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

Unfortunately, the Austrian authorities have known for more than a decade that 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 the risks full well 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 learned in 2008 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 FX loans, mostly in Swiss francs, CHF. Austrian banks expanded into 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 granting FX loans to unhedged households. The warnings were ignored: the banks raked in fees, FX lending kept rising until it topped in 2010, and 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 FX loans to households amounted to €26bn, ca 18% of household loans. With a maturity period of 10 to 25 years, serious legacy issues remain.

Furthermore, three quarters of these loans, ca. €19.5bn, are coupled with a 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 reduce this risk will only be tested when the attached FX loans mature: 80% of them are due to mature in or after 2019.

In addition to the double risk of the domestic FX loans and the repayment vehicles, there are the FX loans issued by small and medium-sized Austrian banks in Central, Eastern and South-Eastern Europe, 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 with 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 clearly in sight since Austria became one of the founding euro countries in 1999. There are still significant challenges ahead for Austrian Banks. Non-performing loans are rising – Austrian banks are above the European average, very much due to Austrian banks’ operations in CESEE.

If you add to all this the Hypo Alpe Adria scandals and the Corinthia guarantees then the Austrian hills are not alive with the sound of music but groaning with well-founded worries. And these concerns, to a large extent, are due to the fact the 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 example of soft-touch regulation working 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.  In 2013, the IMF 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. Other concerns include the sector’s low profitability, seen as a long-term structural risk, as well as a domestic market dominated by a few big banks and large CESEE exposure.

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

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

Austrian FX loans: from specialised product to everyman mortgage 

In the mid-1990s, Austrian households cultivated an appetite for FX loans unaware 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 strengthened as the interest rate differential between these currencies and the Schilling widened.

Quite remarkably, the introduction of the euro on January 1 1999 did not dampen the surge: the Austrians kept their faith with 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 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 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 far as the debt-to-equity ratio is concerned, 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 demand fell. By the end of 2007, FX loans, measured in euro, amounted to €32bn, i.e. almost 30% of the volume of loans issued. It is interesting to keep in mind here that with the exception of a few months, annual growth rates of FX loans to households have always exceeded the growth of household loans in domestic currency until late 2006.

FX loans in Austria are declining: in 2008 270.000 households had FX loans, falling to 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 FX loans to households amounted to €26bn.

There are also indications that because FX loans seemed cheaper than euro loans households tended to borrow more. The ÖBN has flagged 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 gives them the characteristics of sub-prime lending, i.e. leads to households borrowing more than is sensible, thus fuelling the FX risk.

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

*Continue reading at Sigrún Davídsdóttir’s Icelog.