(9)

The ESRB’s assessment of vulnerabilities highlights the following in relation to the Czech Republic: a. The growth in house prices has outpaced the growth in household income over the medium term, and cannot be fully justified by developments in the debt-servicing capacity of households. Česká národní banka (CNB) estimates that as of the second half of 2018, house prices in the Czech Republic were overvalued by between 10 % and 15 %. In addition to the contribution from cyclical factors, there are important structural factors that may have contributed to this overvaluation. In particular, the slow pace of work on the future Metropolitan Plan in Prague and delays in issuing building permits may also have contributed to the shortage in housing supply, especially in the capital. b. The overvaluation of house prices, which continues to increase, coupled with high growth in housing loans and the loosening of lending standards in recent years have increased the possibility of credit losses from mortgage loans in the event of adverse economic and financial conditions or adverse developments in the residential real estate market, with direct effects on financial stability. Similarly, the increasing indebtedness of households, coupled with the growing share of households that are potentially vulnerable to adverse economic and financial conditions or adverse developments in residential real estate market may lead to households reducing their consumption in the event of an economic or financial shock, which could lead to second-round effects that would affect financial stability indirectly. c. The annual growth in housing loans has been high over the medium term. Prior to the introduction of recommended limits to the loan-to-value (LTV) ratio, debt-to-income (DTI) ratio and debt-service-to-income (DSTI) ratio, the growth of housing credit was coupled with the loosening of lending standards as evidenced by the increasing percentage of loans with a high LTV ratio (of over 80 % and 90 %) and the increasing percentage of loans with high DTI and DSTI ratios (of over 8 % and 40 %, respectively). These loans were provided to households that may be vulnerable to adverse economic and financial conditions. Moreover, an increasing percentage of loans were provided that combined high LTV ratios with a high DTI ratio or DSTI ratio, thus further increasing the potential for credit losses related to these new mortgage loans. While the average risk weights for the mortgage portfolios held by credit institutions in the Czech Republic using the internal ratings-based approach can be regarded as being relatively high in comparison to other EEA countries, these risk weights have been declining. d. Although household indebtedness in the Czech Republic can be regarded as being moderate compared to other EEA countries, it has been increasing in line with the growth in housing loans. Despite the fact that recently there have been longer periods during which interest rates were fixed, a significant share of new mortgage loans were previously provided with initial rate fixation periods of less than five years. Consequently, a significant percentage of households taking out new mortgage loans may find it difficult to service their debt in the event of an interest rate increase. e. Adverse economic and financial conditions or adverse developments in the residential real estate market may lead to risks materialising as a result of some of the vulnerabilities mentioned above. For example, if the growth in household income decreases or interest rates increase, then highly indebted households may find it more difficult to service their loans. If these households default on their loans and house prices decrease at the same time, this may lead to credit losses from mortgage loans. Taking into account a previous Recommendation of CNB (12) related to lending standards for new mortgage loans, the risk of defaults and direct credit losses for credit institutions is currently expected to be limited. Moreover, given the relatively high average risk weights for the mortgage portfolios of credit institutions using the internal ratings-based approach and the relatively high capitalisation of the banking sector in the Czech Republic, credit institutions may be well-placed to absorb direct credit risk shocks related to the residential real estate sector. However, households may still need to adjust their consumption, as possible reductions in income or net wealth could lead to indirect effects on financial stability. f. The ESRB takes note of the wide range of borrower-based macroprudential measures to mitigate risks related to the residential real estate sector in the Czech Republic. The limits to the LTV ratio aim to address the build-up of vulnerabilities related to the provision of new mortgage loans in a market in which house prices are overvalued, with potential direct effects on financial stability. Furthermore, limits to the DTI ratio and the DSTI ratio aim to increase the effectiveness of the limits to the LTV ratio by limiting the provision of new loans to households that are potentially vulnerable to adverse economic and financial conditions and adverse developments in the residential real estate market in the Czech Republic. Credit providers are also recommended to stress-test the ability of debtors to withstand shocks related to increased interest rates or decreased incomes. To increase the resilience of institutions in relation to cyclical vulnerabilities, in 2018 CNB further increased the counter-cyclical capital buffer rate to 2 % (from 1,5 %), with effect from 1 July 2020. g. However, the current borrower-based measures have been introduced on the basis of a Recommendation from CNB which is not legally binding, and there is no legal framework in place to activate these measures through legally binding acts. As such, the effectiveness of the current measures cannot be guaranteed over the medium term, and during this period both the overvaluation of house prices and the growth in mortgage credit may increase further. h. The current macroprudential policy is assessed to be partially appropriate and partially sufficient as regards the potential development of vulnerabilities in the residential real estate sector in the Czech Republic over the medium term. It is important that national authorities have legally binding borrower-based measures at their disposal to provide them with the necessary powers to address potential financial stability vulnerabilities, including, in particular, powers to set legally binding limits to loan-to value ratios – and to either debt-to-income ratios or debt-service-to-income ratios, in combination with maturity limits – where necessary in relation to new housing loans. Only legally binding borrower-based measures would ensure that all credit providers, irrespective of their type or whether they are domestic or foreign, comply fully with the measures in place.