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Address by Director Luís Laginha de Sousa at the “Macroprudential Policy Conference – Lietuvos Bankas”: "Borrower-based measures in times of global pandemic and beyond"

I would like to start by thanking the invitation from the Central Bank of Lituania, to participate in this Conference and I would also like to salute my panel colleagues.

The topic of the panel is very challenging and being the last to speak is an additional challenge as the risk of overlapping increases.

In order to mitigate that risk, instead of addressing the topic on just a more pure conceptual basis, I will address it based on the experience we’ve been having at the Portuguese Central Bank, with the Borrower Based Measure we’ve implemented in 2018.

I have organized my presentation around three main points.

In the first point, I will try to describe the main characteristics of the Portuguese BBM, namely the context in which the BBM was implemented, the main goals we wanted to achieve, and its key features.

In the second point, I will focus a little bit more on the strengths and the limits of the BBM. 

In the third and last point, I will share some thoughts related to the discussion of whether or not we should harmonize BBM across EU.

I’ve assumed that this session is not purely technical and this assumption allows me to use some expressions and concepts that might not completely fall in the category of technical purity.

Banco de Portugal applied a borrowed based macroprudential measure to new mortgage and consumer loans since 1 July 2018.  

The context in which the decision was shaped and taken, had plenty of ingredients that could be put on the list, but three of them deserve being mentioned.

At the time, we were observing that credit standards applied by credit institutions, were becoming less restrictive and that trend was expected to intensify.

In spite of the strong adjustment following the sovereign debt crisis, Portuguese households still showed high levels of indebtedness and a low saving rate and we were concerned with the possibility of that adjustment being put on hold, at a moment where it still needed to continue.

The vivid memory of the previous financial crisis provided two important supports, one being an incentive for authorities to take action and the other a positive attitude from different stakeholders.

All this became a reason of concern and it was rapidly translated into a call to action.

When we defined the goals of the BBM we made it very clear at the time that the purpose of the recommendation is not to reduce the credit provided by banks.

What Banco de Portugal aimed was preventing excessive risk taking by the financial sector, which is different from saying that credit must be reduced.

The measure is aimed at promoting the adoption of prudent credit standards on loans granted to households, by the Portuguese financial system.

With this increased prudence on credit standards, we aimed at enhancing both the resilience of the financial sector and the sustainability of households’ financing and, by doing so, minimizing defaults.

Concerning the Key features, the measure comprises the simultaneity of limits to three parameters: the loan-to-value ratio (LTV); the debt service-to-income ratio (DSTI); the maturity of the loan and it requires regular payments of principal and interest.

The degree of comprehensiveness of the measure combined with the simultaneous implementation of several limits helps to reinforce its effectiveness.

We know LTV limits tend to become less restrictive in a context of rising housing prices which is why they are combined with DSTI limits which, in turn, are combined with limits to maturity.

The limits to the DSTI ratio act as automatic stabilizers, and the limit to maturity prevents the circumvention of limits to the DSTI.

The macroprudential measure took the legal form of a recommendation following the “comply-or-explain” principle. 

This feature has not put at stake the compliance by financial institutions, with the limits that were envisaged by the recommendation.

Financial system have broadly agreed on the benefits to financial stability of this borrower-based measure, not to mention that they also saw it as a way to avoid a “race to the bottom”.

The option for a non-binding legal instrument was also the result of taking into account the need to gather experience with the implementation of the measure, particularly to ensure a good understanding of potential impact coming from a measure that was both innovative and complex.

The measure is applicable to new mortgage and consumer loans, and to all credit institutions and financial companies which have their head office or branches in the Portuguese territory and are authorised to grant this type of credits in Portugal.

By covering the full spectrum of entities and both mortgage and consumer loans, we wanted to prevent regulatory arbitrage.

Right from the beginning, the design of the macroprudential Recommendation included elements of flexibility which could be used in a stress situation. Here also, our previous experience with the financial crisis, was extremely valuable.

I’ll just highlight a few of those flexibility elements.

Some credit agreements are excluded from the scope of the Recommendation in order both to (i) give greater flexibility to the design of credit agreements, and (ii) to safeguard consumers against temporary liquidity shortage.

In addition, as another element of flexibility, 5% of the new credit could be granted to borrowers with a DSTI ratio without limit.

Apart from the flexibility elements that existed right from the beginning, Banco de Portugal also decided to take additional temporary flexibility measures, in the context of the Covid-19 pandemic, 

That was the case of “personal credit” with maturities of up to two years, as long as it was duly identified as intended to mitigate households’ temporary liquidity shortage situations. Should “personal credit” fill this criteria, it would be exempted for having to comply with a DSTI ratio limit and also from observing the recommendation of regular principal and interest payments.

This measure applied since 1 of April to new personal credit agreements and was in force until 30 September 2020.

Based on the experience we’ve had so far with the Covid-19 pandemic, we feel very confident in saying that it is essential to include in the design of a borrower-based measure (i) flexibility elements that can be used in a stress scenario, and (ii) temporary exemptions to ensure that, in these stress scenarios, households have liquidity in the very short-term. 

But all this has to be done in such a way that allows continuing to anchor credit standards at prudent levels.

One last key feature I would like to talk about is the “Monitoring” component.

Banco de Portugal has been monitoring the implementation of the Recommendation since July 2018, and, for such monitoring, there were different components involved, of which, I’ll mention two.

One very important component were bilateral meetings with several institutions among the more than 200 covered by the recommendation.

We focused our bilateral meeting efforts in a group of 13 institutions, which represent a market share of approximately 95%. The purpose of such bilateral meetings was: (i) to get a sense of how banks were implementing/adopting the Recommendation in the different channels (branches and digital channels – internet); (ii) to assess whether institutions’ advertising campaigns were in line with the recommendation and; (iii) to detect, at an early stage, potential problems in collecting all the data required for the monitoring process of the Recommendation.

The second very important component was the request of an annual self-assessment report on the implementation of the Recommendation

The report addresses the degree of compliance with the Recommendation with regard to each of the limits (LTV, DSTI, maturity, regular payments of principal and interest) and, very important, the report has to be approved by each institution’s Executive Board.

Let me now move to the second point I would like to cover in my presentation, which is about BBM’s strengths and limits.

Here I would like to focus on the main results we’ve obtained so far. 

To illustrate the results, I’ve chosen a few graphs which will be presented in the following slides.

The first two graphs show how the distribution of new loans for house purchase has evolved, considering the LTV ratio in the first one and, Borrower’s risk profile, in the second one.

What we clear see, through the graph on the left, is that in 2020 almost all new credit for house purchase had an LTV lower than the 90% limit and the amount of new credit agreements with an LTV above 100% is close to zero. 

This contrasts with the situation before the implementation of the measure, where there was a significant share of loans for house purchase with a LTV above 90%.

If we consider the combination of the DSTI and LTV ratios, which is represented through the graph on the right, we can also clearly see a continuous improvement of the risk profile of borrowers’ since the Recommendation came into force. 

This improvement translates in the decrease of the percentage of new loans which are granted to high-risk borrowers, for house purchase.

These two additional graphs show us the distribution of the effective DSTI ratio for new loans to households, both in terms of total new loans and in terms of total new loans aimed specifically for house purchase

It is important to mention that the effective DSTI calculation excludes interest rate shocks and also excludes income reduction shocks

In addition, the calculation of effective DSTI is based on net income, which makes this indicator not fully comparable with the DSTI used in BBM implemented by other countries, as they tend to use the gross income instead.

Through the graph on the left, we observe that the average DSTI ratio for total new loans to households, declined almost 3pp, that is from 28.2% to 25.3%, between the second half of 2018 and 2020.

We can see also that 75% of total new loans to households had a DSTI ratio below 32% in 2020, coming from 35,6% in the second half of 2018

Through the graph on the right, we see that the average DSTI ratio for house purchase declined almost 2pp, from 25.7% to 23.8%, during the same period. 

Here too, we can see that 75% of total new loans to households for house purchase, had a DSTI ratio below 30%, which compares with 32% in the second half of 2018

These results are very encouraging and allow us to think that the BBM functioning properly. 

But in the macroprudential policy area, we are constantly dealing with the challenge of the counterfactual, which is more difficult, if not impossible at all to obtain.

So to this respect, it is always very gratifying when, even if with limitations, there are ways to demonstrate how important macroprudential measures can be, compared with a situation where such measures would not exist.

And it is particularly fortunate that such demonstration can be identified in one of the first studies that assessed the impact of a borrower-based measure in the Covid-19 context.

Neugebauer et al. (2021) developed one study in which the authors find that the Portuguese borrower-based measure led to: (i) a reduction in households’ loss rate (LR), caused by both a decrease in households’ probability of default (PD) and loss given default (LGD), and (ii) an increase in the capital ratio of the banking system, compared with a scenario where the measure is not in place.

Having in mind that the resilience of borrowers is especially important in challenging economic environments, such as those characterized by high uncertainty, as it is the pandemic we’ve been going through, I believe it is fair to say that the balance between the benefits and limitations of this type of measures is clearly in favor of its benefits, especially if taking into account the ultimate objective of financial stability.

Let me now move to the last point I would like to address in the discussion about BBM’s strengths and limits.

I’ll briefly touch upon the BBM’s capability to mitigate risks from the low interest environment.

Again here, I will share my views having in mind the Portuguese experience

The low interest rates create incentives for greater competition among banks, which may lead to the easing of credit standards. As you might remember from the beginning of my presentation, the concern about the easing of credit standards was precisely one the reasons why we implemented a BBM.

But the low interest rate environment also poses another problem, which could also come from the laws of physics and not just from the laws of the economy. The problem is the likelihood of future interest rate rises and the implications this might have, namely by generating an increase in debt servicing costs, which may become too high and compromise the ability of debtors to make their debt repayments, which could ultimately lead to the possibly of increasing their default. That is even more likely for those who are more indebted and/or have lower income.

For such a situation, when we are in a low interest environment, potential increases in interest rates should be taken into account in the calculation of the DSTI ratio.

And in the case of the BBM implemented by Banco de Portugal, that is exactly what we did.

We included the criteria for assessing the impact on consumer creditworthiness (DSTI) of a rise in the reference interest rate applicable to credit agreements, which have variable or mixed interest rate as indexer (fixed rate is of course excluded).

The way this was put in practice, is shown in the Slide. When the maturity of the contract was up to 5 years, a 1PP should be applied to the index used to calculate DSTI. When the maturity of the contract was between 5 and 10 years, the index had to be increased by 2PP and for maturities over 10 years, the index had to be increased by 3PP.

It goes without saying that it is very important to include this type of precautionary component into the BBM framework.

To finish my presentation, I would like to address the last topic that was suggested to the members of this panel, which is to share a few words on whether or not there is a case for harmonizing BBM across EU.

When I was thinking about how to address this topic, two things came to my mind. 

One of those things was the expression you see on the slide, “Retail is detail”. This expression exists for a long time and for a reason and it clearly applies to retail banking activities.

When we have to deal with each individual, probably there is no area that is more “detail” driven than that. 

And BBM qualify to be considered one of such areas, as it directly touches the lives hundreds of thousands of individuals and families.

Apart from the “Retail is detail” expression, the other thing that came to my mind was related to physics and to the characteristics of Materials in particular. 

When materials have flexibility, the capacity to resist to shocks and return to the original shape is more likely to be present. 

When materials have limited or no flexibility, they are more likely to brake, if they become subject to strong shocks.

The two things I’ve just mentioned set the tone for harmonizing BBM across EU.

Rules and procedures for instruments targeting borrowers are dependent on national regulations, these national regulations, by definition, still vary substantially across Member States.

Despite borrower-based measures being currently operational in a number of EU Member States, when it comes to their respective design and implementation it differs substantially across such Members States.

The ESRB clearly has a very important coordination role in assessing measures, in discussing cross-border effects, and also in recommending mitigating measures, including reciprocity.

And this opens space for pursuing some harmonization, but it should be kept at a minimum, to ensure that the balance between harmonization and flexibility is not broken.

We have to keep in mind that when we consider the particular case of Euro Area, the macroprudencial policy was implemented in a way that was meant to take into consideration the specificity of each country’s economy.

This was also considered important as a way to counterbalance the potential build-up of risks arising from the monetary policy, which, contrary to macroprudencial policy, targets the euro area in general, through a common stance that might not be totally adequate for the situation of each individual country.

And this final remark brings me to the end of my presentation.

Thank you once more for the invitation to take part in this panel.