banking sector stress tests capturing the impact of hypothetical transition and physical climate risks over a five-year horizon. Deputy Governor Marek Mora and Jan Frait emphasised that transition risks, i.e. political decisions made mainly at the European level, play an important role. The subsequent reaction of financial institutions to these decisions could lead to reallocation of loan portfolios with a significantly adverse impact on key industries in the Czech Republic. Deputy Governor Marek Mora also mentioned the need to monitor the impact of climate risks on the insurance sector.

After discussing the cyclical sources of systemic risk with a heightened emphasis on the risks of foreign currency loans to non-financial corporations, the stress test results and the outlook for the capitalisation of domestic banks, all the board members present voted to leave the CCyB rate for exposures located in the Czech Republic unchanged at 2.5%.

Upper limits on the LTV, DSTI and DTI credit ratios

The second part of the Bank Board’s meeting was focused on risks connected with the provision of consumer loans secured by residential property, developments on the residential property market, and the upper limits on the LTV, DSTI and DTI credit ratios applicable since 1 April 2022. According to an evaluation of detailed data available to the CNB as of August 2022, banks were essentially compliant with the upper limits on the credit ratios. In the second quarter of 2022, banks had complied with the LTV and DTI caps without exception and with the DSTI cap in a large majority of cases. According to the Financial Stability Department, the risk profile, to which the credit ratios had responded, was essentially unchanged, although the volume of new loans for house purchase had decreased noticeably. An environment of high overvaluation of house prices persisted. As of mid-2022, apartment prices for median-income households had been around 60% higher than the level consistent with their incomes and with the required housing loan rates. Buy-to-let apartments were roughly 40% overvalued. In the Baseline Scenario, the property price projection used for stress-testing purposes assumed that if the CNB’s autumn macroeconomic forecast materialised, housing prices would fall by as much as 6% year on year in 2023 and then record slightly positive growth. There was meanwhile potential for a stronger price correction in the event of worse-than-forecasted macroeconomic developments.

Risks also persisted in the area of borrowers’ vulnerability. The year-on-year decline in new housing loans in 2022 would undoubtedly be significant, owing to the high base of 2021, the increase in interest rates, the sharp growth in energy prices and other costs of living, and the worse economic outlook. However, these factors were simultaneously increasing the risk of excessive debt service. The rise in monetary policy interest rates had been reflected in higher rates on new consumer loans secured by residential property. This had led to a significant increase in the share of new loans with DSTI ratios exceeding 40%. Such loans are considered by the CNB to have increased risk characteristics.

In view of the persisting significant overvaluation of residential property prices, the rise in interest rates on housing loans, the impact of inflation and energy prices on households’ living costs, the expected slowdown in economic activity and the significant economic and geopolitical uncertainties, the Financial Stability Department therefore recommended leaving the upper limits on the LTV, DTI and DSTI credit ratios at the levels approved by the CNB Bank Board in November 2021 and applicable from 1 April 2022.

The board members agreed with the Financial Stability Department that the risk profile was essentially unchanged, that significant property price overvaluation persisted and that the higher interest rates had autonomously tightened the DSTI ratio. There was a consensus that the upper limit on the DSTI ratio, which was becoming the most restrictive, had been set at a relatively high level, i.e. it had anticipated some increase in interest rates when it was originally set, and that it was not appropriate to ease it in an environment of increased living costs.

Governor Aleš Michl said that in the current economic conditions, it was not desirable to ease the lending conditions and thus contribute to credit growth and an increase in the quantity of money in the economy. It was therefore appropriate to confirm the current tight ratios for the provision of consumer loans secured by residential property. This should, among other things, foster a gradual reduction in the overvaluation of residential property prices. There was a need to continue to closely monitor this overvaluation and reassess it in the Spring Financial Stability Report. Deputy Governor Eva Zamrazilová said that the main factor in the downturn in the housing loan market was the current level of interest rates. In this context, she felt that the risks of refinancing loans secured by residential property would be more intense in the coming years. She also drew attention to the need for deeper analyses of the behaviour of the buy-to-let mortgage market, which could generate increased risks in an environment of high overvaluation, lower rental yields and higher interest rates. She did not feel that changes to the caps on the credit ratios were appropriate in the current situation. Deputy Governor Marek Mora emphasised the need for stability of the regulatory environment in a situation of persisting systemic risks, but was in favour of further analysis of the DSTI calibration approach. Karina Kubelková supported keeping the upper limits on the credit ratios at the current level, especially in light of the level of overvaluation of residential property prices. The current caps were sufficiently limiting the accumulation of risks and the market was cooling. She also considered the stability and predictability of the regulatory environment to be an important factor. At the same time, she recommended further refining the property price models. On a general level, Oldřich Dědek said that the current downturn in the mortgage market could be considered excessive. At the same time, however, he noted that at the current level of overvaluation of residential property prices, the upper limit on the LTV ratio could be considered quite relaxed. However, given the expected correction of house prices, he did not consider it necessary to tighten it. The DSTI ratio was currently the most restrictive. He saw it mainly as a consumer protection tool and preferred to keep it stable over the long term. The relatively short time since its introduction was another argument for leaving it unchanged. Tomáš Holub said that he saw synergies in the tight monetary and macroprudential policy stances. He said that after the previous overheating of the mortgage and residential property markets, we were now seeing a cooling. In his view, however, there remained question marks as to whether the adjustment, particularly in the housing market, would be orderly. He considered it important that, according to the analyses of both the Financial Stability Department and the Monetary Department, the adjustment should not lead to broader problems with the refixing of interest rates in mortgage loan portfolios. In his opinion, given the high overvaluation of property prices, the current LTV limit was on the borderline between appropriate and relaxed. As the Baseline Scenario assumed an orderly adjustment, however, he was not proposing to tighten this indicator for the time being. The DSTI ratio was probably acting more tightly than originally intended, but it was a cross between a structural and a cyclical instrument, and he would therefore recommend further consideration of its level at a later date. Jan Frait said that he understood the Financial Stability Department’s arguments for maintaining the current ratio caps. They had been introduced at a relatively benevolent level, the cost of living was rising significantly, which could significantly undermine economic agents’ ability to service their debts without problems, and the high overvaluation of property prices persisted. Regardless of the fact that the rise in interest rates had autonomously tightened the DSTI ratio, he was in favour of maintaining the upper limit on this ratio as well. In his opinion, the credit ratio limits were not currently the main brake on demand for mortgage loans – these were mainly increased housing costs and the general economic situation. Nevertheless, he considered it necessary to conduct a debate on how changes in the economic and financial cycle should be reflected in the settings of the credit ratio limits. As regards the assessment of the LTV cap, some reduction in the overvaluation of property prices had probably already begun and would continue through growth in households’ disposable income amid some correction in house prices.

Marek Mora and Jan Frait then said there was a need to debate whether to apply the sectoral systemic risk buffer (sSRB) to react to the rising risk of concentration of bank loans in financing the purchase and construction of residential and commercial property. In this context, Marek Mora recommended evaluating the international experience with applying the sSRB to real estate exposures. In the subsequent discussion, it was said that the CNB’s supervision of banks continued to be active in stabilising the risk weights for the portfolios of relevant loans based on IRB model approaches. Setting an sSRB requirement therefore did not seem immediately necessary at the moment. The use of this instrument was nonetheless one possible response in the future, especially if CCyB were released. The CNB also supported the existing proposals to simplify the use of the sSRB in the ongoing review of the EU’s macroprudential rules.

After discussing the relevant item, all the board members present voted to leave the upper limit on the LTV ratio at 80% (90% for applicants under 36 years for the purchase of owner-occupied housing), the upper limit on the DTI ratio at 8.5 times net annual income (9.5 times for applicants under 36 years) and the upper limit on the DSTI ratio at 45% of net monthly income (50% for applicants under 36 years).

 Author of the minutes: Libor Holub, Executive Director, Financial Stability Department