Kamil Liberadzki, Director of the Regulation Development Department
I. Interest rate risk: anticipating the future and relying on the collective wisdom of the internet
Have you ever watched smoke dissipate into the air in a perfectly still weather? What do the movement of particles of such smoke and the movements of the floating-interest rate on mortgage loans have in common? Well, banks price contracts based on interest rate using dynamics models that are almost identical to the ones used by physicists to model the movement of smoke dissipating into a still environment. Each single smoke particle bombarded with billions of air particles undergoes diffusion as described by the random walk model. The same rule applies to the market interest rate ‘driven’ by decisions, usually made independently by hundreds of thousands of money market participants.
Financial economists treat interest rate as a ‘stochastic process’, i.e. a random variable. This approach underlies the measurement of bonds, loans and interest-rate derivatives. In the medium and long term, such assumption renders the actual level of interest rate unpredictable. In consequence, when taking a mortgage loan and choosing floating rate instead of temporarily fixed interest rate, based on their own or someone else’s projections – and in today’s reality, increasingly, based on the collective wisdom of the internet – consumers may make a mistake. This has been the case in Poland in 2021, when consumers – contrary to the clear warnings from the UKNF, including as part of our awareness-raising campaign in the media – were massively taking floating-rate loans. It must be noted that following the UKNF’s revised Recommendation S, at that time clients could already choose – in the period of record low interest rates – loans with temporarily fixed interest rate, that were very attractive, if we look from today’s perspective. Most probably they acted based on the conviction that the interest rate on the loan would not increase materially, or at least – based on the intention to benefit from the record low interest rate on floating-rate loans. In other words, they often disregarded or underestimated interest rate risk, particularly a possibility of a material increase in interest rates in such a short time.
The principles of economics are unrelenting, though. Since interest rate is characterised by randomness, as is the movement of smoke particles in a perfectly still environment, one can try to forecast the future level of interest rate just like local shamans prophesied future based on the inspection of the entrails of sacrificed poultry.
And now, with unconcealed surprise, the UKNF hears public statements from anonymous representatives of the banking sector. The statements suggest that banks were willing to offer clients/consumers unlimited possibility of converting the temporarily fixed-rate loans already granted into floating-rate loans, mostly based on... the consumers’ opinion(!) that floating interest rates in Poland would not rise any more, and if they were to change, they would only go down. Now we all have a feeling of déjà vu, as back in September 2021 we heard the same opinions: that interest rates on loans in Poland would never go up, when WIBOR was at about 0.24% (now it’s almost 7%).
The memory of the years 2006–2008 also pops up, when some also thought that the appreciation of the Polish zloty against the Swiss franc would be a permanent trend. Unfortunately, the harsh reality of the fall of 2008 hit hard and the following years brought new events – for example the decision of the Swiss National Bank (SNB) of January 2015 to discontinue the currency intervention – following which the ‘financial invention’ in the form of foreign-currency mortgage loans, combined with the evolution of court rulings, became the major source of systemic risk to the financial market in Poland. At the same time, clients of mortgage loans, once happy and seeing themselves as conscious beneficiaries of low interest rates in CHF linked with the trend of appreciation of the Swiss franc against the Polish zloty, found themselves becoming an alleged target of ‘foreign-currency loan fraud’ and tried to make their fight for the right to benefit from the effects of ‘abusive exchange rate clauses’ a part of the public or journalistic debate.
II. Are consumers free to take unlimited risk?
The main duty of financial regulators and supervisors is to draw conclusions. This applies particularly to past events that were a source of worry for the supervisors , leading to increased systemic risk in the financial sector. Financial regulators have been facing the old fundamental dilemma: should the banking policies allow the individual (consumer) to take unlimited risk or should they restrict that freedom or prohibit it completely? Many people argue that in a free market economy, one of the basic civil rights is the right to take business risk, including financial risk. Compromise, though, is usually the most effective solution in practice. This leads to the conclusion that in general, a borrower/consumer should make a choice independently when there is no certainty as to the future levels of interest rates and exchange rates but in some areas the freedom of choice should be restricted.
In our view, the role of financial supervisor – as pointed out by the Chair of the KNF Board Jacek Jastrzębski in his speeches in recent months – is to give the market a clue on a certain reasonable point of balance in terms of fair distribution of risks and benefits between clients and financial institutions. Another goal is to ensure that no moral hazard will materalise on anyone’s part.
Such risk may now occur on the part of clients as an attempt to figure out whether, if interest rates may soon decrease, perhaps it’s a good idea to go back to a floating-rate loan. However, if it turns out in a while that a different scenario in this respect has materialised, we will again hear arguments attempting to identify the source of the problem in some kind of ‘abusiveness’ of a contract, in an interest rate benchmark, in the lack of appropriate information about interest rate risk or inappropriate incorporation of the benchmark in a credit agreement.
If this transforms into a mass-scale phenomenon, we will then hear from the financial sector that the materialising legal risk threatens the standing of banks or their capacity for financing the economy, or that the legal instability hinders proper lending activity in relation to mortgage loans. This will lead to appeals and demands for support from public institutions. This in turn will expose the phenomenon of moral hazard also on the part of banks, which would now want to convert fixed-rate loans into floating-rate loans.
As financial supervisor, we have to counteract, or ideally prevent, such situations. We believe that a supervisory authority should express its strong position on such problematic issues and adjust market mechanisms where moral hazard occurs.
This also applies to the freedom of choice between a fixed-rate loan and floating-rate loan. The experiences from past years, especially from the period of record low interest rates, when clients were offered fixed-rate loans but still massively opted for a floating-rate loan – enchanted with the then attractive interest rates and the low amounts of instalments, without considering the risk of a material increase in interest rates – show that the pure model of ‘free choice’ is not free from certain imperfections. Later or, the imperfections must be addressed with extraordinary measures, for example moratoria on loan repayment. Those experiences serve as an important lesson.
This is why the Polish financial regulator and supervisor, Komisja Nadzoru Finansowego (KNF), has adopted the ‘happy medium’ approach: at the time of granting a loan, it must be the consumer who makes the choice on the type of interest rate on the mortgage loan1. Banks are to offer fixed-rate or temporarily fixed-rate loans and to allow the conversion of the existing floating-rate loans into fixed-rate loans. Alternatively, an offer addressed to new clients may also include floating-rate loans. A bank granting a mortgage loan is required to provide the client with accurate information about the risk arising from each of the interest rate models and to assess the client’s creditworthiness considering the risk of an increase in the interest rate on the loan. That risk is of course lower for temporarily fixed-rate loans than for floating-rate loans and this should be reflected in the creditworthiness assessment.
A civilisational change in the mortgage loan market will be fostered by the rule that the interest rate risk profile chosen initially by the client, expressed in the choice of a fixed-rate loan, shouldn’t be then converted into a riskier profile, through refinancing based on a floating rate.
The increase in market interest rates in and after 2021 has shown that in the event of a material increase in reference interest rates for floating-rate loans it’s a common practice for the State to intervene, usually by introducing moratoria on loan repayment to protect the clients affected by a surge in the amount of the instalment. This is due to a rising level of burden for households that use long-term floating-rate financing. We’ve watched such solutions in several markets and the related debate. We’ve also noted categorical assertions from the banking sector. It’s all the more ironic that banks in Poland are now pressuring the regulator into making it easier for consumers to convert fixed-rate loans into floating-rate loans.
III. What should be the regulator’s response to the massive urge to convert fixed-rate loans into floating-rate loans?
Let’s go back to the problem the Polish regulator has been facing in recent weeks. Believing that interest rates for floating-rate loans in the Polish zloty will soon decrease, clients – holders of fixed-rate housing loans – are now saying they want to repay the loan early (and contract a new loan, on ‘more favourable’ terms and with a floating interest rate). As if unaware of market volatility – including the possibility of reversal of the trend – mortgage borrowers want to go back to the open position of interest rate risk and enter into a ‘bet with the market’, as previous generations of borrowers did (more or less consciously) in relation to foreign-exchange risk.
Banks seem to be tirelessly backing their clients in their wish, as if unaware that the effects of the clients losing the bet with the market are returning to banks on a massive scale in the form of legal risk, previously highlighted by representatives of the banking sector with such vigour. The duty of financial regulators and supervisors is to draw conclusions.
This is why the regulator in Poland has adopted the following rule: it’s necessary to restrict the possibility for consumers to take unlimited risk of an increase in the reference interest rate. Borrowers should be allowed – under the contract – to make early repayment of a mortgage loan based on temporarily fixed rate but the new loan, which is contracted in lieu of, and which refinances, the loan being repaid should also be a temporarily fixed-rate loan. This doesn’t exclude the borrowers’ option to benefit from interest rate reductions; if the professional market really expects a decrease in the market interest rate, then the bank can lower the interest rates for fixed-rate loans. This happens even if we know that such a market forecast is vitiated by an error, as I mentioned earlier. This is possible thanks to the functioning of the wholesale (inter-bank) markets of interest rate derivatives and bank bonds; those markets properly measure the expectations as to the future interest rate in the quotations of those financial instruments. The measurement is done using the concept of interest rate term structure, but that’s a topic for a separate blog post.