Lack of common sense can lead to systemic risk in the financial system

Lack of common sense can lead to systemic risk in the financial system

Financial services, especially banks, have been the world’s most highly-regulated and supervised industry for a long time, overseen by financial services authorities and Central Banks, writes Prince Michael of Liechtenstein.

Strict professional and ethical criteria called ‘fit and proper’ have been established for the management, with managers and board members of banks being screened for suitability. Any doubts over meeting the ‘fit and proper’ criteria means disqualification.

Systemic risks, which risk jeopardising the solvency of the banking system, are monitored constantly.

The awareness of one particular systemic risk, which has been known for a long time, mostly in Central Europe, has become a widespread social and economic problem and evolved into a political issue.

Switzerland has had the lowest interest rates in Europe for a long time due to the strength of the Swiss franc. Borrowing in Swiss francs appeared on the surface therefore to be advantageous. Professional and monitored short-term borrowing in a limited way was risky but could pay.

However, local and international banks introduced a widespread practice of suggesting that private individuals should have mortgages in Swiss francs, especially in Central European countries such as Hungary, Austria, Croatia, Poland, Romania and others. The low interest rates appeared attractive and the risk of a rising Swiss Franc was considered marginal.

The common-sense rule that debts should only be incurred in the currency of the debtor's revenue was ignored by the banks which included a number of major banks, both local and subsidiaries of large international groups.

The problem emerged when the Swiss franc rose against the euro in 2011. Debts in the local currency for small householders rose. Hungary passed a law asking lenders - the banks - to assume responsibility for the damage. It argued that banks advised financially unprofessional clients to take loans in CHF and they should therefore bear the cost. Banking groups active in Hungary started to have problems at that time.

The Swiss National Bank began a foreign currency purchase programme in September 2011 to avoid further strengthening of the Swiss franc. The problem of outstanding credits in Swiss francs in Central Europe was ‘forgotten’ but new lending continued.

But when the Swiss National Bank announced the end of its purchasing programme on January 15, 2015, the Swiss franc rose dramatically against the euro and against other Central European currencies. The problem was back …..and even bigger.

An estimated US$35 billion in Swiss francs was loaned to households in Poland and US$29 billion in Austria as examples of the volumes of CHF loans in Central Europe. This means that either a good part of these loans will become redundant, as the burden for the debtor becomes too high, or a political solution will be found forcing the banks to adjust the loans to the exchange rate at the time the loans were granted. Both solutions mean vast losses for some large banks and could constitute a systemic risk in some countries.

Croatia plans to peg the conversion rate to the Swiss franc at the pre-January 15, 2015, level for these loans, to avoid social problems. This is a big liability for the banks. The IMF advised Romania not to freeze the conversion rate for CHF loans at historic rates to avoid risks to the financial system. It is a social and major political issue in Poland and could feature in the May 2015 presidential elections. Fortunately Polish banks are solid and their solvency does not appear to be threatened.

This problem was known from the very beginning. It was obvious that the CHF would rise in the long term. So why did it happen?

The only explanation is common sense was lost in the flood of regulations and administrative red tape.

Related reports:

The Swiss National Bank showed responsibility in ending policy

Euro weakness forces SNB’s currency move

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