To strengthen the resilience of credit institutions and protect borrowers from potential future shocks at the downwards phase of the financial cycle it is essential to apply borrower-based measures – quantitative limits that ensure effective credit risk management and prudent creditworthiness assessment of borrowers. These measures promote stability of financial and capital markets.
The Financial and Capital Market Commission (FCMC) Regulation No. 120 “Regulation on Credit Risk Management” has been updated to ensure that for loans issued as of 1st June 2020 respective provisions come into force ensuring harmonised application of:
Detailed description of applicable provisions for new loans issued after the 1st June 2020
where debt-service (DS) is the total monthly aggregate of credit payments to financial institutions and income (I) is the documented and verifiable average monthly income of the borrower after tax and other compulsory national and social payments that the institution recognizes as recurrent.
where debt (D) is all debt obligations of the borrower to financial and non-financial institutions (as far as it is feasible to obtain this information), including the loan to which the borrower has applied. Income (I) is the average monthly income calculated according to the requirements for DSTI and multiplied by 12.
If the DSTI exceeds 40 percent or the DTI exceeds a ratio of 6 then the creditworthiness of the borrower shall be assessed as insufficient, and the loan shall not be issued. Institutions can employ exemption in cases where the creditworthiness of the borrower is assessed to be sufficient despite the DSTI or DTI being above the limits prescribed. In a similar manner, institutions can also apply an exemption to the maximum maturity limits. Such exemptions may not exceed 10 percent of the institution’s total outstanding amount of newly issued loans to households on a quarterly basis. The institution must be able to explain the reasoning behind their decision.
The requirements apply to new residential mortgages and consumer loans issued after 1st June 2020. Requirements are binding for credit institutions and investment firms registered in Latvia, which are institutions according to the Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012. Respective provisions also applies to those credit institutions under direct supervision of European Central Bank.
In order to ensure harmonisation, application of these requirements is recommended also to other financial and capital market participants insofar as the requirements are relevant taking into consideration their specificities. The requirements are not applicable to the branches of credit institutions of other countries in Latvia.
The purpose of the requirements is to strengthen the resilience of credit institutions and protect borrowers from potential future shocks, thus contributing to the financial stability. The measures are of a precautionary nature.
New requirements restrict the ability of borrowers to apply for a larger loan that this person can afford and it limits borrowers’ financial vulnerability.
Quantitative limits ensure harmonised application of key indicators when assessing creditworthiness of a borrower and promote conservative loan issuance practices in periods when there is a risk of excessive provisioning of credit (upswing phase of the financial cycle).
Shortly after the start of global financial crisis in 2008 the amendments were made to the Consumer Rights Protection Law stipulating that loans exceeding 100 minimum wages shall comply with maximum LTV ratio of 90 percent (calculated based on the market value of the loan collateral (real estate)). As Latvia’s and other countries’ past experience shows, in periods of strong credit growth and rapidly increasing prices of real estate that is used as collateral for that credit, credit risk mitigation resulting from setting only LTV limits is not sufficient. Therefore, it is important to also introduce DSTI or DTI requirements to account for the fact that income growth is generally lower than the growth of the real estate prices during the upswing phase of the financial cycle. Maturity limits ensure that DSTI measures are not circumvented through extensions of the repayment term.
Setting limits on loan maturity is also important because excessively large repayment terms are more risky both for the credit institution and for the borrower. Low monthly debt-service payments at the start of loan repayment term due to large maturity and low interest rates can prompt borrowers to overestimate their ability to repay the loan, and therefore result in them becoming excessively leveraged, while still being under the 40 percent DSTI limit. In practice, high maturity loans also exhibit higher total debt-service levels as interest payments accumulate over a longer period. When interest rates increase, borrowers that are excessively leveraged face difficulties in repaying their loans.
The DTI serves as an additional backstop in situations where interest rates are very low, as it is currently the case. In period of historically low interest rates, monthly loan payments (also when viewed in relation to monthly income) are also low, which theoretically could allow borrowers to become excessively leveraged (even above eight net annual salaries) while still being under the 40 percent DSTI limit.
The concerted introduction of DSTI, DTI, LTV and maximum maturity limits ensures an all-encompassing approach toward ensuring prudent creditworthiness assessments. The importance of such measures grows larger during prolonged periods of low interest rates as certain aspects – the most important of which is market participants’ high-risk appetite in a search for higher yield – can negatively reflect on financial stability.
Specific provisions for loans for the purchase of a property by a borrower for purpose of renting it out or otherwise gaining income from real estate transactions are introduced in light of generally higher risk properties of these loans when compared to traditional housing loans. From borrower’s perspective these properties can be in essence viewed as investments, therefore loans granted for their purchase exhibit many risk characteristics that are similar to commercial property loans. The income flows generated by a commercial real estate are closely linked to real estate market dynamics and can be very volatile.
Tailored approach towards this type of loans is indicated in Directive 2014/17/EU of the Parliament and of the Council of 4 February 2014 on credit agreements for consumers relating to residential immovable property and amending Directives 2008/48/EC and 2013/36/EU and Regulation (EU) No 1093/2010 preambles 3, 17 and 55.