House buyers must consider whether they are able to repay their loan when interest rates rise
The latest analysis by Eesti Pank shows that the Estonian financial sector does not currently face any major risks, as the economy as a whole has recovered from the pandemic restrictions and the amount of loans with a payment holiday has declined substantially. The central bank does see some signs of danger though, as the strong demand to buy and the rapidly rising prices for real estate will increase debt levels, so that some people may have difficulties in repaying their loans if the interest rates on them later rise.
Eesti Pank considers that the Estonian economy is generally in a good position, as it is clearly larger in size than it was before the pandemic, while the amount of loans covered by payment holidays has fallen substantially. An exception is the hotel and restaurant sector, where economic activity is still restricted, but the loans to that sector are not that large. The impact of the Covid-19 restrictions on the economy has been moderate, and it has not threatened the functioning of the banks or the rest of the financial sector.
A slightly larger source of risk than before is the very active housing market, which has been boosted by rising incomes, improved confidence among consumers, savings that have built up, and money that was withdrawn from the second pension pillar. Strong demand and rapidly rising real estate prices are increasing the debt burden of those who take loans, and this could later cause problems with loan repayments if incomes were to fall or interest rates to rise. For this reason the central bank recommends that anyone taking a housing loan should consider carefully whether they will be able to repay it even if interest rates are higher in future, or if their income falls.
The two rules of thumb for taking a housing loan
Governor of Eesti Pank Madis Müller said that there is very strong demand in the housing market at the moment, which could give the impression that decisions need to be made in a hurry. “A housing loan is a major financial obligation and I would recommend following two rules of thumb when taking one. First, you should ask yourself whether you will be able to repay the loan even if the interest rate on it, for example, doubles from what it is now. And second, ask whether you have enough money put aside for a rainy day that could see you through for six months or so. It is wise to consider the answers to these questions by consulting with your bank so that the new and better housing does not cause you financial problems in the future”.
The central bank welcomes the government decision to target more accurately the KredEx guarantees that provide support for those buying real estate. The risks in the real estate market are also eased by the requirements on issuing housing loans, which are designed to prevent a lending boom and protect households and borrowers from taking on too much risk. The Eesti Pank rules allow loans to be issued for up to 85% of the value of the real estate backing the loan, while the loan repayments may not exceed 50% of the income of the borrower. If real estate prices and household debt levels should start to rise very rapidly though, the central bank is ready to tighten the requirements on issuing housing loans.
Risks from Sweden and Lithuania
Economic growth has recovered rapidly in Estonia’s near neighbours, as it has in Estonia. This has increased demand for real estate and housing loans. Rapid growth in borrowing has led to a rise in household indebtedness, which was already very high in Sweden. If real estate prices in Sweden were to drop sharply and deeply, the funding of the Swedish banks from bond markets could suddenly become much more expensive. The Swedish parent banks of Estonia’s largest banks might then reduce the funding for the banks in Estonia and raise the price of it, reducing access to loans in Estonia and raising interest rates. The danger in Lithuania arises if a lot of people fall into financial difficulties, as this would hurt the financial position of the Estonian banks that operate in the Lithuanian housing loan market. Sweden and Lithuania have tightened their conditions for taking housing loans and raised the capital requirements for the banks to mitigate the increasing risks.
Larger capital requirements for the banks again
Rapid growth in the Estonian economy is supported by the strong banking sector, and this has ensured the access to loans for companies and households throughout the Covid-19 pandemic. As the economy as a whole has recovered well from the restrictions imposed by the pandemic and the banks are in a strong position, Eesti Pank is planning to reinstate the capital buffer requirement for the banks, which was cut to zero when the pandemic first erupted. While the requirement is being reset, adjustments are planned to the current framework of capital buffers.
Eesti Pank plans to reinstate the buffer requirement by setting a 1% countercyclical capital buffer requirement that will replace the 1% systemic risk buffer requirement that applied before the pandemic. The countercyclical capital buffer is intended to strengthen the capitalisation of the banks during good times, so that in any possible future crisis they would have sufficient capital to cover large loan losses and ensure their capacity to keep lending.
The countercyclical capital buffer requirement, which has so far been set at zero, will moving forwards have two parts. One component will be the base requirement, which will normally be at 1% but can be reduced by Eesti Pank in an extraordinary crisis. On top of the base requirement will be a cyclical requirement, which Eesti Pank can raise if credit growth is consistently faster than long-term growth in the economy. If credit growth is not faster than growth in the economy, the cyclical part of the buffer will remain at zero.
Eesti Pank plans to take the decision in November for setting the countercyclical capital buffer base requirement at the level of 1%. This decision, which will come into force in December 2022, will raise the current capital requirements for the banks by around 117 million euros. After this the central bank will assess each quarter whether the countercyclical capital buffer needs to be raised above its 1% base requirement because of credit growth.
The additional buffer requirement for LHV Pank as a systemically important bank will also rise in the new year to 1.5% because LHV’s market share has grown rapidly. There are four systemically important banks in Estonia, and the buffer requirement will remain at 2% for the other three, which are Swedbank, SEB Pank and Luminor.
The Eesti Pank Financial Stability Review will be published on the Eesti Pank website.