In our branch of the financial services industry, for many years now, we have been required to tell the clients what are the risks from the investments they are planning to make, or from the services they will be using from us. Even more so for retail clients – we are required to make sure the person understands what we are telling them. And if we have doubts about how well they understood the risks, we should avoid selling to those clients products that are not suitable. It is my understanding the same philosophy should apply to banking products – like loans and deposits.
Let’s have the US as an example. We all remember the financial crisis.. some are still struggling to get over its consequences. At the bottom of it, were residential mortgage loans that were given to people who were not able to repay them. The capital markets have generated such a huge demand for securities backed by such loans, that at some point there were big incentives for institutions to generate more of them. They used a lot of tricks for that; the most popular was the so called “teaser-rate”. If the normal interest rate for a loan was say 5%, these loans would be offered with a rate of 1% for the first 2 years and then a 5,1% rate thereafter. And these incentives went on.. they had “interest-only-loans” where you only pay the interest rate, no principle repayments for some years; then they started even capitalising the interest payment, so for the first two years you could pay nothing at all, but the loan amount was increased with the amount of the interest. All these tricks were used to give loans to people who could never repay them. In many cases the sellers of these loans were misleading the clients, they did not tell them the risks, they were misleading them about the level of payments after the initial period etc. And in the US, prosecutors and the US Department of Justice have started legal actions against many such loan origination companies. The fines that they are imposing on them often go for debt-relief programs – helping people repay their loans.
In Poland, the Swiss-franc loans were the equivalent of the teaser-rate trick. Because the interest rate on Swiss francs was so low, it looked like the payments on the loan will be affordable to much more people. And they were, at least for some time, until the Swiss franc started appreciating. This was a risk that the bank officers selling the loans were supposed to inform people about. And to make sure all these people understood the risk.
So there are at least two options here. Either the bank loan officers were intentionally misleading their clients or the bankers didn’t understand the risks themselves. I am not sure which one is worse for the banking industry. But the way to deal with the situation would be different in each case. If the bankers understood the currency risk their clients were about to take and didn’t warn them in the appropriate way (probably with the goal of increasing their own profits and bonuses), then the banks should pay a fine. How big that fine should be? That should depend on how many people who had no way of understanding those risks they mislead. Because there were people who did understand the risk. It should also depend on what practices were used within the banks to generate such new loans etc.
If the bank managers themselves didn’t understand the situation and they didn’t believe their own bank is at higher risk, because of these loans, then the bank shareholders will have to pay. They will have to increase the capital in order to cover for the loan-losses from these portfolios. Regulators should make sure the quality of the loan book is assessed correctly and reflects the true market value of these loans. And if the resulting losses eat too much of the capital, it should be increased.
Finally, the argument that the whole banking system in Europe is very fragile and now is not the time to make more problems is a bit irrelevant. This has never stopped US prosecutors and European regulators from imposing fines, if there is enough evidence of wrongdoing. Bad loans in general and Swiss-franc loans in Poland are a problem that needs to be resolved sooner rather than later. The Bulgarian banking system is a very good example. Banks have not been dealing with the big amount of bad loans, sitting on them and waiting for “somehow” the issue to be resolved gradually. But in the meantime the whole banking sector is not functioning well, which is a disaster for the entire economy.