Europe muddles through: Mediterranean edition

This Politico piece of mine argues that Europe has talked itself around to sharing the effort to rescue shipwrecked migrants in the Mediterranean, having floated a variety of draconian threats to justify getting warships down there and then quietly backed out of them.

I hang this story on the voyage of HMS Bulwark, which started off by sitting the crisis out in Turkey, was then offered by the British to take part in some ill-defined military option, and ended up being congratulated by Defence Secretary Michael Fallon and, dear God, the Daily Mail for its role in the search-and-rescue operation.

Bulwark‘s deployment is up in a few days, and the government has promised to relieve her – however, the relief is HMS Enterprise, a specialised hydrographic survey vessel of all things, lacking Bulwark‘s flock of landing craft, vast flight deck, field hospital, or headquarters facilities. The answer is that the Italians have taken over the command, with the carrier Cavour offering many of the same capabilities (less from landing craft, more from aviation).

Operation Mare Nostrum from last year has, indeed, been internationalised, and this is a major policy change. But what a manipulative and twisted way we took to get there! The lessons for other major European issues, I trust, are obvious.

Greece and Iceland, controls and controls

Now that Greece has controls on outtake from banks, capital controls, many commentators are comparing Greece to Iceland. There is little to compare regarding the nature of capital controls in these two countries. The controls are different in every respect except in the name. Iceland had, what I would call, real capital controls – Greece has control on outtake from banks. With the names changed, the difference is clear.

Iceland – capital controls

The controls in Iceland stem from the fact that with its own currency and a huge inflow of foreign funds seeking the high interest rates in Iceland in the years up to the collapse in October 2008, Iceland enjoyed – and then suffered – the consequences, as had emerging markets in Asia in the 1980s and 1990s.

Enjoyed, because these inflows kept the value of the króna, ISK, very high and the whole of the 300.000 inhabitants lived for a few years with a very high-valued króna, creating the illusion that the country was better off then it really was. After all, this was a sort of windfall, not a sustainable gain or growth in anything except these fickle inflows.

Suffered, because when uncertainty hit the flows predictably flowed out and Iceland’s foreign currency reserve suffered. As did the whole of the country, very dependent on imports, as the rate of the ISK fell rapidly.

During the boom, Icelandic regulators were unable and to some degree unwilling to rein in the insane foreign expansion of the Icelandic banks. On the whole, there was little understanding of the danger and challenge to financial stability that was gathering. It was as if the Asia crisis had never happened.

As the banks fell October 6-9 2008, these inflows amounted to ISK625bn, now $4.6bn, or 44% of GDP – these were the circumstances when the controls were put on in Iceland due to lack of foreign currency for all these foreign-owned ISK. The controls were put on November 29 2008, after Iceland had entered an IMF programme, supported by an IMF loan of $2.1bn. (Ironically, Poul Thomsen who successfully oversaw the Icelandic programme is now much maligned for overseeing the Greek IMF programme – but then, Iceland is not Greece and vice versa.)

With time, these foreign-owned ISK has dwindled, is now at 15% of GDP but another pool of foreign-owned ISK has come into being in the estates of the failed bank, amounting to ca. ISK500bn, $3.7bn, or 25% of GDP.

In early June this year, the government announced a plan to lift capital controls – it will take some years, partly depending on how well this plan will be executed (see more here, toungue-in-cheek and, more seriously, here).

Greece – bank-outtake controls

The European Central Bank, ECB, has kept Greek banks liquid over the past many months with its Emergency Liquid Assistance, ELA. With the Greek government’s decision to buy time with a referendum on the Troika programme and the ensuing uncertainty this assistance is now severely tested. The logical (and long-expected) step to stem the outflows from banks is limit funds taken out of the banks.

This means that the Greek controls are only on outtake from banks. The Greek controls, as the Cypriot, earlier, have nothing to do with the value or convertibility of the euro in Greece. The value of the Greek euro is the same as the euro in all other countries. All speculation to the contrary seems to be entirely based on either wishful thinking or misunderstanding of the controls.

However, it seems that ELA is hovering close to its limits. If correct that Greek ELA-suitable collaterals are €95bn and the ELA is already hovering around €90bn the situation, also in respect, is precarious.

How quickly to lift – depends on type of controls

The Icelandic type of capital controls is typically difficult to lift because either the country has to make an exorbitant amount of foreign currency, not likely, a write-down on the foreign-owned ISK or binding outflows over a certain time. The Icelandic plan makes use of the two latter options.

Lifting controls on outtake from banks takes less time, as shown in Cyprus, because the lifting then depends on stabilising the banks and to a certain degree the trust in the banks.

This certainly is a severe problem in Greece where the banks are only kept alive with ELA – funding coming from a source outside of Greece. This source, ECB, is clearly unwilling to play a political role; it will want to focus on its role of maintaining financial stability in the Eurozone. (I very much understand the June 26 press release from the ECB as a declaration that it will stick with the Greek banks as long as it possibly can; ECB is not only a fair-weather friend…)

Without the IMF it would have been difficult for Iceland to gather trust abroad in its crisis actions – but Greece is not only dependent on the Eurozone for trust but on the ECB for liquidity. Without ELA there are no functioning Greek banks. If the measures to stabilise the banks are to be successful the controls are only the first step.

*Together with professor Þórólfur Matthíasson I have earlier written on what Icelandic lessons could be used to deal with the Greek banks. – Cross-posted at

Club within a club


One official said Eurogroup chair Jeroen Dijsselbloem would make a statement following the meeting of the 19 before a further meeting of the 18 with creditor institutions, including the ECB and IMF.

Greece is excluded from that latter meeting. Greece is a member of the IMF. The IMF’s Articles of Agreement give the first of its purposes as –

To promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems.

Is there a precedent for the IMF sitting in on a meeting of a currency union, minus one of its members, for the purposes of agreeing some kind of currency quarantine of that member?

Very, very foolish words.

This FAZ story, suggesting that Angela Merkel and Wolfgang Schäuble are not on the best of terms over negotiations with Greece and that Wolfi might even resign, should be read in the context of Merkel’s past career.

Schäuble wiederum habe nur zufällig von dem Treffen vorab erfahren und zwar nicht von der Kanzlerin, sondern weil ihm Lagarde davon erzählte, berichtet die „Bild“-Zeitung. Und zitiert einen anonym gebliebenen Berater Schäubles mit den Worten (über Merkel): „Das war eine Solo-Nummer von der Dame.“ Außerdem habe der Beamte in Schäubles Ministerium noch hinterher geschickt: „Merkel lässt sich gerade über den Tisch ziehen.“

So the Bild reckons Wolfi wasn’t invited to the meeting in Berlin where Hollande, Merkel, Juncker, Draghi, and Lagarde got together. (A Bild trigger-warning is probably appropriate, but still.) They also quote an anonymous source as saying “it was one of the lady’s solo numbers” and that Merkel “is getting the wool pulled over her eyes”.

All I can say here is: Watch out! Also, there’s this, which at least has a name attached to it and some direct speech:

„Wolfgang Schäuble geht keine faulen Kompromisse ein, er wird seine Glaubwürdigkeit nicht gefährden“, sagte der CSU-Politiker Hans Michelbach der „Bild“. Und fügte hinzu: „Und ohne Schäuble stimmt die Fraktion nicht zu.“

So, according to a CSU MP, Michelbach, the party won’t vote for anything Schäuble doesn’t support. The first problem here is that Michelbach isn’t in his party. The second, and much more important, is that there’s a word for grey men from Bavaria who patronise Angela Merkel: dead. Or at least mundtot. And just try re-reading that first quote. Either Bild really did make it up – not impossible for them – or someone really went out of their way to make trouble.

Everyone’s now rapid-rebutted the story, which of course they would have done if it was true. But nobody should doubt that she would get rid of Schäuble in a hot minute if that seemed expedient, nor that she’d be entirely willing to use SPD votes to crush Michelbach and Co, if she didn’t just call their bluff. That the AfD was last seen suing itself over whether to elect delegates to a party conference or find a hall big enough for the whole membership only underlines the point.

The graveyard is full of the indispensable, and the CDU chapel within it is full of grand sub-Helmut Kohl male egos who got in Merkel’s way.

Austrian banks and FX lending: tip-toeing authorities and households as carry traders (part 1)

Austria was one of the eleven founding members of the Eurozone in January 1999 but the Austrians never quite put their money where their mouth was: Austria is the only euro country where households flocked to take out foreign currency loans. About three quarters of these loans are coupled with repayment vehicles. Unfortunately, the Austrian authorities have known for more than a decade that the repayment vehicles add risk to the already risky FX loans: the crunch time for domestic foreign currency loans will be in 2019 and later when 80% of these loans mature. – This is the saga of authorities that knew full well of the risks and yet allowed the banks to turn households into carry traders.

Foreign currency loans are “… not suitable as a mass market product” – This was the lesson that the Austrian Finance Market Authority, FMA, had already in 2008 drawn from the extensive foreign currency, FX, lending to Austrian households; only in 2013 did the FMA state it so clearly. Long before these risky loans shot up by 10-15%, following the dramatic Swiss decap from the euro in January 2015, the risks were clear to the authorities.

From 1995, Austrian banks had turned a finance product, intended only for specialised investments, into an everyman mass-market product. Contrary to other founding euro countries, the euro did not dampen the popularity of the FX loans, mostly in Swiss francs, CHF. Austrian banks expanded into the neighbouring emerging markets, offering the same product there. Consequently, Austrian banks have turned households at home and abroad into carry traders.

From the beginning, the FMA and later also the Austrian Central Bank, ÖNB had been warning the fast-growing financial sector, with kind words and kid-gloves, against FX loans to unhedged households. The warnings were ignored: the banks raked in fees, FX lending kept rising until it topped (on unadjusted basis) in 2010, not in 2008 when the FMA claimed it banned FX lending.

FX loans in Austria are declining: in 2008 270.000 households had FX loans, 150.000 in March 2015. In February 2015 the FX loans to households amounted to €26bn, ca 18% of household loans. With maturity period of ten to 25 years serious legacy issues remain.

Further, three quarters of these loans, ca. €19.5bn, are coupled with repayment vehicle, sold as a safety guarantee to pay up the loans at maturity. Ironically, they now risk doing just the opposite: according to FMA the shortfall by the end of 2012 (the latest available figure) stood at €5.3bn. An FMA 2013 regulation to diminish this risk will only be tested when the attached FX loans mature: 80% of them are set to mature in or after 2019.

Added to the double risk of the domestic FX loans and the repayment vehicles are FX loans issued by small and medium-sized Austrian banks in the Central European and South-Eastern European, CESEE (the topic of the next article in this series). All this risk is susceptible to multiple shocks, as the IMF underlined as late as January 2014: “Exchange rate volatility (e.g., CHF) or asset price declines associated to repayment vehicles loans (RPVs) could increase credit risk due to the legacy of banks’ FCLs to Austrian households.”

Consequently, as stated by the ÖNB in April this year, seven years after the 2008 crisis FX loans “continue to constitute a risk for households and for the stability of the Austrian financial system” – a risk well and clear in sight since Austria became one of the founding euro countries in 1999. There are still significant challenges ahead for Austrian Banks. Nonperforming loans are rising – Austrian banks are above the European average, very much due to Austrian banks’ operations in CESEE.

Add to all of this the Hypo Alpe Adria scandals and the Corinthia guarantees and the Austrian hills not alive with the sound of music but groaning with well-founded worries, to a great extent because Austrian authorities did not react on their early fears but allowed banks to continue the risky project of turning households into carry traders – yet another lesson that soft-touch regulation does work well for banks but not for society.

Kid-gloves against a mighty and powerful banking (and insurance) sector

There are over 800 banks in Austria, but the three largest, Erste, Raiffaisen and UniCredit Bank Austria, “account for almost half of total bank assets” according to the IMF, which in 2013 pointed out that the financial system, “dominated by a large banking sector,” faces “significant structural challenges, especially the smaller banks.”

Six Austrian banks, three of which are Raiffeisenbanks in different parts of Austria, were included in the ECB Asset Quality Review in October 2014. As expected, the Österreichische Volksbank, partially nationalised, did not pass but the others did. However, the Austrian banks require an additional loan provisioning of €3bn.

The size of the banking sector as a ratio of GDP has been rising, at 350% by mid 2014. The expansion of small Austrian banks in CESEE, where non-covered non-performing loans in these banks’ operations are high, is a serious worry. As is the sector’s low profitability, seen as a long-term structural risk, as is a domestic market dominated by a few big banks and large CESEE exposures.

Theoretically, unhedged borrowers alone bear the risk of FX loans but in reality the risk can eventually burden the banks if the loans turn into non-performing loans en masse, which make these loans significant in terms of financial stability as the IMF has been warning about for years.

Intriguingly, already in 2013 the IMF pointed out that Austria needed to put in place a special bank resolution scheme and should not await the formal adoption of the EU Directive on bank recovery and resolution. It should also pre-empt the coming EU Deposit Guarantee Scheme Directive and the Basel Committee on Banking Supervision (BCBS) Core Principles for Effective Deposit Insurance Schemes as minimum standards. However, the progress in this direction has been slow.

Austrian FX loans: from a specialised product to everyman mortgage

In the mid 1990s Austrian households cultivated an appetite for FX loans, unknowing that they were indeed turning into carry traders without the necessary sophistication and knowledge. The trend started in the 1980s in Vorarlberg, the Bundesland in Western Austria where many commute for work to neighbouring Switzerland and Liechtenstein.

At the end of the 1980s 5% of household loans in Vorarlberg were in FX, compared to the Austrian average of 0.2%. From 1995 there was a veritable Austrian boom in FX lending, with borrowers preferring the CHF, and to a lesser degree, the Japanese yen, to the Austrian Schilling. This trend only got stronger as the interest rate differential between these currencies and the Schilling widened.

Quite remarkably, the introduction of the euro January 1 1999 did not dampen the surge: the Austrians kept their faith to the currency of their Swiss neighbours. At the end of 1995 FX loans to individuals amounted to 1.5% of total lending; in 2000 this had risen to 20%. The popularity of the FX loans was clear: in December 2000 82% of household loans issued that month were in FX. Even though the CHF appreciated by over 6% in 2000 it did not affect the popularity of the FX loans. The FX selling machine was well-oiled.

Since household debt in Austria was fairly low, Austria being among the lower middle group of countries as to the debt-to-equity ratio, the ÖNB was relatively relaxed about these changes – but not quite: already in its first Financial Stability report, published in 2001, it underlined the risk of FX lending and borrowing.

FX loans issuance to Austrian households continued to increase. In 2004, 12% of households reported a mortgage in FX. The trend topped in 2006, after which the demand fell. By the end of 2007 the FX loans, measured in euro, amounted to €32bn, i.e. almost 30% of the volume of loans issued. Here it is interesting to keep in mind that with the exception of few months annual growth rates of FX loans to households have always exceeded the growth of household loans in the domestic currency, until late 2006.

FX loans in Austria are declining: 2008 270.000 households had FX loans, 150.000 in March 2015 but the size of the problem is by no means trivial: in December 2014 “18.9% of the total volume of loans extended to Austrian households was still denominated in foreign currency;” in February 2015 the FX loans to households amounted to €26bn.

There are also indications that because the FX loans seemed cheaper than the euro loans households tended to borrow more. The ÖBN has pointed out that the growth in household borrowing in 2003 to 2004 “can to a large part be attributed to foreign currency loans.” As I have mentioned earlier, the fact that FX loans seem cheaper than loans in the domestic currency, lends them the characteristics of sub-prime lending, i.e. leads to households borrowing more than sensible, thus yet fuelling the FX risk.

This FX lending boom did not only signify borrowers’ taste for carry trade but also that financial products, earlier only on offer for large-scale investments had now become an everyman product, as was ominously pointed out in the first ÖBN Financial Stability report 2001.

Why did (only) Austrians turn into a nation of carry traders?

Nowhere in Europe were FX loans to households as popular as in Austria, as the ÖBN noted in its first Financial Stability report in 2001. At the introduction of the euro, FX loans had been popular in various European countries. Around 2000 Austria stood out but so did Germany where FX loans were being issued at the same rate as in Austria. But only in Austria did the trend continue.

The question is why Austrian households favoured FX over euro loans.

A study in the December 2008 Financial Stability report sketched a profile of Austrian household borrowers, based on an Austrian 2004 wealth survey of 2556 households. The outcome suggested “that risk-loving, high-income, and married households are more likely to take out a housing loan in a foreign currency than other households. Housing loans as such are, moreover, most likely taken out by high-income households. These findings may partially assuage policy concerns about household default risk on foreign currency housing loans.” – This profile only tells who was most likely to choose FX loans over domestic loans, not why this group in Austria differed from the same social groups in the other euro countries.

As I have explained earlier, FX loans often characterise emerging markets, as in the CESEE, where Austrian banks have indeed promoted them, or in Asia in the 1980s and the 1990s. FX tend to gain ground in newly liberalised markets, as in Australia in the 1980s. Then there is Iceland where the banks, fully privatised in 2003, expanding and borrowing abroad, hedged themselves by issuing FX loans, also to households.

FX loans are often an indication of instability where people try to bypass a fickle domestic currency, the apparition of bad policies and feeble politicians. In addition, there are interest rate margin, which may look tempting, if one ignores the fact that currencies rarely have a stable period of more than a few years, making them risky as an index for mortgages, normally runnig for ten to twenty years or more.

None of this is particularly fitting for Austria or any more fitting for Austria than the other mature European economies.

As always when FX loans turn into a problem, the banks blame the borrowers for demanding these highly risky products. If this were the case it could only happen because banks do not fulfil their duty of care, of fully informing the clients of the risks involved. As an Australian banker summed up the lessons of the Australian FX lending spree in the 1980s: “…nobody in their right mind, if they had done a proper analysis of what could happen, would have gone ahead with it (i.e. FX loans).”

According the ÖNB’s December 2008 Financial Stability report banks did claim there was so much demand for these loans that in order to be competitive they had to issue FX loans. But Peter Kolba from the Austrian Consumers Association, Verein für Konsumentinformation, VKI, disagrees that the demand came from the customers: in an information video he claims the loans were very much peddled by the banks, which reaped high fees from these loans.

It is indeed interesting that from 1995 to 2000 Austrian banks experienced a veritable fee surge of 75%, part of which the ÖNB attributed to the increase in FX lending. For the banks there was an extra sugar coating on the increased FX lending profits: “the interest rate and exchange rate risks are borne largely by the borrowers. However, the risk of default by debtors has increased the risk potential of such operations” – the possibility of a default did of course expose the banks to a growing FX risk.

There is one aspect of the Austrian FX lending, which seems to have greatly underpinned their popularity: the loans were widely sold by agents, paid directly for each loan, thus with no incentive to inform clients faithfully about the risk. In addition, the same agents often sold the repayment vehicles, thus reaping profits twice from the same customer.

As summed up by ÖNB’s spokesman Christian Gutlederer (in an e-mail to me) there were specific Austrian structural weaknesses: “Presumably, the interplay of the role of financial service providers, extensive media coverage and rational herding behaviour would offer the most plausible explanation for the popularity of such products in Austria. Tax incentives provided one additional layer: payments of life insurance premiums (the most important kind of repayment vehicle loans) and, in some cases, interest payments for mortgages can be deducted from the tax base.”

The above caused an Austrian FX loans surge, contrary to other euro countries. In addition, the fact that the authorities were so timid in clamping down on the risky behaviour of the banks is worth keeping in mind: the lesson for policy makers is to act decisively on their fears.

Lessons of domestic FX loans: “not suitable as mass product”

Being so aware of the risk the ÖNB and the FMA, have over the years taken various measures to mitigate the risk stemming from the FX lending, though timidly for the first many years.

Already in 2003 the FMA issued a set of so-called “Minimum Standards” in FX lending to households but this did little to dampen rise in FX loans to Austrian households. In 2006, the FMA and the ÖNB jointly published a brochure for those considering FX loans, warning of the risk involved. At the time, businesses were less inclined to take out FX loans: whether the brochure or something else, there was a decline in FX loans 2006 but only temporary.

Andreas Ittner, ÖBN’s Director of Financial Institutions and Markets worried at the time that “private borrowers in particular are unaware of all of the risks and consequences.” FMA Executive Director Kurt Pribil found it particularly worrying that “people seem to be unaware of the cumulative risks involved and of the implications this might have, especially if you consider the length of the financing.”

Though contradicted by the rise in FX lending to households, the two officials emphasised that restrictions put in place in 2003 were working. There was though a clear unease at the state of affairs: “At the end of the day, any foreign currency loan is nothing more than currency speculation.”

On October 10 2008, during turbulent times on the financial markets, the FMA “strongly recommended” that banks to stop issuing FX loans to households. The FMA has since repeatedly claimed FX loans were “banned” in 2008 but that was not the wording used at the time. Funnily enough there is no press release in the ÖBN web archive from this date related to the October restrictions. In its 2014 Annual Report it talks of the autumn 2008 measures “de facto ban” on issuance of new FX loans to households.

According to the IMF, in 2013, the measures “introduced in late 2008 to better monitor and contain FC liquidity risks, by encouraging banks to diversify FC funding sources across counterparties and instruments, and lengthen FC funding tenors.”– There was no ban, not even a “de facto ban.”

FMA’s 2003 “Minimum Standards” for FX lending were revised in 2010. By then, the FMA and the ÖNB had been warning about the FX loans for a decade or longer. In spite of the “non-ban” 2008 measures, it was only in 2010 that Austrian banks “made a commitment to stop extending foreign currency loans associated with high levels of risk, in line with supervisory guidance provided to this effect (“guiding principles”).” In January 2013 the FMA issued revised the “Minimum Standards,” also taking into account recommendations by the European Systemic Risk Board, ESRB.

All of these warnings are in tip-toeing and kid-glove central bank and regulator speak: there is no doubt that behind these Delphic utterances there were real concern. All along, Austrian authorities have underlined that these standards were not rules and regulations, more a kind advice to the banks to act more sensibly.

The IMF has over the years voiced concern in a much stronger tone and language than the Austrian authorities. As late as January 2014 the IMF underlined the possibility of multiple shock: “Exchange rate volatility (e.g., CHF) or asset price declines associated to repayment vehicles loans (RPVs) could increase credit risk due to the legacy of banks’ FCLs to Austrian households.”

It was not until 2013, five years after the crisis hit and, counting from 2000 when the FX lending had soared, numerous currency fluctuations later that the FMA finally had a clearly worded lesson for the banks and their household FX borrowers: “foreign currency loans to private consumers are not suitable as a mass product…”

Another dimension of FX lending risks: other shocks accompany exchange volatility

In the FMA’s latest regular FX lending overview, from December 2014 it points out that following initiatives to limit the risk on outstanding FX loans, as well as what it there (as elsewhere) calls ban in 2008 on new loans, the volume of borrowings has been falling: outstanding FX loans to private individuals, as a share of all outstanding loans end of September 20014 is now at 19.1%; 95% of these loans are denominated in CHF, the rest mostly in Japanese yen.

Correctly stated, the FX lending is declining but the devilish nature of FX loans is that the principal is affected by chancing rates of the currency the loans are linked to. The number of loans issued may have been declining – the ÖNB points out FX loans to Austrian borrowers have indeed been declining since autumn 2008 but the real decline in the FX lending has been “offset by the appreciation of the Swiss franc.” As seen from ÖNB data the loans did indeed not top until 2010 (see Table A11).

The ceiling set by the Swiss National Bank, SNB, in late summer 2011 helped stabilise the exchange rate – but this stability ended spectacularly in January this year.

What further adds to the risk of FX lending is that it is easy to envisage a situation where banks and borrowers are not hit only by a single shock wave stemming from currency fluctuations but by other simultaneous shocks, such as a slump in asset prices; again something that the ÖNB has underlined, i.a. as early as in the bank’s Financial Stability report April 2003.

If several private borrowers would become insolvent due to rising exchange rates, “the simultaneous and complete realization of the above-mentioned collateral would considerably dampen the price to be achieved.” Thus, banks with a high percentage of foreign currency loans incur a concentration risk, which would endanger financial stability in the region, if the collaterals needed to be sold. It is an extra risk that the banks with the highest share of FX lending were small and medium-sized regional banks in Western Austria; in some cases up to 50% of total assets were FX loans.

Repayment vehicles = no guarantee but an even greater risk

The fact that the majority of Austrian domestic FX loans comes with a repayment vehicle has often been cited as a safety net for FX borrowers and consequently for the banks. This is however a false safety and both the ÖNB and the FMA, as well as foreign observers such as the IMF have, again for a long time, understood this risk.

In order to gauge the risk it is necessary to understand the structure of the FX loans: almost 80% of the FX loans are balloon loans, i.e. the full principal is repaid on maturity: interest rates, according to the LIBOR of the currency and repriced every three months, are paid monthly. The FX loans can normally be switched to euro (or any other currency) but at a fee; another aspect in favour of the bank is a forced conversion clause, allowing the bank to convert the loan into a euro loan without the borrower’s consent.

The repayment vehicle is usually a life insurance contract or an investment in mutual fund, paid into the scheme in monthly instalments. The majority of those who have taken out the FX loans coupled with repayment vehicle have done so via an agent, clearly an added risk as mentioned above.

Consequently, for borrowers there is a twofold risk attached to FX loans with repayment vehicle: firstly, there is the currency risk related to the loans themselves; second there is the real risk of a shortfall in the repayment vehicle, clearly born out by the volatility in 2008. As pointed out in the ÖNB’s Financial Stability October 2008 report  the repayment vehicles “in addition to other risks, are exposed to exchange rate risk.”

The ÖNB had however been aware of the repayment vehicle risk much earlier than 2008. Already in its Financial Stability October 2002 report, the risk was spelled out very clearly: the repayment vehicles “usually do not serve to hedge against exchange rate or interest rate risk; rather, they add risk to the entire borrowing scheme.”

If the repayment vehicle does not perform well enough to cover the principal of the FX loan one may try to switch to other investments but at a cost. “If the performance of these repayment vehicles cannot keep up with the assumptions used in the provider’s model calculations, the borrower, who is already exposed to high exchange rate and interest rate risk, becomes exposed to even greater risk.”

In short: on maturity, there is high risk that the repayment investment will not cover the loan, i.e. the alleged safety net has a hole in it. In the present environment of low interest rates it is a struggle to avoid this gap.

Following a 2011 survey there was already a growing shortfall in sight, according to an FMA statement in March 2012. At the time, FX loans with repayment vehicle amounted to €28.6bn. By the end of 2008 the shortfall had been €4.5bn, or 14% of the loan volume. End of 2011 the shortfall in cover amounted to ca. €5.3bn, at the time 18% of the outstanding loans; the increase between 2011 and 2012 had been €800m, an increase in the shortfall by 22%.

In 2013 the FMA put in place regulation, which obliges the insurance companies to create provisions from their own profits should these repayment vehicles fail. This will however only be tested when the attached FX loans mature: 80% of them are set to mature in or after 2019; a “significant redemption risks to Austrian banks” according to the ÖNB in December 2014.

The ÖNB and the FMA are indeed paying extra attention to the interplay between FX loans and the repayment vehicles: the two authorities are conducting a survey in the first quarter of 2015 to uncover the risks posed by these two risk factors, the FX loans and the repayment vehicles. Somewhat wearily, the ÖNB points out that the two authorities have been warning against these loans for more than ten years. Though reined in and declining FX loans still “continue to constitute a risk for households and for the stability of the Austrian financial system.”

Austrian consumer action in sight

Following the Swiss decap in January the Austrian Consumer Association, VKI, has taken action to inform FX borrowers on their options.

The Austrian FX loan agreements normally have a “stop-loss” clause, seemingly a protection for the borrower to limit sudden losses because of currency appreciation. Sadly, following the Swiss decap in January many FX borrowers have discovered that this clause did not limit their losses. These clauses have been the cause of many queries made at the VKI. The FMA, claiming it can not act on this, has advised borrowers to bring the matter to the attention of the banks, but gave the end of February 2015 as a deadline; a remarkably short time.

VKI is also advising FX borrowers to try to negotiate with the banks regarding coast of converting CHF into euro loans or loss incurred from the FX loans compared to euro loan, arguing that these costs should not be carried by the borrowers alone but shared with the bank.

As elsewhere, the Austrian banks have taken fees for administering the FX loans, typically 1 to 2%, as if they had incurred costs by going into the market to buy CHF in connection to the FX loans. However, as elsewhere, the Austrian loans are CHF indexed, not actual lending in FX. In the Árpad Kásler case the European Court of Justice, ECJ, ruled that this cost was illegal since there were no actual services carried out. Consequently, this might be of help to Austrian FX borrowers; also that part of the ruling, which obliges banks to inform clients properly.

If these actions take off this could mean a considerable hit for the banks. After all, 150.000 households have FX loans of €25bn in total, not a trivial sum.

Given the fact that so many of these loans and the repayment vehicles were sold through agents their responsibility for informing clients has to be tested at some point: it is inconceivable that important intermediaries between banks and their clients bear no responsibility at all for the products they arrange to be sold.

As in other countries, Austrian FX borrowers have already been heading for the courts. So far, the cases are few but have at least in some cases been positive for the borrowers.

The question is whether Austrian politicians will be firmly on the side of the banks or if they will come to the aid of FX borrowers. But there really is good reason for political attention, given that the problem certainly is still lingering. It should also be of political concern that the ÖNB and the FMA chose to treat banks with kid-gloves lightly – though full well knowing that the products being sold to consumers were highly explosive and hugely risky both to the borrowers and the country.

* This is the second article in a series on FX lending in Europe: the unobserved threat to FX unhedged borrowers – and European banks.The next article will be on Austrian banks and FX lending abroad. The series is cross-posted on Icelog.

Occupational shifts in the UK

Following up on the ideas in this post, here’s an interesting chart from the Bank of England Inflation Report.


In our model, people advance along at least locally optimal career paths in expansions, and then have to find a new one in recessions. So you’d expect job tenure, marked in green, to reflect the business cycle – people accumulate it during expansions and lose it in recessions – and that’s precisely what we see. In 1996-2000, when unemployment dropped sharply, it was a strongly negative contributor to wage growth. After that, it began to be a positive contribution as the new hires progressively accumulated tenure and advanced along their career paths. We also see a bit of this after the .com crash. However, it didn’t become a big negative item after the great financial crisis, perhaps because unemployment didn’t rise as much as expected.

The effect of change in qualifications has been quite surprising; it was negative for most of the boom, and then very positive immediately post-crisis.

From 1999 to 2007, workers changing between occupations seems to have been a significant contributor to wage growth (about +0.2% a year). Between 1996 and 2002, workers changing between industries was a positive contribution, but it then swung negative between 2002 and 2006, before becoming positive again in 2007.

During the great financial crisis, it was significantly negative, and it then became positive in the recovery. Since then, it’s disappeared as a factor. Change between occupations, however, was strongly positive in the crisis, erratic and noisy in the recovery, and since Q1 2013, has become very strongly negative. So has the effect of job tenure. At the moment, the combination of tenure and occupational change accounts for -0.75 percentage points of wage growth. The strong negative tenure effect is comparable to that in the late 90s expansion, implying significant net hiring. The occupational change effect is, however, unprecedentedly awful, and it is increasing.

This is consistent with the perverse selection I proposed in the original post. The big difference between now and the 90s experience, though, is that the occupational shift effect is much bigger.

Which is also consistent with making Jobseekers’ Allowance claimants stand around Finsbury Park station wearing a hi-viz vest to no particular purpose.

If Greece Had Not Existed, Europe’s Leaders Would Have Had to Invent It

He must be chosen from among you as a scapegoat. Hipponax

One of the more intriguing aspects of the whole modern Greek drama is the tragicomic way the country seems to be constantly condemned to live out well known themes which come from its own mythology. The latest example is the way what was once the cradle of European civilization has allowed itself to be converted into the role model for everything its fellow Europeans are not. Or at least, this is the story we are supposed to believe. Continue reading

This time, no different from earlier: FX risk hidden from borrowers

The Swiss Franc unpegging from the euro 15 January this year brought the risk of foreign currency borrowing for unhedged borrowers yet again to the fore. In Central, Eastern and South-Eastern Europe lending in Swiss Franc and other foreign currency, most notably in euros, has been common since the early 2000s, often amounting to more than half of loans issued to households. The 2008 crisis put some damper on this lending, did not stop it though and in addition legacy issues remain. Now, actions by foreign currency borrowers in various countries are also unveiling a less glorious aspect: mis-selling and breach of European Directives on consumer protection. Senior bankers involved in foreign currency lending invariably claim that banks could not possibly foresee FX fluctuation. Yet, all of this has happened earlier in different parts of the world, most notably in Australia in the 1980s.

“The 2008-09 financial crisis has highlighted the problems associated with currency mismatches in the balance sheets of emerging market borrowers, particularly in Emerging Europe,” economists at the European Bank of Reconstruction and Development, EBRD, Jeromin Zettelmeyer, Piroska Nagy and Stephen Jeffrey wrote in the summer of 2009.*

In the grand scheme of Western and Northern European countries this mismatch was a little-noticed side-effect of the 2008 crisis. But at the EBRD, focused on Central, Eastern, South East European, CESEE, countries, its chief economist Erik Berglöf and his colleagues worried since foreign currency, FX, lending was common in this part of Europe. FX lending per se was not the problem but the fact that these loans were to a great extent issued to unhedged borrowers, i.e. borrowers who have neither assets nor income in FX. This lending was also partly the focus of the Vienna Initiative, launched in January 2009 by the EBRD, European and international organisations and banks to help resolve problems arising from CESEE countries mainly being served by foreign banks.

In Iceland FX lending took off from 2003 following the privatisation of the banks: with the banks growing far beyond the funding capacity of Icelandic depositors, foreign funding poured in to finance the banks’ expansion abroad. Icelandic interest rates were high and the rates of euro, Swiss Franc, CHF and yen attractive. Less so in October 2008 when the banks had collapsed: at the end of October 2007 1 euro stood at ISK85, a year later at ISK150 and by October 2009 at ISK185.

After Icelandic borrowers sued one of the banks, the Supreme Court ruled in a 2010 judgement that FX loans were indeed legal but not FX indexed loans, which most of household loans were. It took further time and several judgements to determine the course of action: household loans were recalculated in ISK at the very favourable foreign interest rates. Court cases are still on-going, now to test FX lending against European directives on consumer-protection.

In all these stories of FX loans turning into a millstone around the neck of borrowers in various European countries senior bankers invariably say the same thing: “we couldn’t possibly foresee the currency fluctuations!” In a narrow sense this is true: it is not easy to foresee when exactly a currency fluctuation will happen. Yet, these fluctuation are frequent; consequently, if a loan has a maturity of more than just a few years it is as sure as the earth revolving around the sun that a fluctuation of ca. 20%, often considerably more, will happen.

Interestingly, many of the banks issuing FX loans in emerging Europe did indeed make provisions for the risk, only not on behalf of their clients. According to economist at the Swiss National Bank, SNB, Pinar Yesin banks in Europe have continuously held more foreign-currency-denominated assets than liabilities, indicating their awareness of the exchange-rate-induced credit risk they face.”

Indeed, many of the banks lending to unhedged borrowers took measures to hedge themselves. Understandably so since it has all happened before. Recent stories of FX lending misery in various European countries are nothing but a rerun of what happened in many countries all over the world in earlier decades: i.a., events in Australia in the 1980s are like a blueprint of the European events. In Australia leaked documents unveiled that senior bankers knew full well of the risk to unhedged borrowers but they kept it to themselves.

It can also be argued that given certain conditions FX lending led to systematic lending to CESEE clients borrowing more than they would have coped with in domestic currency making FX lending a type of sub-prime lending. What now seems clear is that cases of mis-selling, unclear fees and insufficient documentation now seem to be emerging, albeit slowly, in European FX lending to unhedged borrowers.

FX lending in CESEE: to what extent and why

A striking snapshot of lending in Emerging Europe is that “local currency finance comes second,” with the exception of the Czech Republic and Poland, as Piroska Nagy pointed out in October 2010, referring to EBRD research. With under-developed financial markets in these countries banking systems there are largely dominated by foreign banks or subsidiaries of foreign banks.

This also means, as Nagy underlined, that there is an urgent need to reduce “systemic risks associated with FX lending to unhedged borrowers” as this would remove key vulnerabilities and “enhance monetary policy effectiveness.”

Although action has been taken in some of the European countries hit by FX lending, “legacy” issues remain, i.e. problems stemming from prolific FX lending in the years up to 2008 and even later. In short, FX lending is still a problem to many households and a threat to European banks, in addition to non-performing loans, i.e. loans in arrears, arising from unhedged FX lending.

The most striking mismatch in terms of banks’ behaviour is evident in the operations of the Austrian banks that have been lending in FX at home in Austria the euro country, but also abroad in the neighbouring CESEE countries. In Austria, FX loans were available to wealthy individuals who mostly hedged their FX balloon loans (i.e. a type of “interest only” loans) with insurance of some sort. Abroad however, “these loans in most cases had not been granted mostly to relatively high income households,” as somewhat euphemistically stated in the Financial Stability report by the Austrian Central Bank, OeNB in 2009.

There is plenty of anecdotal evidence to conclude that during the boom years banks were pushing FX loans to borrowers, rather than the other way around. Thus, it can be concluded that the FX lending in CESEE countries was a form of sub-prime lending, that is people who did not meet the requirements for borrowing in the domestic currency could borrow, or borrow more, in FX. This would then also explain why FX loans to unhedged borrowers did become such a major problem in these countries.

Where these loans have become a political issue FX borrowers have often been met with allegations of greed; that they were trying to gain by gambling on the FX market. In 2010 Martin Brown, economist at the SNB and two other economists published a study on “Foreign Currency Loans – Demand or Supply Driven?” They attempted to answer the question by studying loans to Bulgarian companies 2003-2007. What they discovered was i.a. that for 32% of the FX business loans issued in their sample the companies had indeed asked for local currency loan.

“Our analysis suggests that the bank lends in foreign currency, not only to less risky firms, but also when the firm requests a long-term loan and when the bank itself has more funding in euro. These results imply that foreign currency borrowing in Eastern Europe is not only driven by borrowers who try to benefit from lower interest rates but also by banks hesitant to lend long-term in local currency and eager to match the currency structure of their assets and liabilities.”

In other words, the banks had more funding in euro than in the local currency and consequently, by lending in FX (here, euro), the banks were hedging themselves in addition to distancing themselves from instable domestic conditions. A further support for this theory is FX lending in Iceland, which took off when the banks started to seek funding on international markets. (The effect on banks’ FX funding is not uncontested: further on reasons for FX lending in Europe see EBRD’s “Transition Report” 2010, Ch. 3, esp. Box 3.2.)

The Australian lesson: with clear information “…nobody in their right mind… would have gone ahead with it”

Financial deregulation began in Australia in the early 1970s. Against that background, the Australian dollar was floated in December 1983. In the years up to 1985 banks in Australia had been lending in FX, often to farmers who previously had little recourse to bank credit. However, the Australian dollar started falling in early 1985; from end of 1984 to the lowest point in July 1986 the trade-weighted index depreciated by more then a third. Consequently, the FX loans became too heavy a burden for many of the burrowers, with the usual ensuing misery: bankruptcy, loss of homes, breaking up of marriages and, in the most tragic cases, suicide.

The Australian bankers shrugged their shoulders; it had all been unforeseeable. FX borrowers who tried suing the banks lost miserably in court, unable to prove that bankers had told them the currency fluctuations would never be that severe and if it did the bank would intervene. As one judge put it: “A foreign borrowing is not itself dangerous merely because opportunities for profit, or loss, may exist.” The prevailing understanding in the justice system was that those borrowing in FX had willingly taken on a gamble where some lose, some win.  

But gambling turned out to be a mistaken parallel: a gambler knows he is gambling; the FX borrowers did not know they were involved in FX gambling. The borrowers got organised, by 1989 they had formed the Foreign Currency Borrowers Association and assisted in suing the banks. The tide finally turned in favour of the borrowers and against the banks; the courts realised that unlike gamblers the borrowers had been wholly unaware of the risk because the banks had not done their duty in properly informing the FX borrowers of the risk. But by this time FX borrowers had already been suffering pain and misery for four to five years.

What changed the situation were internal documents, two letters, tabled on the first day of a case against one of the banks, Westpac. The letters, provided by a Westpac whistle-blower, John McLennan, showed that when the loan in question was issued in March 1985 the Westpac management was already well aware of the risk but said nothing to clients. Staff dealing with clients was often ignorant of the risks and did not fully understand the products they were welling. When it transpired who had provided the documents Westpac sued McLennan – a classic example of harassment whistle-blowers almost invariably suffer – but later settled with McLennan.

As a former senior manager summed it up in 1991: “Let us face it – nobody in their right mind, if they had done a proper analysis of what could happen, would have gone ahead with it.” (See here for an overview of some Australian court cases regarding FX loans).

FX borrowers of all lands, unify!

“Probably like a lot of other people (.) I felt that the banks knew what they were doing, and you know, that they could be trusted in giving you the right advice,” is how one Westpac borrower summed it up in a 1989 documentary on the Australian FX lending saga.

This misplaced trust in banks delayed action against the banks in Australia in the 1980s and in all similar sagas. However, at some point bank clients realise the banks take their care of duty towards clients lightly but are better at safeguarding own interests. As in Australia, the most effective way is setting up an association to fight the banks in a more targeted cost-efficient way.

This has now happened in many European countries hit by FX loans and devaluation. At a conference in Cyprus in early December, organised by a Cypriot solicitor Katherine Alexander-Theodotou, representatives from fifteen countries gathered to share experience and inform of state of affairs and actions taken in their countries regarding FX loans. This group is now working as an umbrella organization at a European level, has a website and aims i.a. at influencing consumer protection at European level.

Spain is part of the euro zone and yet banks in Spain have been selling FX loans. Patricia Suárez Ramírez is the president of Asuapedefin, a Spanish association of FX borrowers set up in 2009. She says that since the Swiss unpegging in January the number of Asuapedefin members has doubled. “There is an information mismatch between the banks and their clients. Given the full information, nobody in their right mind would invest all their assets in foreign currency and guarantee with their home. Banks have access to forecasts like Bloomberg and knew from early 2007 that the euro would devalue against the Swiss Franc and Japanese Yen.”

As in Australia, the first cases in most of the European countries have in general and for various reasons not been successful: judges have often not been experienced enough in financial matters; as in Australia clients lack evidence; there tends to be a bias favouring the banks and so far, only few cases have reached higher instances of the courts. However, in Europe the tide might be turning in favour of FX borrowers, thanks to an fervent Hungarian FX borrower.

The case of Árpád Kásler and the European Court of Justice

In April 2014 the European Court of Justice, ECJ, ruled on a Hungarian case, referred to it by a Hungarian Court: Árpád Kásler and his wife v OTP Jelzálogbank, ECJ C?26/13. The Káslers had contested the bank’s charging structure, which they claimed unduly favoured the bank and also claimed the loan contract had not been clear: the contract authorised the bank to calculate the monthly instalment on the basis of the selling rate of the CHF, on which the loan was based, whereas the amount of the loan advanced was determined by the bank on the basis of the buying rate of the CHF.

After winning their case the bank appealed the judgement after which the Hungarian Court requested a preliminary ruling from the ECJ, concerning “the interpretation of Articles 4(2) and 6(1) of Council Directive 93/13/EEC of 5 April 1993 on unfair terms in consumer contracts (OJ 1993 L 95, p. 29, ‘the Directive’ or ‘Directive 93/13’).”

In its judgment the ECJ partly sided with the Káslers. It ruled that the fee structure was unjust: the bank did not, as it claimed, incur any service costs as the loan was indeed only indexed to CHF; the bank did not actually go into the market to buy CHF. The Court also ruled that it was not enough that the contract was “grammatically intelligible to the consumer” but should also be set out in such a way “that consumer is in a position to evaluate… the economic consequences” of the contract for him. Regarding the third question – what should substitute the contract if it was deemed unfair – the ECJ left it to the national court to decide on the substitute.

Following the ECJ judgement in April 2014, the Hungarian Supreme Court ruled in favour of the Káslers: the fee structure had indeed favoured the bank and was not fair, the contract was not clear enough and the loan should be linked to interest rates set by the Hungarian Central Bank. – As in the Australian cases Kásler’s fight had taken years and come at immense personal pain and pecuniary cost.

Hungarian law are not precedent-based, which meant that the effect on other similar loan contracts was not evident. In July 2014 the Hungarian Parliament decided that banks lending in FX should return the fee that the Kásler judgement had deemed unfair.

The European Banking Authority, EBS is the new European regulator. The ECJ ruling in many ways reflects what the EBA has been pointing from the time it was set up in 2011. In its advice in 2013 on good practice for responsible mortgage lending it emphasises “a comprehensive disclosure approach in foreign currency lending, for example using scenarios to illustrate the effect of interest and exchange rate movements.”

Calculated gamble v being blind-folded at the gambling table

“Since the ECJ judgment in the Kásler case, judges in Spain have started to agree with consumers from banks,” says Patricia Suárez Ramírez. So far, anecdotal evidence supports her view that the ECJ judgment in the Kásler case is, albeit slowly, determining the course of other similar cases in other EU countries.

The FX loans were clearly a risk to unhedged borrowers in the countries where these loans were prevalent. If judgements to come will be in favour of borrowers, as in ECJ C?26/13, the banks clearly face losses: in some cases even considerable losses if the FX loans will have to be recalculated on an extensive scale, as did indeed happen in Iceland.

Voices from the financial sector are already pointing out the unfairness of demands that the banks recalculate FX loans or compensate unhedged FX borrowers. However, it seems clear that banks took a calculated gamble on FX lending to unhedged borrowers. In the best spirit of capitalism, you win some you lose some. The unfairness here does not apply to the banks but to their unhedged clients, who believed in the banks’ duty of care and who, instead of being sold a sound product, were led blind-folded to the gambling table.

*The first draft was written in July 2009; published 2010 as EBRD Working Paper.

This is the first article in a series on FX lending in Europe: the unobserved threat to FX unhedged borrowers – and European banks.The next article will be on Austrian banks, prolific FX lenders both at home and abroad, though with an intriguing difference. The series is cross-posted on Icelog.

See here an earlier article of mine on FX lending, cross-posted on Fistful of Euros and my own blog, Icelog

ECB Taper News

What Business Insider’s Mike Bird somewhat ironically calls #euroboom2015 seems to be well and truly with us.

The WSJ’s Simon Nixon spelled  it out for us in his “QE is Working Better than the ECB Dared Hope” article:  “one month into the ECB’s €1 trillion ($1.06 trillion) quantitative-easing program, and ECB President Mario Draghi was only too happy to take credit for a remarkable turnaround in the economy’s fortunes at Wednesday’s news conference.” And he goes on to give examples:

“Growth forecasts have been continually revised up since January when the program was announced: the International Monetary Fund said this week it now expects the eurozone to grow by 1.5% in 2015. Business and consumer confidence are the highest since 2007. Bank lending is finally picking up.”

“The strongest growth is coming from former crisis countries: Spain is forecast to grow by up to 3% and Ireland up to 4% this year. Meanwhile German policy makers fret that with growth likely to hit 2.5%, the economy may overheat.”

 Naturally, as he also says, “not all of this can be traced to quantitative easing.” But then, here comes the point: “Indeed, if the ECB had delayed its decision on quantitative easing until March, as the Bundesbank had urged, it may have concluded it didn’t need to buy any bonds at all.” Continue reading