Circular BCL 2012/230 of June 29, 2012 — Foreign Currency Loans

Luxembourg, June 29, 2012
To all credit institutions, investment firms and professionals carrying out lending operations Concerning: Foreign Currency Loans

Ladies and Gentlemen,

Articles 5(1bis) and 17(1bis) of the Law of April 5, 1993 on the financial sector require credit institutions, investment firms, and professionals carrying out lending operations to have effective processes for detecting, managing, controlling, and reporting the risks to which they are or could be exposed.

This circular aims to clarify the implementation modalities of these articles for banks, investment firms, and professionals carrying out lending operations that grant foreign currency loans as defined in Section II.

Section I. Introduction

1. On September 21, 2011, the General Board of the European Systemic Risk Board (ESRB) adopted Recommendation ESRB/2011/1 concerning foreign currency loans [1].
   This circular implements Recommendation ESRB/2011/1 at the level of credit institutions, investment firms, and professionals carrying out lending operations.

2. In accordance with CSSF Circular 07/301, credit institutions and investment firms must reflect material risks related to foreign currency loans in their ICAAP report.

[1] The recommendation, as published in the Official Journal of the European Union (2012/C 342/01), is reproduced in the annex to this circular. It is also available on the ESRB website (www.esrb.europa.eu).

CIRCULAR BCL 2012/230
CIRCULAR CSSF 12/538

Circular BCL 2012/230 page 2/4
Circular CSSF 12/538

Section II. Scope and Principle of Reciprocity

3. This circular applies to all credit institutions, investment firms, and professionals carrying out lending operations [2] that grant foreign currency loans. The term "establishments," used hereinafter, refers to the entirety of these credit institutions, investment firms, and professionals carrying out lending operations. The circular applies based on the individual situation and, where applicable, (sub-)consolidated situation of these establishments.

4. Within the context of this circular, foreign currency loans are defined as loans to non-financial private borrowers (households and non-financial corporations) in currencies other than the legal tender in the State where the borrower is domiciled. The borrower is deemed uncovered when they do not have natural or financial coverage that mitigates the exchange rate risks associated with foreign currency loans. A borrower has natural coverage, for example, when they receive income in foreign currency (derived, for example, from export activity). Financial coverages generally require the conclusion of a contract with a financial institution. The local currency is the legal tender in the State where the borrower is domiciled.

5. Section III, except for Sub-section III.D, covers foreign currency loans granted to uncovered non-financial private borrowers.

6. Establishments apply this circular proportionally to the nature, scale, and complexity of their activities and organization regarding foreign currency loans. The principle of proportionality does not apply to sub-sections "III.A. Borrower Awareness of Risks" and "III.B. Borrower Solvency."

7. Following the principle of reciprocity, when granting foreign currency loans via cross-border service provision or branches, establishments apply to these loans a treatment at least as strict as the treatment in force in the host Member State where the borrower is domiciled.

Section III. Regulatory Requirements

Sub-section III.A. Borrower Awareness of Risks

8. Establishments must provide borrowers with adequate written information concerning the risks associated with foreign currency loans. This information must be sufficient to allow borrowers to make decisions prudently and with full knowledge. It includes at least the impact on repayments of a significant depreciation of the local currency and an increase in foreign interest rates.

9. Establishments are encouraged to offer their clients local currency loans for the same purposes as foreign currency loans, as well as financial instruments to hedge against exchange rate risk.

[2] As defined in Article 28-4 of the Law of April 5, 1993 on the financial sector

Circular BCL 2012/230 page 3/4
Circular CSSF 12/538

Sub-section III.B. Borrower Solvency

10. Establishments only grant foreign currency loans to borrowers who establish their solvency, taking into account the loan repayment structure and the borrowers' capacity to withstand adverse shocks on exchange rates and foreign interest rates.

11. Establishments are encouraged to apply stricter lending conditions for foreign currency loans, for example in terms of debt ratio (debt service / revenues) and financing quota.

Sub-section III.C. Internal Risk Management

12. Establishments must integrate specific risks related to foreign currency loans into their internal risk management systems. These risks must be reflected particularly in their internal risk pricing and internal capital allocation.

Sub-section III.D. Governance of Liquidity and Funding Risks

13. Establishments must detect, manage, control, and internally report funding and liquidity risks they take in the context of foreign currency loans as well as in relation to their overall liquidity positions. Particular attention must be paid to risks related to:
    a) concentrations of funding sources; b) the use of currency swaps; c) maturity asymmetries between foreign currency assets and liabilities; d) currency asymmetries between assets and liabilities.

14. Credit institutions must implement strategies, policies, and limits specifying their tolerance to liquidity and funding risks in foreign currency. They ensure compliance with this tolerance and these limits, which must remain within the bank's capacity to support and manage the underlying risks.

Circular BCL 2012/230 page 4/4
Circular CSSF 12/538

Section IV. Entry into Force

15. This circular enters into force with immediate effect.

Please accept, Ladies and Gentlemen, the assurance of our most distinguished sentiments.

CENTRAL BANK OF LUXEMBOURG
The Directorate
FINANCIAL SECTOR SUPERVISION COMMISSION
The Directorate

Annex: Recommendation of the European Systemic Risk Board of September 21, 2011 concerning foreign currency loans (ESRB/2011/1).

I
(Resolutions, recommendations and opinions)
RECOMMENDATIONS
EUROPEAN SYSTEMIC RISK BOARD
RECOMMENDATION OF THE EUROPEAN SYSTEMIC RISK BOARD of 21 September 2011 concerning foreign currency loans (2011/C 342/01)

THE GENERAL BOARD OF THE EUROPEAN SYSTEMIC RISK BOARD, Having regard to Regulation (EU) No 1092/2010 of the European Parliament and of the Council of 24 November 2010 on macro-prudential oversight of the financial system in the Union and establishing a European Systemic Risk Board (1), and in particular Article 3(2)(b), (d) and (f) thereof, and Articles 16 to 18 thereof, Having regard to Decision ESRB/2011/1 of the European Systemic Risk Board of 20 January 2011 adopting the Rules of Procedure of the European Systemic Risk Board (2), and in particular Article 15(3)(e) thereof, and Articles 18 to 20 thereof, Having regard to the opinions of the concerned private sector stakeholders, Whereas:

(1) The granting of foreign currency loans to uncovered borrowers has increased in a number of Member States of the Union.

(2) An excess of foreign currency loans can generate significant systemic risk in those Member States and create conditions conducive to the development of negative cross-border contagion effects.

(3) Since 2000, economic policy measures have been adopted in Member States to address the risks resulting from excessive growth in foreign currency lending, but many of them have proven ineffective, mainly due to regulatory arbitrage.

(4) Measures should be taken concerning foreign currency loans in order: i) to limit exposure to credit and market risks and, thus, strengthen the resilience of the financial system; ii) to prevent excessive growth in foreign currency lending and avoid the formation of asset price bubbles; iii) to limit funding and liquidity risks and, thus, minimize this vector of contagion; iv) to create incentives to improve the pricing of risks associated with foreign currency loans; and v) to avoid circumvention of national measures through regulatory arbitrage.

(5) Correcting the information asymmetry between borrowers and lenders could alleviate concerns about financial stability, better raise borrower awareness of risks, and encourage lender accountability.

(6) The resilience of the financial system to negative developments in exchange rates that impair borrowers' ability to service their foreign currency-denominated debts must be increased, also by establishing borrower solvency before granting foreign currency loans and by reviewing it throughout the life of the loan.

(7) Measures producing counter-cyclical effects should be adopted during expansion phases, particularly when the growth of foreign currency loans represents a significant part of a broader general credit expansion phenomenon, in order to reduce the risk of formation and subsequent bursting of asset bubbles.

(8) Incentives should be created to bring financial establishments to better identify hidden risks and extreme loss risks associated with foreign currency loans, and to internalize the corresponding costs.

22.11.2011 FR Official Journal of the European Union C 342/1

(1) OJ L 331 of 15.12.2010, p. 1.
(2) OJ C 58 of 24.2.2011, p. 4.

(9) National supervisory authorities should ask financial establishments to redefine the pricing of foreign currency loans by internalizing the inherent risks through holding an adequate level of own funds, which also strengthens the resilience of the financial system to negative shocks by increasing loss absorption capacity.

(10) Anticipating the granting of liquidity support has the effect, due to a moral hazard phenomenon, of sustaining unsustainable funding structures, which should be addressed by controlling and, if necessary, limiting the funding and liquidity risks that establishments can take in the context of foreign currency loans.

(11) To counter the risk of circumvention of national measures concerning foreign currency loans, it must be ensured that when such loans are granted by a financial establishment, in the framework of cross-border service provision or by a branch established in a host Member State, to borrowers domiciled there, these loans are subject to measures at least as strict as the measures concerning foreign currency loans adopted by the host Member State.

(12) The annex to this recommendation contains an analysis of the important systemic risks for the stability of the Union's financial system resulting from excessive levels of foreign currency loans.

(13) This recommendation is without prejudice to the monetary policy mandates of central banks in the Union and the missions entrusted to the European Systemic Risk Board (ESRB).

(14) ESRB recommendations are published once the intention of the ESRB General Board to proceed with publication has been brought to the knowledge of the Council of the European Union and the latter has had the opportunity to react.

HAS ADOPTED THIS RECOMMENDATION:

SECTION 1
RECOMMENDATIONS

Recommendation A – Borrower Awareness of Risks National supervisory authorities and Member States are invited to:

1. require financial establishments to provide borrowers with adequate information concerning the risks associated with foreign currency loans. This information must be sufficient to allow borrowers to make decisions prudently and with full knowledge and must at least address the impact on repayments of a significant depreciation of the legal tender in the Member State where the borrower is domiciled and an increase in the foreign interest rate;
2. encourage financial establishments to offer their clients national currency loans for the same purposes as foreign currency loans, as well as financial instruments to hedge against exchange rate risk.

Recommendation B – Borrower Solvency
National supervisory authorities are invited to:

1. monitor levels of foreign currency loans and currency asymmetry in the non-financial private sector and adopt necessary measures to limit the granting of foreign currency loans;
2. permit the granting of foreign currency loans only to borrowers whose solvency is established, taking into account the loan repayment structure and the borrowers' resistance capacity to negative shocks on exchange rates and on the foreign interest rate;
3. consider establishing stricter underwriting standards, such as a debt ratio (debt service / revenues) and a financing quota.

Recommendation C – Credit Growth Induced by Foreign Currency Loans National supervisory authorities are invited to monitor whether foreign currency loans induce a general phenomenon of excessive credit growth and, if so, to adopt new or stricter rules than those referred to in Recommendation B.

Recommendation D – Internal Risk Management
National supervisory authorities are invited to issue guidelines to financial establishments so that they better integrate risks associated with foreign currency loans into their internal risk management systems. These guidelines should cover at least internal risk pricing and internal capital allocation. Financial establishments should be required to implement these guidelines proportionally to their size and complexity.

Recommendation E – Own Funds Requirements

1. National supervisory authorities are invited to implement specific measures provided for by Pillar 2 of the revised Basel II framework (1), and in particular to require financial establishments to hold a sufficient level of own funds to cover risks associated with foreign currency loans, in particular risks resulting from the non-linear relationship between credit risks and market risks. The assessment of these elements should take place in accordance with the supervisory review and evaluation process described in Article 124 of Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 on the taking up and pursuit of the business of credit institutions (2) or under equivalent Union regulation establishing own funds requirements applicable to credit institutions which would be adopted in the future. It is recommended in this regard that the authority responsible for the establishment of the concerned credit institution first takes regulatory measures; if the authority in charge of consolidated supervision considers that these measures are insufficient to adequately counter the risks associated with foreign currency loans, it may take appropriate measures to mitigate the observed risks, including by imposing additional own funds requirements on a parent credit institution located in the Union.
2. The European Banking Authority (EBA) is invited to issue guidelines to national supervisory authorities regarding the own funds requirements referred to in paragraph 1.

Recommendation F – Liquidity and Funding
National supervisory authorities are invited to closely monitor the funding and liquidity risks taken by financial establishments in the context of foreign currency loans, as well as their overall liquidity positions. Particular attention should be paid to risks related to:
a) any progression of maturity and currency asymmetry between assets and liabilities; b) dependence on foreign markets for currency swaps (including cross-currency interest rate and currency swaps); c) concentration of funding sources.
National supervisory authorities are invited, before exposures to the above-mentioned risks reach excessive levels, to consider limiting exposures while avoiding a sudden unwinding of current funding structures.

Recommendation G - Reciprocity

1. National supervisory authorities of the home Member State of the concerned financial establishments are invited to impose measures concerning foreign currency loans that are at least as strict as the measures in force in the host Member State where these establishments operate via cross-border service provision or branches. This recommendation applies only to foreign currency loans granted to borrowers domiciled in the host Member State. Where applicable, these measures should be applied at the individual, sub-consolidated, and consolidated levels.
2. National supervisory authorities of the home Member States of the concerned financial establishments are invited to publish on their websites the measures adopted by the supervisory authorities of the host State; supervisory authorities of the host State are invited to communicate all measures, present and future, concerning foreign currency loans to all concerned home State supervisory authorities, as well as to the ESRB and the EBA.

SECTION 2
IMPLEMENTATION

1. Interpretation

2. For the purposes of this recommendation, the following definitions apply:
   "financial establishments": financial establishments within the meaning of Regulation (EU) No 1092/2010; "currency": any currency other than the legal tender in the Member State where the borrower is domiciled; "national supervisory authority": a competent authority or a supervisory authority within the meaning of Article 1(3)(f) of Regulation (EU) No 1092/2010; "uncovered borrowers": borrowers who do not have natural or financial coverage. Coverages are natural notably when borrowers receive income in foreign currency (for example remittances or export receipts). Financial coverages generally require the conclusion of a contract with a financial establishment.

3. The annex forms an integral part of this recommendation. In case of divergence between the annex and the main text, the latter prevails.

4. Implementation Criteria

5. The following criteria are applicable for the implementation of this recommendation:
   a) Recommendations A to G set out above concern only foreign currency loans granted to uncovered borrowers, with the exception of Recommendation F which also applies to covered borrowers; b) Regulatory arbitrage should be avoided; c) The principle of proportionality should be duly taken into account in the implementation of Recommendations B to F regarding the different systemic importance of foreign currency loans among Member States and by considering the objective and content of each recommendation; d) Specific criteria for the implementation of Recommendations A to G are set out in the annex.

22.11.2011 FR Official Journal of the European Union C 342/3

2. Recipients are invited to communicate to the ESRB and the Council the measures taken in response to this recommendation or to provide adequate justification in case of inaction. Reports must at least contain:
   a) information on the content and schedule of measures taken; b) an assessment of the functioning of the measures taken from the perspective of the objectives of this recommendation; c) a detailed justification of any inaction or deviation from this recommendation, including any delays.

3. Follow-up Schedule

4. Recipients are invited to communicate to the ESRB and the Council the measures taken in response to this recommendation, and to provide adequate justification in case of inaction, by December 31, 2012, unless otherwise indicated below.

5. Specific deadlines for follow-up apply in the following cases:
   Recommendation A – national supervisory authorities and Member States are invited to report in two steps:
   a) by June 30, 2012, national supervisory authorities and Member States indicate whether, prior to the adoption of this recommendation, they had issued guidelines addressing the issues mentioned therein. Furthermore, they communicate their assessment of the need to revise these guidelines; b) by December 31, 2012, national supervisory authorities and Member States communicate any additional guideline related to Recommendation A, as well as their assessment of the existence of national currency loans equivalent to the foreign currency loans offered by financial institutions. Member States may report through national supervisory authorities.

Recommendation D – national supervisory authorities are invited to report in two steps:
a) a first interim report by June 30, 2012; and b) a second interim report by December 31, 2012.

Recommendation E, point 2 – the EBA is invited to respond in two steps:
a) by December 31, 2012, the EBA reports on the steps taken towards the adoption of the guidelines referred to in this recommendation; b) by December 31, 2013, the EBA adopts these guidelines.

3. The General Council may extend the deadlines mentioned in points 1 and 2 when legislative initiatives are necessary in Member States to comply with one or more recommendations.

4. Monitoring and Evaluation

5. The ESRB Secretariat:
   a) provides assistance to recipients, including by facilitating coordination in the preparation of reports, providing appropriate templates, and giving clarification on the modalities and schedule of follow-up where necessary; b) monitors follow-up by recipients, including by responding to their requests for assistance, and reports on the follow-up to the General Council through the Steering Committee within two months of the expiry of the deadlines for follow-up.

6. The General Council assesses the measures and justifications communicated by recipients and, where appropriate, determines whether this recommendation has not been followed and whether recipients have not given adequate justification for their inaction.

Done at Frankfurt am Main, 21 September 2011.
The President of the ESRB
Jean-Claude TRICHET

C 342/4 Official Journal of the European Union 22.11 FR .2011

ANNEX
RECOMMENDATION OF THE EUROPEAN SYSTEMIC RISK BOARD (ESRB) ON FOREIGN CURRENCY LENDING
TABLE OF CONTENTS
Page
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 8
I. Foreign currency lending within the European Union: an overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 8
I.1. Foreign currency lending within the European Union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .......

Chart 1
Foreign currency loans to households and non-financial corporations in the Union Source: balance sheet statistics and own calculations of the European Central Bank (ECB).
Note: this chart shows foreign currency loans granted by monetary financial institutions (MFIs) to resident counterparties, as a percentage of the total loan stock, April 2011. The household sector includes households and non-profit institutions serving households (NPISH).

In countries where the share of foreign currency loans is high, the phenomenon is often observed in the area of loans to households and non-financial corporations. Conversely, in countries where foreign currency loans represent a relatively small share of the total loan stock, non-financial corporations tend to borrow more in foreign currency than households. This development could be linked to the presence of exporting companies and the general degree of commercial openness.

The risks to financial stability are particularly high in countries where the stock of foreign currency loans granted to uncovered borrowers is significant. Households and certain non-financial corporations, such as SMEs active in the domestic market, are generally not covered, i.e., they are exposed to a currency asymmetry, as their incomes are generally denominated in national currency.

Exporting non-financial corporations, for their part, are likely to be less sensitive to exchange rate fluctuations, as they have greater opportunities to hedge against exchange rate risk (2). Consequently, the analysis focuses on countries where the share of foreign currency loans granted to households is significant (3).

The currency structure of foreign currency loans also varies from one Member State to another (see Chart 2). In most of the countries considered (e.g., Bulgaria, Latvia, Lithuania, and Romania), foreign currency loans were granted essentially in euros, which seems to be a natural choice due to membership in the Union, and notably fixed exchange rate regimes against the euro. On the other hand, in some countries, other currencies played a predominant role, particularly the Swiss franc (e.g., in Hungary, Austria, and Poland).

22.11.2011 Official Journal of the European Union FR C 342/9
(2) Exchange rate risk hedging can take various forms. It can be natural hedging, when a household or a non-financial corporation receives income in foreign currency (e.g., remittances or export revenues) or financial hedging which requires a contract with a financial institution. Financial hedging is often considered inaccessible for households and certain SMEs, mainly due to its relatively high cost. The inclusion of uncovered non-financial corporations, for which data is not available, would probably not modify the sample of countries under review. (3) Bulgaria, Latvia, Lithuania, Hungary, Austria, Poland and Romania.

Chart 2
Foreign currency loans to the private sector excluding monetary financial institutions (excluding public administrations) (4) in the Union Source: balance sheet statistics and own calculations of the ECB.
Note: this chart shows foreign currency loans granted by monetary financial institutions to resident counterparties, broken down by currency, as a percentage of the total loan stock. The data concern April 2011.

The study of countries in which the share of foreign currency loans to uncovered borrowers (estimated from the volume of loans to households) is significant reveals various common characteristics. First, the share of foreign currency loans has increased since December 2004 in almost all countries (see Chart 3), with the exception of Austria.

At the same time, the share of foreign currency deposits held by the non-financial private sector in these countries has increased slightly or, in some cases, decreased (except in Latvia where foreign currency deposits increased significantly). These asymmetric reallocations in favor of foreign currency loans could, for the most part, be a sign of an intensification of currency imbalances in the balance sheets of the non-financial private sector. They also indirectly testify to the existence of incentives stimulating foreign currency lending activity in Member States. Since the global economic and financial crisis hit Member States, the share of foreign currency loans to the non-financial private sector has continued to grow in some countries while remaining globally unchanged in others. In a number of countries, this increase occurred in a context of declining credit demand.

Chart 3
Shares of foreign currency loans and foreign currency deposits in certain Member States Source: balance sheet statistics and own calculations of the ECB.
Note: this chart shows foreign currency loans granted to resident non-MFIs and deposits of the resident non-MFI sector, excluding public administrations, as a percentage of the total loan stock and the total deposit stock. The variations concern the period between December 2004 and April 2011.

C 342/10 Official Journal of the European Union 22.1 FR 1.2011 (4) The private sector excluding monetary financial institutions (excluding public administrations) covers the following entities: non-financial corporations, financial auxiliaries, other financial intermediaries, insurance companies and pension funds, households and non-profit institutions serving households.

The loan-to-deposit ratio can be used as an approximate indicator of the funding sources available at the national level to determine the funding sources for credit growth in these countries. A marked growth in the loan-to-deposit ratio, on the other hand, indicates a strong dependence on foreign capital to finance loans in these economies (see Chart 4). In some CESEE countries, foreign capital was channelled mainly through borrowings from parent companies of credit-granting financial institutions (5), operating in these countries, but also by raising funds on interbank markets abroad.

Chart 4
Share of foreign currency loans and loan-to-deposit ratio in certain Member States Source: balance sheet statistics and own calculations of the ECB.
Note: the chart shows differences in shares in percentage points. The loan-to-deposit ratio concerns all currencies taken together. The sector of counterparties for loans and deposits is always the sector of resident non-MFIs, excluding public administrations. The variations concern the period between December 2004 and April 2011.

I.2. Factors underlying the expansion of foreign currency loans

There are several factors favouring foreign currency lending activity, both on the supply and demand sides.

Regarding supply, the rapid growth of foreign currency loans in Central and Eastern Europe is largely explained by easy access to interbank refinancing (benefiting from favourable liquidity conditions globally and funding from foreign parent companies). On the demand side, interest rate differentials seem to have played a predominant role. Even if common factors can be identified, their importance probably varies from one country to another.

Apart from the many factors influencing supply and demand, the expansion of foreign currency loans in some CESEE countries took place in a broader context characterised by the financing of demand by foreign capital and/or the surge in asset prices. In addition, most Member States where foreign currency loans constitute a significant share of the total loan stock are converging economies characterised by a strong catch-up potential. The process of real convergence in these countries relied largely on foreign capital inflows, domestic savings being insufficient.

I.2.1. Factors influencing supply

I.2.1.1. International financing and internal financing

In the CESEE countries under review, foreign currency loans were largely financed by cross-border borrowings in the form of credit lines obtained from parent institutions located in another EU country. Other credit institutions with a very significant base of foreign currency deposits at the national level, on the other hand, raised funds on foreign currency swap markets.

When domestic funding sources were insufficient, financial institutions resorted to foreign funding (6) (see Chart 5). The low level of development of national financial markets in the CESEE countries, compared to euro area countries, may also have played a role. In particular, due to the relatively low volume of long-term national currency debt instruments that could serve as a reference for pricing or be used to obtain long-term capital, financial institutions may have hesitated to engage in long-term national currency lending operations. The high costs of securitising national currency instruments constituted an additional factor contributing to banks resorting to foreign currency funding in the context of mortgage loans.

22.11.2011 Official Journal of the European Union FR C 342/11
(5) Consequently, the terms "institutions", "credit-granting financial institutions" and "financial institutions" will be used interchangeably. They refer to all financial institutions that can grant credit. Essentially, these are banks, but all other non-bank institutions capable of granting credit are included.
(6) In Hungary and Romania, funding from parent companies represented 50 to 70% of the total foreign currency liabilities of the banking sector. For further information, see Zalko, Z.: "The refinancing structure of banks in some Central, Eastern and South-Eastern European countries", Financial Stability Report No 16, Oesterreichische Nationalbank, November 2008.

Chart 5
Foreign currency loans and loan-to-deposit ratio in national currency in certain Member States Source: balance sheet statistics and own calculations of the ECB.
Note: the chart shows differences in terms of shares in percentage points, corresponding to the period between December 2004 and April 2011.

Furthermore, fund raising within an international financial group constituted a relatively inexpensive source of funding, compared to resources available from local banks not belonging to such groups. This phenomenon has further reinforced other factors, such as interest rate differentials and margins.

The availability of foreign currency funding and the transfer of exchange rate risk to borrowers have allowed financial institutions to offer credit products with interest rates significantly lower than those applied to national currency loans. In some countries such as Bulgaria and Latvia, where the share of foreign currency deposits is high, institutions, having access to a stable and significant base of foreign currency funding (essentially in euros) within national borders, may have been incentivised to grant foreign currency loans. In addition, fixed or pegged exchange rate regimes have allowed the elimination of costs related to hedging exchange rate risk (7).

I.2.1.2. Growing presence of foreign groups in the CESEE countries

The progress of credit was facilitated by the integration of European financial markets, resulting notably in an increased presence or growing activity of foreign financial institutions already present in the financial systems of these economies.

With the exception of Austria, the share of assets of foreign banks in the total assets of the banking sector of the seven countries considered in the analytical part of this annex approaches or exceeds 60% (see Chart 6). The commitment of parent companies in the foreign currency financing of their subsidiaries was motivated to a large extent by the higher profitability of credit activities in catching-up economies and the desire to increase their market shares in these countries. A large part of the foreign banks operating in the national financial sectors of the CESEE countries thus created an additional channel for capital inflows, which were channelled mainly towards credit markets.

C 342/12 Official Journal of the European Union 22.1 FR 1.2011 (7) This was the case in Bulgaria, Latvia and Lithuania, countries that have established currency board arrangements or pegged their national currency to the euro.

Chart 6
Share of assets of subsidiaries and branches under foreign control in the total banking sector (in %) Source: consolidated banking data (ECB) for June 2010.

I.2.1.3. Competitive pressures

The high share held by foreign banks in the financial sectors of the CESEE countries, combined with their significant growth potential, contributed to an intensification of competitive pressures on credit markets, mainly in the housing lending sector (8). Increased competition resulted in an expansion of the range of products offered by financial institutions, which offered foreign currency mortgage loans, allowing households to obtain credit on favourable terms. Efforts to offer products with low interest rates were one of the factors contributing to the progress of Swiss franc loans in some CESEE countries as well as in Austria. Banks providing Swiss franc and yen loans could gain market shares thanks to a more advantageous debt service cost than that offered by banks granting euro loans.

The impact of competitive pressure was double. On the one hand, in a competitive environment, more "conservative" financial institutions were forced to enter the foreign currency loan market so as not to lose their market shares, which seems to have coincided with a relaxation of lending criteria. On the other hand, due to significant interest rate differentials, financial institutions were able to increase their profit margins and commissions compared to national currency loans and, thereby, improve their financial results (which intensified the competitive pressures on banks not offering foreign currency loans). In the case of indexed foreign currency loans, banks recorded additional profits from the conversion of loan installments into national currency or foreign currency, thanks to the spreads between exchange rates.

I.2.2. Factors influencing demand

I.2.2.1. Interest rate differentials

Interest rate differentials between the countries under review and the main advanced economies in Europe were the main factor underlying the strong demand for foreign currency loans in the CESEE countries and Austria (see Chart 7, Chart 8 and Chart 9). Foreign currency loans became particularly attractive in the long-term loan segment (e.g., mortgage loans), the effect of the interest rate differential on the initial monthly repayment being more sensitive in this compartment than in the short term. In the case of fixed exchange rate regimes, foreign currency loans were generally less expensive due to several factors, including lower risk premiums (e.g., credit and liquidity).

22.11.2011 Official Journal of the European Union FR C 342/13
(8) This preference is explained by several factors: the issuance costs of mortgage loans are relatively low, a long-term relationship is established with the customer [possibility to cross-sell all banking products] and mortgage loans generally involve large amounts and long maturities, thus favouring rapid growth of bank assets. In addition, financial institutions gave preference to mortgage loans insofar as they were considered less risky than other categories of loans due to the provision of collateral.

Interest rate differentials for national currency and euro loans to households (in percentage points) Chart 7 Countries having adopted an anchoring regime and a fixed exchange rate regime Source: ECB and own calculations.
Note: these data refer to annualised contractual interest rates applied to new housing loan contracts excluding revolving credits and overdrafts, convenience credits and credit card payment limit increases. They concern floating rates and cover revision periods of less than or equal to one year.

Chart 8
Countries having adopted a floating exchange rate regime Source: ECB and own calculations.
Note: these data refer to annualised contractual interest rates applied to new housing loan contracts excluding revolving credits and overdrafts, convenience credits and credit card payment limit increases. They concern floating rates and cover revision periods of less than or equal to one year.

C 342/14 Official Journal of the European Union 22.1 FR 1.2011

Graph 9
Interest rate spreads for loans in national currency and Swiss francs in Hungary, Austria and Poland (in percentage points) Source: ECB and national central banks, and own calculations.
Note: Data for Hungary are only available up to March 2010, as Swiss franc products were no longer available after that date. Data for Poland are only available from January 2007. For Hungary, this refers to the average monthly contractual interest rate for consumer and housing loans in Swiss francs granted to households, weighted by the volume of new contracts. The data concern a floating rate and cover a revision period of one year or less. For Austria, they refer to the annualised contractual interest rate for all new credit contracts in Swiss francs concluded in favour of households and non-financial corporations. For Poland, they refer to the average interest rate applied to new housing loan contracts.

I.2.2.2. The perception of exchange rate risk and expectations regarding the adoption of the euro The fact that euro-denominated loans reached their highest levels in economies that have adopted a fixed exchange rate regime could be attributed to several reasons, including lower liquidity premiums on euro-denominated debt securities and the perception of low exchange rate risk, which may have generated stronger demand for euro-denominated loans in these countries. Some borrowers may not have been aware of the risks incurred by taking out a foreign currency loan. Even well-informed borrowers have probably taken uncovered foreign currency positions as they assumed that these were implicitly guaranteed by the existing monetary regime.

To some extent, these assumptions seem to have been confirmed during the recent crisis, particularly in the CEE countries that have established currency board arrangements or have adopted exchange rate pegging regimes, as they have not devalued their currency, although in Latvia the maintenance of the fixed exchange rate required a sustained programme jointly supported by the Union and the International Monetary Fund (IMF), mainly due to a procyclical fiscal policy and a tightening of liquidity on global capital markets.

Furthermore, exchange rate developments have probably reinforced the demand for foreign currency loans in some countries that have adopted a floating exchange rate regime (9). In Austria, the historically low volatility of the euro exchange rate against the Swiss franc contributed to the perception of low exchange rate risk. In CEE countries that have adopted a floating exchange rate regime, borrowers turned to foreign currency loans due to the prolonged appreciation of the nominal exchange rate and the expectation of a continuation of this appreciation trend. Borrowers' expectations regarding the appreciation of the nominal exchange rate were to some extent self-fulfilling (10). This appreciation amplified the external imbalances that had accumulated following strong domestic demand growth.

The perception of risks concerning euro-denominated loans and borrowing in some of these countries may have been influenced by expectations of short-term euro adoption. Such expectations reinforced both the assumption of a "zero" exchange rate risk in the case of countries that have adopted a fixed exchange rate regime or exchange rate peg, and the assumption of a sustained appreciation trend of the nominal exchange rate in the case of countries with a floating exchange rate regime.

II. RISKS RELATED TO FOREIGN CURRENCY LOANS
This section deals mainly with the main risks related to foreign currency loans. However, it is recognised that financial integration and sustainable levels of foreign currency loans also constitute benefits.

II.1. The impact of exchange rate and foreign interest rate variations on credit risk Banks that make foreign currency loans are exposed to indirect exchange rate risk (as a component of credit risk) due to currency asymmetries in their clients' balance sheets. A significant depreciation of the local currency translates into an increase in the local currency value of the debt outstanding (as well as the value of the collateral) and an increase in the debt service payment flow. Consequently, the ability of local uncovered borrowers to service their debt deteriorates, leading to a significant weakening of the private sector's financial situation. The reduced ability of borrowers to service their loans (11) and a lower recovery rate affect the quality of loan portfolios, increase loan losses for banks and create tensions on profits and capital buffers. Although this is not taken into account in the stress test scenarios carried out under the auspices of the European Banking Authority (EBA) across the European Union, the EBA highlighted in its report that unfavourable currency fluctuations associated with an impact on foreign currency-denominated loans were likely in some Member States to constitute the main risk (12).

It is difficult to determine the exact magnitude of the exchange rate (and interest rate) risks of foreign currency loans. Traditional risk calculation methods do not take into account the fact that foreign currency bank loans allocated to uncovered borrowers combine market and credit risk in a non-linear manner (13). Academic literature shows how standard risk management approaches that treat different types of risk separately can lead to a significant underestimation of overall risk. By simply adding the components of exchange rate and default risk measured separately, the actual level of risk is largely underestimated.

Finally, the interest rate risk profile of foreign currency loans differs from that of loans denominated in national currency. This may harm the quality of foreign currency loans if the interest rate cycles of the currency deviate from those of the national economy. However, the magnitude of exchange rate and foreign interest rate risks differs significantly depending on the currency pair and due to the pricing regimes prevailing in each country.

In countries that have adopted a fixed exchange rate regime, the exchange rate risk of foreign currency loans did not materialise during the crisis as local currencies did not depreciate and remained anchored to the euro. Consequently, foreign currency borrowers did not suffer from currency devaluation and rather benefited from reductions in euro interest rates.

As for countries with a floating exchange rate regime, the impact of the depreciation of the national currency was largely a function of the pricing regimes applied by banks granting different types of loans. In some countries (such as in Austria, Poland and Romania), interest rates on foreign currency mortgages are explicitly indexed to market interest rates, so that the negative effects of a depreciation of the local currency were largely offset by a decrease in euro and Swiss franc interest rates. It should be noted, however, that the interaction described between national exchange rate variations and foreign interest rates resulted from a specific situation in advanced economies and global financial markets during the crisis. In the case of a depreciation of the national currency accompanied by a rise in foreign interest rates, countries with a floating exchange rate regime would have faced an increase in borrower default risk, regardless of the credit pricing regime.

On the other hand, the materialisation of exchange rate risk was amplified by the rise in interest rates on foreign currency loans in Hungary (simultaneous shocks of exchange rates and interest rates). The pricing regime applied by Hungarian banks allows them to unilaterally set the interest rate for small borrowers and not to take into account variations in foreign interest rates. As a result, in Hungary, the interest charges of small foreign currency borrowers have increased over the last two or three years, which has accentuated the negative effect of a significant depreciation of the Hungarian forint against the Swiss franc.

In some countries, foreign currency loans show higher ratios of non-performing loans and a higher volume of loan restructuring (in Hungary and Romania, for example). This conclusion is reached when loan generation is taken into account, i.e. in general borrowers who took out a foreign currency-denominated mortgage loan at a stronger exchange rate tend to show a higher default rate. This also proves that some borrowers are probably not aware of the risks they incur by taking out a foreign currency loan.

In other countries, such as Poland, data show that foreign currency loans tend to show better results than national currency loans. The better financial situation of customers taking out a foreign currency loan cannot, however, be the only reason. In fact, this is the result of a banking practice of converting foreign currency loans into national currency when they are about to default or are subject to restructuring, as well as interventions by authorities that have limited access to foreign currency loans to quality borrowers.

Finally, credit quality also depends on the type of loan, with consumer loans generally being riskier than mortgage loans (or other secured loans).

C 342/16 Official Journal of the European Union 22.11.2011 FR 1.2011 (11) The depreciation of the national currency may even reduce the borrower's willingness to pay in cases where, for example, the value of the loan exceeds that of the collateral. However, this mechanism is more common on markets (such as, for example, on a large part of the US residential mortgage credit market) where banks limit their recovery efforts to the collateral and do not seek to be reimbursed from other assets or income of the borrower. (12) Cf. 2011 EU-wide stress test aggregate report, European Banking Authority, 15 July 2011, p. 28. (13) This issue was examined in a study conducted by the Oesterreichische Nationalbank and carried out by a working group of the Basel Committee (Research Task Force). Cf. Breuer, T., Jandacka, M., Rheinberger, K. and Summer, M., Does adding up of economic capital for market- and credit risk amount to conservative risk assessment?, Journal of Banking and Finance, Volume 34(4), 2010.

Overall, the available data show that credit risk has indeed materialised, particularly over the last two years, but to varying degrees depending on the country. However, it is difficult to distinguish the impact on credit quality of exchange rates and foreign interest rates. This results from several factors, and in particular the following: (a) credit quality also depends on other economic conditions, such as the unemployment rate, and the age of the portfolio; (b) most of the affected countries have implemented policy measures to overcome the phenomenon which have had repercussions on the characteristics of foreign currency loan portfolios; and (c) the inherent limitations of the data.

II.2. Funding and liquidity risks
In some CEE countries, funding and liquidity risks generally related to banks' lending activity are higher due to the predominance of foreign currency loans. In these countries, funding risks have increased as banks have financed themselves by increasingly turning to interbank markets and parent companies, rather than to retail deposits. This has significantly increased the dependence of local banks on foreign funds and the external vulnerability of some countries. The dependence of some CEE banks on intra-group funding may present relevant risks when parent companies are established in countries with persistent budgetary vulnerabilities. Sovereign risk in the home countries may become a vector of contagion via the availability and cost of funding provided by parent companies to their subsidiaries and branches established in the CEE countries. Careful planning is therefore necessary (for example in the form of funding plans) to limit any repercussions in the host countries.

Over the last two or three years, however, these funding risks have not materialised and parent companies have maintained their commitments to their subsidiaries by providing and renewing the necessary funds. The cooperation of European authorities and parent companies has also helped to avoid the materialisation of this type of funding risk (such as, for example, the Vienna Initiative, see Box 3). Nevertheless, this type of risk remains, reflecting, inter alia, a concentration of funding sources. In addition, funding costs may vary depending on the evolution of risk perception. As for credit institutions without a parent company, the concentration risk is probably not very relevant but other aspects of interbank funding risks may be more so.

On the other hand, a new source of liquidity funding risk has emerged in some countries (notably in Hungary and Poland) when banks began to use national currency deposits to finance foreign currency loans via the swap market. In order not to have open currency positions, local banks have swapped their national currency deposits for foreign currency funds, mostly short-term, which has exposed them to refinancing risk. When financial turbulence manifested itself on the bond and swap markets and these markets dried up, banks did everything possible to renew their short-term currency swaps. In addition, in the context of depreciation of local currencies, national banks had to meet higher margin calls (deposit requirements) on their swap operations, which increased their foreign currency liquidity needs. The consequences of this liquidity funding risk linked to exposures on the swap market were mitigated by central banks, which introduced swap lines and lending facilities in order to provide local banks with emergency foreign currency facilities, and by parent companies, which provided currency swaps to their subsidiaries. In some cases, the actions of central banks had to be supported by loans, credit lines and swap lines from the IMF, the ECB and the Swiss National Bank.

However, it is necessary to highlight once again the differences that exist between countries insofar as their funding sources vary. As for economies characterised by a high share of foreign currency deposits and, consequently, a lower foreign currency loan / foreign currency deposit ratio, access to a large and stable national foreign currency funding base may have meant that funding risks were lower.

II.3. Excessive credit growth, poor risk assessment and the possible formation of asset price bubbles Foreign currency loans can cause significant vulnerabilities by promoting excessive credit growth (14). Excessive credit growth generally leads to the emergence of asset price bubbles which may have negative consequences for financial stability and overall economic performance. In particular, balance sheet imbalances resulting from excessive foreign currency borrowing by uncovered borrowers in the non-financial private sector can lead to increased vulnerability to external financial and real shocks. These vulnerabilities can be particularly strong if credit growth is concentrated in the real estate sector. Excessive concentration of bank lending in the real estate market can facilitate the creation of a bubble insofar as increased demand for real estate induces an increase in real estate prices, which in turn leads to an increase in the supply of credit due to the increase in the value of collateral and increased demand in anticipation of a new rise in asset prices. If the loans are financed by capital inflows, the country's foreign currency debt increases while its productive potential increases little. Past experiences, including those of Ireland, Spain and the Baltic countries during the recent financial crisis, show that a reversal of this self-sustaining interaction can have heavy consequences for macroeconomic and financial stability.

Rapid credit growth and foreign currency borrowing seem to be closely linked in the new Member States (NMS) (15), particularly in countries where non-financial sector debt has increased at a very rapid pace in recent years, as observed by Rosenberg and Tirpark (16). Their study concludes that, even assuming that the upward trend in the credit/GDP ratio results from financial deepening, a number of NMS have shown "excessive" credit growth in the sense that the observed credit growth is higher than that suggested by the evolution of macroeconomic variables. Countries that have experienced particularly strong credit booms before the global financial crisis have also tended to show a higher share of foreign currency loans (see Graph 10). Historical data indicate that an increase in foreign currency loans may be linked to credit booms in the NMS financed by foreign capital inflows. Rapid growth of credit allocated to the non-financial private sector may be associated with an increase in the share of foreign currency loans (see Graph 11). If the presence of a correlation does not imply a causal relationship between foreign currency loans and credit booms, it should be noted their historical similarity.

Graph 10
Share of foreign currency loans and credit/GDP ratio in some Member States (in %) Source: national central banks and national statistical institutes Note: The counterparty sector for foreign currency loans and credits is the sector of resident non-MFIs, excluding general government. The data refer to March 2011.

Graph 11
Differences in the share of foreign currency loans and credit/GDP ratio in some Member States (in percentage points) Source: balance sheet statistics and own calculations by the ECB.
Note: The counterparty sector for foreign currency loans and credits is the sector of resident non-MFIs, excluding general government. The share differences cover the period December 2004/March 2011.

C 342/18 Official Journal of the European Union 22.11.2011 FR 1.2011 (15) Bulgaria, Czech Republic, Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, Romania, Slovenia and Slovakia.
(16) Rosenberg, C. and Tirpak, M. Determinants of foreign currency borrowing in the new Member States of the EU, IMF Working Paper No 8/173, July 2008.

The expansion of foreign currency loans could be explained by the fact that, before the crisis, internal transfer prices within a financial group (i.e., between the parent company and the subsidiary/branch) did not correctly reflect the risks associated with foreign currency loans, namely exchange rate risk, country risk premium, and funding risk. As it is difficult to properly assess some of these risks, determining the price of foreign currency loans poses a problem. In fact, the observed levels of foreign currency loans could have signaled increased risk-taking.

Generally, the poor assessment of risk premiums on the supply side is a common characteristic of boom periods. A decrease in risk premiums resulting from excessive confidence in growth prospects and country risk can contribute to reducing the nominal interest rates of foreign currency loans. The decline in interest rates and the easing of credit conditions strongly influence asset prices, and particularly those of real estate. Consequently, resource allocation may be distorted and asset price bubbles are likely to form. The rise in real estate prices, accompanied by easing credit conditions and incentives for speculation and indebtedness, led to a strong growth in real estate prices in a number of countries.

Borrowing in foreign currencies generally involves interest rates lower than those for local currency loans, a situation that influences the real interest rate as perceived by borrowers. By taking out a foreign currency loan, individuals often use the expected rise in domestic consumer prices or the rise in country wages to "correct" the nominal interest rate of the foreign currency loan, particularly if exchange rate risk is considered negligible. A fixed or tightly controlled exchange rate as well as episodes of strong sustained appreciation of the local currency can contribute to an underestimation of the exchange rate risk associated with foreign currency-denominated loans.

This evolution can result in extremely low real interest rates, or even, in many cases, strongly negative ones, which greatly stimulates overall credit demand and potentially favors asset price spikes.

The combination of all these factors before the crisis led to capital inflows in many CEECs, accompanied by strong growth in credit denominated largely in foreign currencies. Most of the funds were transferred into real estate and construction, boosting consumption and favoring the emergence of asset price bubbles. Moreover, these countries recorded a strong increase in the number of new households and the general standard of living. These developments sharply stimulated overall credit demand and favored the spike in asset prices. Real estate prices then skyrocketed (see Chart 12).

Chart 12
Real Estate Prices and Credit Growth in Some Member States (in %) Source: Eurostat, ECB and own calculations.
Note: average annual growth of credit and average annual growth of residential real estate prices for the period 2006/2010. For availability reasons, 2009 data were used for Poland and Romania.

It should be emphasized that a large share of foreign currency loans allocated to the uncovered private sector and asset price bubbles tend to worsen external vulnerabilities.

22.11.2011 Official Journal of the European Union FR C 342/19

Foreign currency loans contribute to increasing the volume of external debt over time, a country can then become more vulnerable to a sudden loss of confidence or contagion effects resulting from crises in countries whose weaknesses are considered similar. In this case, market doubts about the viability of the large stock of foreign currency commitments or an external shock causing a devaluation of the exchange rate can trigger abrupt corrections of accumulated imbalances.

As mentioned in section II.1, the balance sheet of the non-financial private sector is exposed to risks that may materialize in the event of a strong depreciation of the real exchange rate. This effect can be accentuated in the case of a strong simultaneous correction of asset prices. Furthermore, an internal shock causing the bursting of an asset price bubble may lead to a loss of confidence regarding major balance sheet problems.

There does not appear to be a short-term risk of a resurgence of credit and asset price booms stimulated by foreign currency loans insofar as deleveraging is not yet complete in many NEMs. In the medium term, however, a strong rebound cannot be excluded when the economic environment has fully normalized and deterioration risks have decreased worldwide. Although foreign currency credits have shown only a slight recovery so far, supply and demand incentives and market structures do not appear to have changed much. In fact, the experience gained during the global financial crisis does not seem to have caused a fundamental reassessment of the risks associated with taking out foreign currency loans on the consumer side. Indeed, in some cases, incentives for foreign currency borrowing resulting from interest rate spreads have even increased, given the exceptionally low level of interest rates in the euro area and Switzerland. Finally, it is unlikely that financial deepening processes are already complete in the NEMs, although credit levels relative to GDP recorded a strong increase on the eve of the financial crisis. Moreover, despite banks' efforts to increase their local deposit base, local currency funding remains limited by the lack of sufficiently deep and liquid local markets.

In this context, it should be noted that the Basel III framework has proposed an additional tool for national authorities that could help prevent a new credit boom. While the main objective of the countercyclical capital buffer (17) is to impose on the banking system the building up of provisions during favorable economic conditions to better withstand losses recorded after a credit boom, a slowdown in credit growth resulting from the increase in capital requirements could constitute a positive side effect. However, the assessment of excessive credit growth on which the quantification of the cyclical buffer is based can be difficult in NEMs given the recent nature of data histories and the convergence process (18).

II.4. Concentration and contagion effects between host and home countries: risks for financial stability in the Union

Exchange rate movements have an impact, simultaneously, on the solvency of a whole group of borrowers taking out uncovered foreign currency loans. Such a concentration risk can occur within a country/institution and across all Member States. This phenomenon is aggravated by the characteristics of events at the extremes of the curve (namely a much stronger impact of large exchange rate movements). Other forms of concentration risk may be present in foreign currency loans, particularly in funding and guarantees. The concentration of funding sources makes this type of activity extremely sensitive to shocks affecting the parent company and/or foreign exchange swap markets. Finally, since most of these loans are mortgage loans, there is also concentration in terms of collateral since it is essentially residential or commercial real estate whose value depreciates in the event of negative exchange rate developments, which then weighs on loan-to-value ratios and recovery rates.

The existence of high volumes of foreign currency loans can contribute to amplifying contagion vectors.

On the one hand, the dependence between subsidiaries that allocate this credit and their parent companies is strong. If subsidiaries suffer a negative shock, capital and/or liquidity needs may evolve in parallel in several countries due to similar vulnerabilities, which could weigh heavily on the resources of the parent company. The intragroup exposure thus links the parent company even more closely to its subsidiary, the probability of the parent company intervening in case of tensions increasing with the size of the exposure. Even if this possibility of parent company intervention may be considered positive for the host country, it also shows that there is a risk of contagion between the financial system of the host country and that of the home country and that the credit risk associated with foreign currency loans can have repercussions in the home country (see Box 2 on the Swedish experience).

C 342/20 Official Journal of the European Union 22.1 FR 1.2011

(17) Basel Committee on Banking Supervision, Guidance for national authorities operating the countercyclical buffer, December 2010. For an analysis of the countercyclical buffer in the context of excessive credit growth and asset bubbles in the Nordic countries, see Financial Stability Report No 1/2011, Sveriges Riksbank, 2011.

(18) For an approach to the problems related to the assessment of excessive credit growth in CEECs using the Hodrick-Prescott filter and for an overview of alternative methods, see Geršl, A. and Seidler, J., Excessive credit growth as an indicator of financial (in)stability and its use in macroprudential policy, Financial Stability Report 2010/2011, Česká národní banka, p. 112.

On the other hand, in some typical cases, parent companies act only as financing intermediaries between foreign investors and subsidiaries. By issuing on international capital markets debt securities with a shorter maturity than the loan portfolio of the subsidiaries and transferring them immediately to the latter, parent companies are confronted not only with counterparty risk related to their subsidiaries but also with refinancing risk. The risk resulting from such a funding strategy may force the central banks of home countries to hold more reserves than necessary from a lender of last resort perspective and, ultimately, it is the taxpayers of the home country who will bear the burden of the foreign currency loans granted by the subsidiaries.

BIS data on international interbank claims can be used as an indicator of the exposures of home country banks towards their foreign subsidiaries (19). According to data collected on the basis of the direct borrower (20), these claims amounted to approximately 339 billion dollars at the end of 2010, or about 0.7% of banking assets in home countries. Chart 13 shows, however, that more than 75% of claims are concentrated in only five countries, namely Germany, Austria, Greece, Italy and Sweden. Consequently, in some cases, individual exposures towards the banking systems of host countries can be considered substantial (for example, nearly 6% of banking sector assets in Austria).

Chart 13
Share of Home Country Claims vis-à-vis Host Country Banking Systems (End 2010) Source: Bank for International Settlements, own calculations.

This strong concentration is also evident in Chart 14 which illustrates the structure of international interbank claims of some home countries. On the one hand, it appears that funding granted to the banking systems of host countries represents a large share of international banking claims in the home countries presented.

Chart 14
Share of Banking Claims vis-à-vis Host Countries in Total International Banking Claims Source: Bank for International Settlements, own calculations.
Note: this chart illustrates the share of banking claims, originating from home countries holding the largest share of banking claims vis-à-vis host countries, in the total of their international banking claims.

22.11.2011 Official Journal of the European Union C 342/21

(19) Home countries: Germany, Austria, Belgium, Denmark, Spain, France, Greece, Italy, Netherlands, Portugal, Sweden, Switzerland and United Kingdom. Host countries: Bulgaria, Latvia, Lithuania, Hungary, Poland, Czech Republic and Romania.

(20) International banking claims, consolidated on the basis of the direct borrower. The international claims of banks of country A on banks of country B encompass cross-border claims on banks of country B in any currency, recorded by all offices of banks of country A worldwide, as well as foreign currency claims on non-affiliated banks residing in country B, recorded by foreign subsidiaries of banks of country A located in country B.

On the other hand, the relative exposure vis-à-vis CEECs increased significantly between 2005 and 2010, making the banking systems of home countries more vulnerable to shocks affecting their foreign subsidiaries.

The increased exposure is also confirmed by data on international banking claims vis-à-vis the group of host countries, presented in Chart 15.

Chart 15
Banking Claims vis-à-vis Host Countries Held by the Group of Home Countries with the Largest Exposures End 2010 (in billion US Dollars) Source: Bank for International Settlements.

The transmission of risk between the banking systems of the home country and the host country is not a one-way phenomenon. Risks can also be transmitted from home countries to host countries. Tensions exerted on the capital and/or liquidity of the parent company can have repercussions on host countries where subsidiaries or branches of the same group are located.

Furthermore, a change in the strategy implemented by parent companies can have macroeconomic repercussions, for example in the event of deleveraging, tightening of lending criteria or emergency sales.

Contagion to other Member States is very likely if credit and funding risks materialize in countries with high volumes of foreign currency loans. Even if these are observed primarily in CEECs, the risk of contagion via the so-called common lender channel (21) could weigh on the financial stability of the entire Union.

The analysis of contagion risks related to the common lender channel shows, on the one hand, that the degree of vulnerability of each country to regional shocks is more or less homogeneous. This testifies to the predominance of foreign banking groups from a small number of countries in the Union in the banking sectors of CEECs. On the other hand, the situation in certain countries (such as Poland and the Czech Republic) is likely to influence very strongly that observed in the CEEC zone if risks materialize in their banking sectors. Finally, the sensitivity to regional shocks of each country and the regional importance of a country in the region have slightly decreased (Q4/2010 compared to Q4/2009).

An additional contagion vector could act on markets, due in particular to the herding behavior of investors. This phenomenon can be caused or aggravated by the similar vulnerabilities of countries due to foreign currency loans, even if the capacity of borrowers and financial institutions differs from one country to another. The materialization of risks related to foreign currency loans in one country can have repercussions on other countries in which foreign currency loans are predominant, investor sentiment becoming a propagation vector leading to the transmission of exchange rate volatility and a shortage of liquidity in local markets.

C 342/22 Official Journal of the European Union 22.1 FR 1.2011

(21) Cf. Fratzscher, M., On currency crises and contagion, ECB Working Paper No 139, April 2002. This document proposes a methodology to assess the importance of the transmission channel between two countries based on exposure to the common lender, taking into account only the banking credit channel and assuming equal transmission of the shock between countries.

II.4.1. Case studies on cross-border repercussions: Austria and Sweden

BOX 1 The experience of Austria in the context of foreign currency lending activity carried out by Austrian banks in CEECs and the CIS

If the exposure of Austrian banks to CEECs and the Commonwealth of Independent States (CIS) proved generally solid during the recent crisis and supported the economies concerned in their catch-up process, it entails contagion risks weighing on the Austrian financial sector and Austrian sovereignty. Foreign currency loans constitute one of the possible sources of contagion risks in this regard. Since mid-2010, the foreign currency lending activity of subsidiaries operating in CEECs and the CIS of the six main Austrian banks (22) has slightly declined in exchange-rate-adjusted data, oscillating around 80 billion euros at the end of 2010. This corresponds on average to a foreign currency loan ratio of 47.5% of the total loans granted by subsidiaries in CEECs and the CIS. As during the previous reporting period, the credit quality of foreign currency loans proved on average worse than that of local currency loans. The average ratio of non-performing loans in the foreign currency loan portfolio amounted to 15.9% for CEECs and the CIS, a ratio 2.5 percentage points higher than that of total loans. Despite substantial amounts of available collateral, these loans were also covered to a lesser extent by risk provisions.

Another relevant characteristic in terms of risk presented by these foreign currency loans is that they generate a need for foreign currency funding. While the funding of euro-denominated loans is relatively stable insofar as they are funded either by euro deposits in the corresponding banking sector or by intragroup liquidity transfers, the funding of loans denominated in a currency other than the euro (essentially Swiss franc loans) comes from less stable sources, such as money markets and foreign exchange swaps. At the height of the crisis, Austrian banking groups therefore had to resort to the EUR/CHF swap provided by the Swiss National Bank. Intragroup liquidity transfers (44 billion euros at the end of 2010) to subsidiaries operating in CEECs and the CIS of Austrian banks are also significant, as evidenced by the loan-to-deposit ratio of 108.1% on average for CEECs and CIS countries, despite strong regional differences. Consequently, intragroup funding can also constitute a contagion vector in times of crisis if central banks are unable to provide extensive liquidity support as they did during the last crisis.

Thus, foreign currency lending activity in CEECs and the CIS entails contagion vectors due, on the one hand, to high credit risk, and, on the other hand, to the need to ensure sufficient foreign currency funding. However, contagion risks do not pass only through direct vectors but also through "informational" vectors.

In the first half of 2009, for example, due to uncertainty regarding the risk associated with the exposure of Austrian banks to CEECs and the CIS, the 5-year credit default swap (CDS) yield spreads of Austrian banks as well as the 5-year sovereign CDS rate spreads of Austria widened significantly compared to German sovereign bonds (respectively more than 450 basis points and more than 250 basis points). When the situation became clearer for investors and the Vienna initiative proved effective, EU banks maintaining their exposure in CEECs and the CIS, Austrian CDS spreads quickly fell again.

In order to limit contagion risks, Austrian authorities published guidelines on foreign currency loans in spring 2010 which apply to subsidiaries of Austrian banks operating in CEECs and the CIS. Initially, banks were invited to no longer grant particularly risky foreign currency loans. Initiatives were also taken at the international level to strengthen local currency markets and avoid a resurgence of foreign currency loans in CEECs.

Another factor limiting risk lies in the constant improvement over time of the capital levels of subsidiaries, which are above minimum regulatory standards in all countries and regions, or even widely exceeded in some countries.

BOX 2 The experience of Sweden in the context of foreign currency lending activity carried out by Swedish banks in the Baltic states

When the financial crisis hit the Baltic states in 2008, the two Swedish banks with the largest exposure to these countries, SEB and Swedbank, quickly posed a problem for systemic stability in Sweden. This was mainly due to the fact that most of the loans granted in these countries were denominated in euros and a large number of market players thought that the Baltic states would be forced to devalue their currencies.

A devaluation, particularly an uncontrolled devaluation, would have had a devastating effect at that time on Swedish banks active in the Baltic states. In such a situation, the Sveriges Riksbank estimated that the loan losses of the banks would be heavy, although manageable, and that this could compromise the banks' access to market funding.

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(22) The six main Austrian banks include the six banking groups with the strongest exposure (in terms of foreign assets) to CEECs and the CIS.

When the crisis entered its acute phase in Latvia in December 2008, and significant amounts of capital left the country, a swap agreement was signed very quickly between the Sveriges Riksbank and the Danmarks Nationalbank on the one hand, and the Latvijas Banka on the other. The agreement covered 500 million euros, but only part of this amount was actually drawn. This agreement mainly aimed to bolster Latvia's foreign exchange reserves until the first payments from the IMF and the Union became available.

The Sveriges Riksbank also provided support to Estonia. In February 2009, it concluded a preventive agreement with the Eesti Pank to support the currency in the short term. However, this agreement was never activated. Its objective was to give the Eesti Pank the possibility to provide liquidity within the framework of the currency board arrangement.

The actors involved in foreign currency lending in the Baltic countries clearly underestimated the exchange rate risk. At the time of the crisis, the Baltic countries participated in ERM II in preparation for the introduction of the euro, and the currency of the three countries was unilaterally linked to the euro via a rigid peg (Latvia) or currency board arrangements (Estonia and Lithuania). Furthermore, the announced euro adoption plans by the authorities of these countries and their strong commitment to maintaining the central rate gave the impression that these loans were exempt from exchange rate risk.

Although the rigid peg systems and currency boards ultimately held up, the risk of devaluation in the Baltic countries had strong repercussions on Sweden as the country of origin of the foreign currency loans. The credits granted by Swedish banks in the Baltic states relied largely on financing provided by parent companies. By issuing debt instruments on international capital markets with a shorter maturity than the loan portfolio of their subsidiaries and transferring the funds to them, the parent companies faced not only counterparty risk vis-à-vis their Baltic subsidiaries, but also refinancing and funding risk.

Due to private investors' concerns about the extent of loan losses that Swedish banks might incur due to their activities in the Baltic countries and the impact on the Swedish banking system, the funding of Swedish banking groups in the interbank market, and not just their Baltic-related funding, was subjected to strong tensions during the crisis. This particularly concerned market funding of banks denominated in foreign currencies. The funding difficulties of banks, in turn, contributed to an increase in the contingent commitments of the Swedish public sector. Even though banks had to pay a fee to issue securities as part of the public guarantee scheme organized by the Swedish National Debt Office, the Swedish government ultimately guaranteed a large portion of Swedbank's debts, the bank most heavily engaged in the Baltic countries. In addition, dollar loans from the Sveriges Riksbank and other central banks also replaced part of the normal market funding in foreign currencies for Swedish banking groups.

The objective of these exceptional loans from the Sveriges Riksbank was to support loans by banks in currencies other than the krona. At its peak, in early 2009, the outstanding amount of foreign currency debt issued under the public guarantee scheme and the dollar loans from the Sveriges Riksbank granted to its counterparties (i.e., most banks operating in Sweden) amounted to 430 billion Swedish kronor, or approximately 15% of Swedish GDP. Thus, the credit risk presented by foreign currency loans in the Baltic states transformed into a funding risk, and ultimately into a risk for Swedish taxpayers.

II.5. Increased volatility of capital adequacy ratios due to exchange rate fluctuations

Exchange rate movements are a source of volatility in the value of foreign currency assets, and consequently, in the value of risk-weighted assets used to calculate capital requirements. Bank capital is held in local currency, even if the capital from the parent company was provided in foreign currency. Therefore, potential currency fluctuations modify banks' capital requirements, without affecting the amount of capital, causing a deterioration of the capital adequacy ratio in the event of local currency depreciation and vice versa.

This risk does not concern countries with fixed exchange rate regimes (as long as they are sustainable). In countries with a floating exchange rate regime, banks were able to manage this type of risk. In fact, they had high capital buffers, and strong depreciations were rather related to currency pairs with the Swiss franc, the main currency used in retail (mortgage) loans. As this corresponded only to a fraction of capital requirements due to the low risk weighting on these loans, banks were able to cover their additional capital needs by using the capital buffers they had available.

II.6. Obstacles to monetary policy transmission channels

The negative impact of foreign currency loans on the monetary policy transmission mechanism can take at least four different forms, as presented below: the effects of foreign currency loan flows and the cumulative outstanding amount of foreign currency loans on, on the one hand, the interest rate channel, and on the other hand, the exchange rate channel.

Regarding the interest rate channel, studies show that the substitutability between domestic currency loans and foreign currency-denominated loans can disrupt monetary policy transmission (23). Tightening monetary policy through an increase in domestic interest rates results in higher borrowing costs in domestic currency. However, given the availability of foreign currency loans with lower interest rates, the decline in domestic currency loan growth can be compensated by the growth of foreign currency loans, which become relatively more attractive for domestic borrowers. Consequently, the monetary policy transmission mechanism through the interest rate channel becomes ineffective.

The cumulative outstanding amount of foreign currency loans can also influence the interest rate channel. If loans granted in the economy are denominated in domestic currency and have floating interest rates, monetary tightening will reduce borrowers' disposable income and domestic demand. If a large proportion of these loans are instead denominated in foreign currency, this effect will be less pronounced.

Foreign currency loan flows also have repercussions on the monetary policy transmission mechanism through the exchange rate channel. However, this monetary policy transmission channel could become less effective insofar as exchange rate movements are strongly influenced by the sentiment prevailing on global financial markets. Banks transform foreign currency financing into foreign currency-denominated loans, which are generally paid out in domestic currency (24). Consequently, rapid growth in foreign currency loans exerts pressure on the exchange rate of the domestic currency, which can lead to appreciation. The growth of foreign currency loans will then strengthen the exchange rate channel as a vector of monetary policy during a cycle of tightening monetary conditions, by amplifying the appreciation of the local currency caused by capital flows resulting from higher interest rates. Moreover, this appreciation trend can create a self-sustaining interaction, as potential borrowers may rely on the persistence of this appreciation trend. This can be an additional incentive to take out foreign currency loans.

On the other hand, during a loosening of national monetary policy, new borrowers tend to opt for domestic currency loans. The pressures for local currency appreciation will ease, but downward pressure should not occur since domestic currency loan flows are insensitive to exchange rate market developments. Foreign currency loan flows thus introduce noise (probably asymmetric) into the monetary transmission mechanism, making it even more complex.

The high outstanding amount of foreign currency loans is another source of disruption of the monetary transmission mechanism through what are called "exchange rate limits," namely that the advantage linked to currency depreciation via increased competitiveness is neutralized to some extent by negative balance sheet effects. In extreme cases, depreciations, particularly in emerging countries, can have a contractionary effect due to the high volume of foreign currency loans (25). Consequently, many authorities in countries with high volumes of foreign currency debt pursue restrictive policies to stabilize the exchange rate during a crisis in order to avoid negative effects on financial stability due to balance sheet effects. Academic literature often refers to "fear of floating" to describe this reaction to downward pressures (26). It should be noted that these policies can even prove optimal ex post, as the decline in production due to monetary tightening can be more than compensated by avoiding the repercussions of negative balance sheet effects. Ex ante, however, the development of currency asymmetries is favored if economic agents anticipate this type of monetary policy reaction (27).

For a sample of 22 EU countries and emerging economies (28) for which information on foreign currency loans is available, the data confirm the validity of the above considerations during the crisis. It appears overall that countries with a high volume of foreign currency loans faced certain constraints in responding to the crisis in terms of monetary policy and exchange rates. On the one hand, countries with a high volume of foreign currency loans generally recorded a smaller nominal depreciation of their currency, which also reflects exchange rate regimes (see Chart 16). While the exchange rates of most of these countries were under downward pressure during this period, central banks lost reserves defending their currency. Overall, countries with a high volume of foreign currency loans tended to lose more reserves than countries not displaying such currency asymmetry (see Chart 17). It should be noted, however, that countries that have adopted a currency board arrangement do not conduct their own monetary policy (i.e., interest rates, reserves, and money supply are not policy variables). Note, however, that the correlation between currency depreciations, reserve losses, and balance sheet imbalances could have been even stronger if cross-border exposures had been included in the analysis (29).

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(23) Cf. Brzoza-Brzezina, M., Chmielewski, T. and Niedźwiedzińska, J., Substitution between domestic and foreign currency loans in central Europe. Do central banks matter?, ECB Working Paper No 1187, April 2010.

(24) Even if loans are paid out in foreign currency, the funds will ultimately have to be converted into domestic currency when the final recipient (for example, the seller of a real estate property) wants to buy goods and services.

(25) Cf. Galindo, A., Panizza, U. and Schiantarelli, F., Debt composition and balance sheet effects of currency depreciation: a summary of the micro evidence, Emerging Markets Review, volume 4, No 4, 2010, p. 330–339.

(26) Cf. for example Hausmann, R., Panizza, U. and Stein, E., Why do countries float the way they float?. Journal of Development Economics, volume 66, No 2, 2001, p. 387–414.

(27) Cf. Caballero, R. and Krishnamurthy, A., Inflation targeting and sudden stops, in: Bernanke, B. and Woodford, M., (editors), The Inflation Targeting Debate, National Bureau of Economic Research, Chicago, 2005.

(28) These are the following countries: Albania, Bulgaria, Chile, Colombia, South Korea, Egypt, Hungary, Indonesia, Israel, Kazakhstan, Latvia, Macedonia, Mexico, Poland, Czech Republic, Romania, Russia, Serbia, Singapore, Turkey and Ukraine.

(29) For example, in Russia, which lost about 40% of its foreign exchange reserves during the crisis, the main concern was cross-border foreign currency loans by banks, while the share of domestic foreign currency loans was modest.

Chart 16
Foreign currency loans and exchange rate adjustment (max. variation in % between July 2008 and June 2009) Source: ECB calculations, Haver Analytics, IMF and national sources.

Chart 17
Foreign currency loans and reserve losses (min. variation in % between July 2008 and June 2009) Source: ECB calculations, Haver Analytics, IMF and national sources.

In addition to foreign exchange market interventions, some countries, particularly those with a high volume of foreign currency loans, had to raise their interest rates during the crisis in order to defend their exchange rate (see Chart 18). Interest rate hikes and the sale of foreign exchange reserves have a contractionary effect on money supply growth, which tends to slow down, or even become negative in countries where the volume of foreign currency loans is high (see Chart 19).

C 342/26 Official Journal of the European Union 22.1 FR 1.2011

Chart 18
Foreign currency loans and interest rates (max. variation in basis points between July 2008 and June 2009) Source: ECB calculations, Haver Analytics, IMF and national sources.

Chart 19
Foreign currency loans and money supply (min. variation in % between July 2008 and June 2009) Source: ECB calculations, Haver Analytics, IMF and national sources.

II.7. The realization of risks: probability and conditions

Risks related to foreign currency loans can materialize, for example, in the case of a sudden stop scenario accompanied by capital outflows and depreciation of the currencies of emerging countries as well as certain Member States in which foreign currency loans play an important role. This would lead to the realization of credit risks related to foreign currency loans and likely also banking funding risks. Such a sudden stop scenario is triggered notably by a collapse in asset prices or a systemic banking crisis in a major emerging country, a revision of growth prospects, an unexpected increase in interest rates in a major advanced economy, and an increase in investor risk aversion.

Regarding a possible timeline for such realization, risks related to foreign currency loans are more pronounced in the medium term, although the recent appreciation of currencies, particularly the rise in the Swiss franc, has amplified credit risk in some countries where Swiss franc loans play a predominant role.

In the long term, risks related to foreign currency loans can also be amplified by a resurgence of credit growth in the CEE countries, in the context of economic recovery and positive expectations regarding future economic developments. In a study, Bijsterbosch and Dahlhaus (30) identify the factors contributing to so-called credit-less recoveries, i.e., economic recoveries not accompanied by credit growth for supply or demand reasons. Estimates of the probability of a credit-less recovery in a group of CEE countries indicate a resurgence of credit growth coinciding with the region's economic recovery. Only the Baltic countries should experience a credit-less recovery. Consequently, the currently moderate credit growth in many CEE countries cannot be considered a permanent situation, and in the near future, there is a risk of excessive expansion of foreign currency loans.

It should be emphasized that this list of factors capable of realizing risks related to foreign currency loans is not exhaustive, as the assessment may change over the coming quarters, due for example to variations in the pace of global recovery. Although the probability of a resurgence of risks related to foreign currency loans differs from country to country, a large number of factors make the realization of these risks possible. Despite the recent crisis, banks' business models and the fundamental characteristics of emerging economies have remained virtually unchanged, which may contribute to the development of foreign currency lending in the future.

Finally, the realization of risks differs depending on the exchange rate regime adopted by various countries. Regarding floating exchange rate regimes, exchange rate fluctuations on markets immediately impact borrowers' solvency. This risk is continuous for this type of regime. For fixed exchange rate regimes or currency board arrangements, borrowing in the anchor currency, the risk is that of a single devaluation, which, if it were to occur, would have a strong impact. Those arguing that risks also exist in fixed exchange rate regimes emphasize that a prudent assessment must take into account the possibility of a break in these regimes or a strong devaluation, and recall similar past events that had severely shaken financial stability. Nevertheless, the probability of realization in countries with fixed exchange rate regimes or currency board arrangements also depends on the stability of their exchange rate regime, the consistency of their fiscal policy, and the rigor of the monitoring policies they implement.

III. MEASURES TAKEN AT THE NATIONAL LEVEL

III.1. Measures adopted by different countries

Although most actions were implemented from 2007-2008, the authorities of Member States adopted measures from the beginning of 2000 to address the risks arising from the excessive growth in the volume of foreign currency loans. Since 2010, several countries have introduced new measures and/or strengthened the rigor of existing measures. Among these prudential, administrative, or monetary measures were warnings, binding rules, and recommendations. Generally, these measures were introduced in blocks, in the form of programs, rather than separately.

The analysis of adopted measures highlights two aspects. First, countries with fixed exchange rate regimes tended either not to act on the level of foreign currency loans, or to act more generally on the excessive overall volume of loans. For these countries, foreign currency loans were, most often, denominated in the anchor currency. As such, the introduction of measures against foreign currency loans could be perceived by markets as the realization of a concern regarding the ability to maintain the peg, thus giving rise to self-fulfilling prophecies. Countries with floating exchange rate regimes introduced several measures aimed at combating excessive levels of foreign currency loans.

Secondly, the measures targeted both the supply and demand for foreign currency loans. Measures focused on demand mainly consisted of limiting loan-to-value ratios or debt-to-income ratios and establishing eligibility criteria for borrowers. These instruments mainly aimed to ensure borrowers' solvency, targeting in some cases only those without coverage.

Supply-focused measures were primarily intended to ensure the ability of credit institutions to absorb losses, if any, by requiring them to hold additional capital for this purpose. While, in most cases, banks did not experience significant currency asymmetries arising from foreign currency loans, given that they were also financed by foreign currency loans or that they hedged their positions via swaps, two countries also implemented limitations and/or capital requirements for open foreign currency positions. In 2010, Hungary banned foreign currency loans (31). Table 1 provides an overview.

Table 1
Measures implemented to reduce the excessive growth of foreign currency loans

Measures taken	Country (year)
Warnings regarding risks related to foreign currency loans	Latvia (2007); Hungary (2004-2008); Austria (2001) Transparency and information requirements

C 342/28 Official Journal of the European Union 22.1 FR 1.2011

(31) Commissioner Michel Barnier, in his response of December 3, 2010, to a question posed in the European Parliament (E-8389/2010), stated that "a complete ban on granting foreign currency loans provided by law does not seem to be consistent with the principle of proportionality."

Measures Taken Country (year)

Supply-Focused Measures
Increase in risk weighting or tightening of capital requirements Latvia (2009); Hungary (2008) (3); Poland (2008 and 2012); Romania (2010) (4) Minimum standards for foreign currency loans and bullet repayment loans linked to a repayment instrument, targeting risk management systems used by banks Austria (2003) Raising provisioning coefficients for uncovered borrowers Romania (2008) Limiting foreign currency loans granted to uncovered borrowers to 300% of the own funds of credit institutions Romania (2005-2007) Limiting open foreign currency positions or capital requirements for open foreign currency positions Latvia (1995); Lithuania (2007); Romania (2001) Differential constitution of mandatory reserves Romania (2004) Extension to non-bank financial institutions of all measures intended to control rapid credit growth Romania (2006) Other Prohibition of foreign currency mortgage loans to uncovered borrowers (5) Hungary (2010) Contribution of national supervisory authorities to the prevention of regulatory arbitrage Italy (2007 and 2010); Austria (2010) Source: national central banks and national supervisory authorities. ( ) The year indicates the initial introduction date of a measure. Mention of another year signals a strengthening of this measure. ( ) Measures are mentioned even when they are recommendations rather than laws. ( ) In the case of Hungary, this measure was announced but never implemented, and concerned only yen loans. ( ) In the case of Romania, this increase in capital requirements was imposed on credit institutions excessively exposed to foreign currency loans compared to the sector. ( ) In July 2011, the Hungarian government abolished the law prohibiting foreign currency mortgage loans (6) but adopted at the same time a decree (7) which restricts the granting of foreign currency mortgage loans only to borrowers who can prove that their monthly income is denominated in the currency of the loan and is equal to 15 times the minimum wage. Although these measures repealed the total prohibition on foreign currency mortgage loans, the criteria are so draconian that more than 99% of Hungarians will not be able to take out such a loan. (6) Law XC of 2010 on the "creation and modification of certain laws concerning economic and financial matters". (7) Government Decree no 110/2011 amending Government Decree no 361/2009 concerning "conditions for prudent retail credit and solvency assessment".

BOX 3 The Vienna Initiative and cases of coordination between home country authorities and host country authorities

The European banking coordination initiative, known as the "Vienna Initiative", is a public-private forum created in January 2009 in response to the financial crisis and aiming to help emerging economies in Europe cope with turbulence. The group brings together international financial institutions (the IMF, the European Bank for Reconstruction and Development, the European Investment Bank, the World Bank), European institutions (the European Commission, the ECB as an observer), central banks of home and host countries, regulatory authorities, and major Western banking groups active in emerging European countries.

The main successes achieved by the Vienna Initiative over the last two years have been to ensure that foreign parent companies maintain their commitment to meet the financing needs of their Eastern European subsidiaries and that Western government support plans are extended to banking subsidiaries in Eastern Europe.

One of the medium-term objectives of the Vienna Initiative is to deal with the issue of foreign currency loans in Eastern European countries by developing local currency savings and markets. To this end, the Vienna Initiative created, in March 2010, the Public-Private Sector Working Group on Local Currency and Local Market Development. Recently, this working group formulated a series of recommendations and concluded that any approach in the field of economic policy must take into account national specificities and requires close coordination between home and host country authorities in order to avoid regulatory arbitrage and circumvention of measures through cross-border lending.

The Vienna Initiative had already proven that it was fully capable of providing a tailor-made program for such coordination when, in 2010, Austrian authorities put in place two initiatives intended to limit foreign currency lending in Austria as well as in Eastern European and CIS countries.

The first initiative aimed to reduce the high share of foreign currency loans (mainly in Swiss francs) in Austria. In March 2010, the Austrian Financial Market Authority adopted minimum standards for the granting and management of foreign currency loans and loans with repayment instruments to uncovered Austrian households (consumers).

Banca d'Italia approved the initiative to restrict foreign currency lending in Austria. When it authorized, a few years before the adoption of the new minimum standards by the Austrian Financial Market Authority, the internal ratings-based approach of an Italian banking group operating in Austria, Banca d'Italia explicitly requested the intermediary to avoid regulatory arbitrage by allocating local portfolio exposures to the parent company's balance sheet or through direct cross-border loans. This provision also proved useful regarding the prevention of circumvention of the new standards of the Austrian Financial Market Authority relating to foreign currency lending in Austria.

The second initiative aimed to reduce the credit risk exposure of subsidiaries of Austrian banks established in Eastern European and CIS countries through the publication of guidelines by the Oesterreichische Nationalbank and the Austrian Financial Market Authority. In order to address the most urgent issues, the guidelines require Austrian banks with activities in said countries to cease granting foreign currency loans other than the euro to uncovered households and the SME sector (euro-denominated consumer loans can only be granted to the most solvent borrowers). In a next step not yet implemented, the guidelines also provide for the reduction, in all currencies, of mortgage loans to uncovered households and SMEs through a country-by-country approach and coordination with host country supervisory authorities.

Regarding the intention to reduce foreign currency lending in Eastern European and CIS countries, Austrian authorities invited Belgian, Greek, French, and Italian supervisory authorities (home country authorities of banks mainly exposed in these countries) to adopt a common position.

Banca d'Italia, approving the initiative, emphasized that agreement from host country authorities is necessary for the program to be effective, given their assessment of the importance and degree of risk of foreign currency loans in their countries.

However, when an internal ratings-based approach of an Italian banking group operating in Eastern European and CIS countries was launched in 2011, Banca d'Italia requested the intermediary to extend to subsidiaries located in these countries the prohibition on allocating local exposures to the parent company's balance sheet.

III.2. Evaluation of the effectiveness of implemented measures

The effectiveness of these measures depends primarily on two elements: (a) factors driving foreign currency lending and; (b) the possibility of circumvention.

Warnings, which usually constitute the first approach adopted in the face of risk, do not seem to have been effective in reducing excessive levels of foreign currency lending. This could, admittedly, be explained by a poor perception of risk, agents not assessing the risk at the same level as authorities, but it more likely results from perverse incentives. Indeed, there is a concern about moral hazard because institutions count on public aid when the activities in which they are engaged are so risky and extensive that a lack of support could further compromise financial stability and the real economy. Moreover, the continuation of these activities may, despite their degree of risk, prove rational at the individual level. The sum of actions rational at the individual level may however contribute to the formation of a global risk that justifies a reaction from authorities.

Theoretically, recommendations suffer from the same problem regarding incentives. However, national authorities consider that recommendations have been, to some extent, effective in reducing the volume of excessive foreign currency lending, or at least in improving borrower quality, insofar as no cross-border arbitrage is observed.

Demand-focused measures, such as loan-to-value ratios and debt-to-income ratios, seem to have been more successful in containing excessive levels of foreign currency lending and associated risks (32). They can also be applied as consumer protection measures (and, as such, be imposed on subsidiaries), thereby limiting regulatory arbitrage. Nevertheless, direct cross-border loans remain outside the scope of any national measure. Given that interest rate spreads (demand factor) are the main drivers of expansion of foreign currency lending, demand-focused measures generally achieve better results.

C 342/30 Official Journal of the European Union 22.11.2011 FR (32) Finding corroborated by an analysis of case studies from Hungary, Hong Kong, and South Korea.

The effectiveness of supply-focused measures is more difficult to evaluate due to the difficulty in assessing, for example, how the increase in costs related to risk coverage translates into a decrease in the supply of foreign currency loans.

Ultimately, the effectiveness of measures has appeared relatively modest thus far, due notably to the possibility of circumventing them, and has diminished over time as foreign currency lending continued its progress.

IV. ESRB RECOMMENDATIONS
OBJECTIVES

The objectives that should guide the examination of the ESRB recommendations on foreign currency lending depend on the risks facing financial stability, as previously determined. Risks that could spread throughout the system and therefore deserve attention are credit risks, closely linked to market risks; excessive credit growth; and funding and liquidity risks. Therefore, the purpose of the recommendations must be:
(i) to limit exposure to credit and market risks, which would strengthen the resilience of the financial system; (ii) to prevent excessive growth of foreign currency lending and avoid the formation of asset price bubbles; (iii) to limit funding and liquidity risks, which would minimize this vector of contagion.

However, the evolution observed so far shows that one of the reasons why foreign currency lending has reached worrying levels lies in the poor pricing of risk. Consequently, an additional goal is to create incentives to improve the pricing of risk associated with foreign currency lending.

Finally, measures taken so far at the national level have been, to varying degrees, circumvented by the practice of regulatory arbitrage. That is why the recommendations formulated at the European Union level should be based on coordination at the Union level.

PRINCIPLES FOR IMPLEMENTATION OF RECOMMENDATIONS

The measures listed below form a set of recommendations to be implemented whenever they can apply. Although concrete, the recommendations formulate only principles, since it is recognized that there is no single solution applicable in all cases to the problem of excessive volumes of foreign currency lending. For example, regarding the "excessive" nature of foreign currency lending, the recommendations do not refer to specific numerical levels, as these may differ from country to country.

The recommendations will apply in all Member States. However, the degree of prevalence and systemic importance of foreign currency lending vary by country. Therefore, when evaluating the implementation of Recommendations B to F, the ESRB will apply the principle of proportionality with regard to the different systemic importance of foreign currency lending among Member States, and taking into consideration the objective and content of each recommendation. To this end, the ESRB will use in particular the information provided by the addressees, which may refer to the indicators listed in section IV.2.3.2. The principle of proportionality will apply without prejudice to regular and adequate monitoring of foreign currency lending.

Furthermore, the recommendations will be without prejudice to the monetary policy mandates of national central banks.

Most of the recommendations concern only uncovered borrowers, i.e., those who do not have natural or financial hedging. Natural hedging is ensured when a household or non-financial corporation receives income in foreign currency (e.g., remittances or export revenues). Financial hedging involves concluding a contract with a financial institution. However, some of the recommendations address risks that exist regardless of whether borrowers are covered or not; this is the case notably for the recommendation on liquidity and funding.

For the purposes of the recommendations, a foreign currency loan is defined as a loan in a currency other than the legal tender in the borrower's country.

The remainder of this section reviews the ESRB recommendations. For each recommendation, the following aspects are addressed:

1. the economic reasoning underlying it;
2. an evaluation, mentioning advantages and disadvantages;
3. the specific follow-up to be provided;
4. where applicable, the legal context.

According to the report, the excessive volume of foreign currency lending generates systemic risks that raise concerns. However, there are no obvious macroprudential measures that can be used to remedy such risks. In this context, the following recommendations aim to address these macroprudential risks using currently available tools, which focus either on one of the factors of the excessive volume of foreign currency lending, or on one of the components of the problem.

COMMON FOLLOW-UP FOR ALL RECOMMENDATIONS

For all recommendations, addressees should:
— describe all measures taken (including the main content and timeline) in response to each recommendation; — for each recommendation, specify how the measures taken performed relative to their objective, taking into account compliance criteria; — where applicable, provide a detailed justification when they have not adopted the recommended measures and for any deviation from the recommendations.

As provided for in Article 17(1) of Regulation (EU) No 1092/2010 (33), this response will be addressed to the ESRB and the Council of the European Union. In the event of a response by national supervisory authorities, the ESRB also informs the European Banking Authority (EBA), respecting confidentiality rules.

CREDIT AND MARKET RISKS
IV.1. Recommendation A – Borrower awareness of risks

National supervisory authorities and Member States are invited to:

1. require financial institutions to provide borrowers with adequate information concerning the risks associated with foreign currency loans. This information must be sufficient to allow borrowers to make decisions prudently and with full knowledge, and must at least address the impact on repayments of a significant depreciation of the legal tender in the Member State where the borrower is domiciled and an increase in the foreign interest rate;
2. encourage financial institutions to offer their clients loans in national currency for the same purposes as foreign currency loans, as well as financial instruments to hedge against exchange rate risk.

C 342/32 Official Journal of the European Union 22.11.2011 FR (33) Regulation (EU) No 1092/2010 of the European Parliament and of the Council of 24 November 2010 on macro-prudential oversight of the financial system in the European Union and establishing a European Systemic Risk Board (OJ L 331 of 15 December 2010, p. 1).

IV.1.1. Economic reasoning
This recommendation is motivated by several reasons. First, from a prudential perspective, correcting information asymmetries between borrowers and lenders can alleviate concerns regarding financial stability. Indeed, communicating appropriate information on product characteristics reduces adverse selection and credit risk, given that "bad" borrowers or those least informed are more likely to choose foreign currency loans. Second, from a monetary policy perspective, communicating appropriate information helps mitigate market frictions, which are a common hindrance to bank lending and good credit transmission. Finally, from a consumer protection perspective, communicating transparent, complete, and detailed information in a standardized format is essential for making informed decisions.

IV.1.2. Assessment, including advantages and disadvantages The advantages of this recommendation are as follows:
a. Increased risk awareness. If uncovered borrowers have adequate information on the risks associated with foreign currency loans (exchange rate risk, tightening of monetary policy in the foreign country, etc.), they better understand that foreign currency loans are not risk-free ( 34). b. By being better informed about the risks they take when taking out a foreign currency loan, some borrowers may internalize the risks inherent in such a loan and i) contain their spending during periods when their currency appreciates, or ii) decide instead to take out a loan denominated in the national currency. Ultimately, this could smooth borrowers' incomes over time and reduce cases of default and, consequently, losses.
c. Better risk mitigation. Risk awareness would further encourage borrowers to avoid excessive debt or to take out insurance guaranteeing the payment of their repayments (covering, for example, unemployment risk, etc.), particularly in the event of volatility in the exchange rate of the currency in question. The purchase of insurance, however, has a cost, of course.
d. Limiting abusive sales and strengthening the substitutability of loans. Better information on clients fosters more favorable relationships for them, as the bank representative must explain the risks involved in a foreign currency loan and can therefore more difficultly apply an aggressive sales tactic. The obligation on financial institutions to offer their clients national currency loans for the same purposes as foreign currency loans strengthens the substitutability of loans (between national currency and foreign currencies), thus stimulating competition to the benefit of borrowers.

It also has, however, disadvantages:
e. Imperfect substitution of loans. If the substitution of foreign currency loans by national currency loans is only imperfect (for example, due to a lack of funding) or if interest rates on foreign currency loans are lower and, at a given time, less unstable than the rates applicable to national currency loans over the entire business cycle, variations in production could give rise to costs ( 35). f. Compliance costs for financial institutions, including the cost of time spent drafting the required documentation and explaining to borrowers the potential risks associated with these loans. National supervisory authorities will also incur compliance costs attributable to the drafting and revision of guidelines.

IV.1.3. Follow-up
IV.1.3.1. Calendar
Recipients are invited to report to the ESRB on the measures taken to implement this recommendation, in two stages: the first report will be submitted by June 30, 2012 and the second by December 31, 2012 at the latest.

IV.1.3.2. Compliance criteria
With regard to Recommendation A, the compliance criteria are defined as follows:
22.11.2011 Official Journal of the European Union FR C 342/33
( 34) Uncovered borrowers, i.e. essentially households, are generally not aware of the risks presented by foreign currency loans. They may be attracted by the nominal interest rates of foreign currency loans, which are lower than those of national currency loans, and they tend to underestimate the risk of depreciation of the national currency or not understand the impact of such depreciation on the cost of servicing their debt and on the total amount due. ( 35) Variations in production over the business cycle are a predictable consequence of all recommendations. Despite its repetitive nature, the remark concerning this factor will be mentioned for all relevant recommendations, because each recommendation may have a different impact on production. Moreover, this method will help the reader, who will thus not be obliged to read all sections concerning assessments.

— For recipients who have already published guidelines covering the points mentioned in the recommendation:
a. assessment of the need to revise the published guidelines, in light of what is required of recipients who have not yet published such guidelines; b. if it turns out that the published guidelines are not sufficient to comply with Recommendation A, recipients should revise them so that all compliance criteria are covered.

— For recipients who have not yet published such guidelines:
c. issuance and publication of guidelines;
d. these guidelines must include at least:
(i) a mention of the obligation on financial institutions to highlight the impact of a significant depreciation of the local currency on repayments; (ii) a mention of the obligation on financial institutions to highlight the impact of a significant depreciation of the local currency on repayments, combined with the effect of a rise in foreign interest rates.

— For all recipients:
e. assessment of the existence of local currency loans equivalent to the foreign currency loans offered by financial institutions.

IV.1.3.3. Communication regarding follow-up
The communication must cover all compliance criteria. Member States may entrust supervisory authorities with drawing up these reports.
The first report, to be submitted by June 30, 2012 at the latest, must contain the following elements:
— For recipients who have already published guidelines:
a. the previously adopted guidelines; b. an assessment of the need to revise these guidelines in light of the compliance criteria.

— For recipients who have not yet published such guidelines:
c. no report to be submitted.

The second report, to be submitted by December 31, 2012 at the latest, must contain the following elements:
— For recipients who have already published guidelines:
d. the revised guidelines, if recipients concluded that the previously adopted guidelines needed to be revised.

— For recipients who have not yet published such guidelines:
e. the guidelines issued following this recommendation.

C 342/34 Official Journal of the European Union 22.1 FR 1.2011

— For all recipients:
f. an assessment of the existence of local currency loans equivalent to the foreign currency loans offered by financial institutions. This assessment could be based, for example, on on-site inspection reports confirming the existence of such loans.

IV.1.4. Relationship with the European Union legal framework The ESRB welcomes the proposal for a directive of the European Parliament and of the Council on credit agreements relating to residential immovable property, which contains provisions specifically targeting foreign currency loans and consumer protection ( 36). This proposal envisages granting Member States two years to transpose the directive after its entry into force. The Parliament's draft report on the proposed directive contains additional references to foreign currency loans, namely the possibility of converting these loans ( 37). The ESRB recommendation remains relevant, however, as its scope is broader (it does not apply only to residential immovable property) and it is more demanding, as it specifically refers to "the impact on repayments of a significant depreciation of the currency legal tender in the Member State where the borrower is domiciled" and includes a provision on the substitutability of loans (between foreign currency and local currency loans).

IV.2. Recommendation B – Borrower solvency
National supervisory authorities are invited to:

1. monitor levels of foreign currency loans and currency asymmetries in the non-financial private sector, and to adopt the necessary measures to limit the granting of foreign currency loans;
2. permit the granting of foreign currency loans only to borrowers whose solvency is established, taking into account the loan repayment structure and the borrowers' resilience to negative shocks on exchange rates and on the foreign interest rate;
3. consider establishing stricter underwriting standards, such as a debt-to-income ratio and a loan-to-value ratio.

IV.2.1. Economic reasoning
This measure is intended to increase the resilience of the financial system to a negative evolution of exchange rates harming borrowers' ability to service their debt. To this end, it requires proof of the borrower's solvency at the time of concluding the contract and its periodic review throughout the duration of the contract, which results in a limitation of the quantity and amount of foreign currency loans.
Furthermore, the establishment of a loan-to-value ratio and a debt-to-income ratio has the effect of sorting borrowers, as lenders can thus limit the supply of additional funds even if the borrower is willing to pay the price asked (interest).

IV.2.2. Assessment, including advantages and disadvantages The advantages of this recommendation are as follows:
a. It should be the most effective measure to prevent an excessive volume of foreign currency loans. b. In a period of recovery and currency appreciation, financial institutions would realize fewer profits, in the presence of such measures, since they would accept fewer risky operations. However, over the cycle, the effect could be the opposite, and this measure could contribute to smoothing the credit cycle ( 38). The establishment of a loan-to-value ratio protects banks against excessive risk-taking since their losses are lower in the event of borrower default (lower loss given default) ( 39). The debt-to-income ratio protects borrowers against over-indebtedness and can save them from the transaction costs resulting from the irresponsible opening and closing of a borrowing position (fewer defaults).
22.11.2011 Official Journal of the European Union FR C 342/35
( 36) COM(2011) 0142 final. See proposals for Article 9, paragraph 1, point f) and Article 11.
( 37) Draft report on the proposal for a directive of the European Parliament and of the Council on credit agreements relating to residential immovable property No 2011/0062(COD) of 18 July 2011. See proposal amendments Nos 32, 140, 152, 153 and 154.
( 38) One of the most important lessons of the recent crisis is that economic growth fueled by debt is fragile, and the objective to pursue is medium and long-term economic growth.
( 39) In such a case, the borrower may lose their property. In countries where the right of rescission does not exist and where the loan-to-value ratio is high, borrowers can easily see their equity become negative. (By "right of rescission" is meant the right, for the holder of a mortgage loan, to close the transaction without being required to repay the balance of the loan beyond the value of the property given as security).

c. In the presence of a minimum regulatory level of income and collateral, financial institutions would assume less credit risk (through the selection of the best borrowers). Thus, a portion of capital that would otherwise have been used to absorb unexpected losses on foreign currency loans becomes available for other, more viable activities.
d. The exposure of the non-financial private sector to currency asymmetries is limited to borrowers who are best able to withstand a negative evolution of exchange rates. Stricter requirements regarding borrower solvency should result in a mitigation of the impact of a negative evolution of the exchange rate on the bank's foreign currency loan portfolio. e. Concretizing the objective of better borrower solvency, the introduction of explicit debt-to-income and loan-to-value ratios is a transparent measure that would apply uniformly to all lenders in a country. Moreover, these ratios take into account the two main factors determining a borrower's solvency, namely the collateral they can provide and their ability to honor their repayment obligations.

It also has, however, disadvantages:
f. Potential costs in terms of viable operations. Defining the optimal solvency threshold (i.e. the appropriate calibration of the loan-to-value ratio and the debt-to-income ratio) that can be implemented is a delicate task. Indeed, if the chosen solvency level is set at a prudent threshold, it is likely that some borrowers who would otherwise be considered solvent will be refused a foreign currency loan, solely due to this regulatory threshold. In the long term, however, it can be expected that these short-term costs will be compensated by the smoothing of credit cycles. g. Due to potentially realizing fewer profits during periods of recovery or currency appreciation, financial institutions may be incentivized to take greater risks in their other activities, in order to compensate for this lost revenue. h. Other difficulties reside in the valuation of the collateral provided (illiquid and immovable), for the purpose of determining the loan-to-value ratio, and in defining the income to be taken into account in the debt-to-income ratio, as well as in the procyclical effect that maintaining the limits set for the loan-to-value ratio and the debt-to-income ratio at a constant level over time may induce. However, setting a loan-to-value ratio and a debt-to-income ratio that vary over time is itself a challenge. First, authorities must determine in which phase the economic and credit cycles are; then, they would face the obligation to make standards stricter when the general economic climate encourages excessive optimism. An additional difficulty lies in the possible time lag relative to the moment when the legislation must enter into force and/or the variable ratios must be modified.
i. Financial institutions incur compliance costs, as they must monitor the solvency of their borrowers. However, it is estimated that these costs are low, as institutions are expected to ensure this monitoring in all cases. Supervisory authorities also bear compliance costs, as they must verify whether financial institutions comply with the recommendation.

IV.2.3. Follow-up
IV.2.3.1. Calendar
Recipients must send the ESRB, by December 31, 2012 at the latest, a report on the measures taken to implement this recommendation.

IV.2.3.2. Compliance criteria
With regard to Recommendation B, the compliance criteria are defined as follows:
a. Monitoring the level of foreign currency loans and currency asymmetries in the non-financial private sector, using the following indicators, at minimum:
— Loans granted by resident monetary financial institutions (MFIs).
Stock:
(i) total stock of loans granted to households in currencies other than the local currency / total stock of loans to households; (ii) total stock of loans granted to non-financial corporations in currencies other than the local currency / total stock of loans to non-financial corporations;

C 342/36 Official Journal of the European Union 22.1 FR 1.2011

(iii) total stock of loans granted to households in currencies other than the local currency / GDP cumulated over the last four quarters (at nominal prices); (iv) total stock of household deposits in currencies other than the local currency / GDP cumulated over the last four quarters (at nominal prices); (v) total stock of loans granted to non-financial corporations in currencies other than the local currency / GDP cumulated over the last four quarters (at nominal prices); (vi) total stock of non-financial corporation deposits in currencies other than the local currency / GDP cumulated over the last four quarters (at nominal prices). Flow:
(vii) gross flows of loans, new and renegotiated, in currencies other than the local currency, broken down as appropriate between euro, Swiss franc and yen.

— Loans granted by entities other than MFIs (leasing companies, consumer credit companies, card issuing or management companies, etc.):
(viii) total foreign currency loans granted to households by non-MFIs / total loans granted to households by non-MFIs; (ix) total foreign currency loans granted to non-financial corporations by non-MFIs / total loans granted to non-financial corporations by non-MFIs.

b. Collection of information on new foreign currency loans regarding borrower solvency.
c. Granting of new foreign currency loans only to borrowers who are able to provide proof of their solvency and their resilience to significant negative shocks on exchange rates and foreign interest rates.
d. Where applicable, definition at the national level of minimum ratios guaranteeing borrower solvency and/or the existence of sufficient collateral (for example, debt-to-income ratio, loan-to-value ratio).

IV.2.3.3. Communication regarding follow-up
The communication must cover all compliance criteria. The report must present the following elements:
a. the aforementioned indicators (i to ix) presented in the form of time series. The data should cover at least the year following the publication of the recommendation and their frequency should be at least monthly for indicators i) and ii), and quarterly for the others. The authorities' report should also indicate the underlying time series for each ratio, to allow for further exploitation of the data (for example, calculation of growth rates, etc.). Moreover, if available, the history of the three years preceding the publication of the recommendation should also appear in the report. Preference should be given to loan data collected in accordance with ECB Regulation 2008/32 of 19 December 2008 concerning the balance sheet of the monetary financial institutions sector (recast) ( 40), preferably to other non-standardized data sources. As for the transmission of data on foreign currency loans by non-MFIs (indicators viii and ix), it will be done as far as possible ( 41). b. An assessment of the solvency of new borrowers as well as the data available on this subject. The report will contain, if available, data on the debt-to-income ratio and the loan-to-value ratio relating to new loans.

22.11.2011 Official Journal of the European Union FR C 342/37
( 40) OJ L 15 of 20 January 2009, p. 14.
( 41) Countries that are unable to provide information from non-MFIs and credit institutions outside the scope regarding debt in foreign currency should adopt a prudent approach to the treatment of risks associated with foreign currency loans; they are encouraged to collect this data in the future. It is recognized that presenting the most complete dataset (including notably loans granted in foreign currency by non-MFIs) may reveal a higher level of foreign currency debt than that of countries where this is not the case. However, countries providing the most detailed information will not be penalized during the assessment.

IV.2.4. Relations with the EU legal framework
The aforementioned proposal for a directive on credit agreements relating to residential immovable property (42) introduces the obligation for Member States to ensure that "consumers provide lenders or, where applicable, credit intermediaries with complete and correct information on their financial and personal situation as part of the loan application" (43). This is a general approach, which does not specifically concern foreign currency loans, but obliges Member States to ensure that consumers provide this information. The ESRB recommendation goes beyond the requirements set out in this proposal, as it requires the lender to assess the borrower's solvency and authorizes the granting of new loans only to solvent borrowers.

CREDIT GROWTH
IV.3. Recommendation C – Credit growth induced by foreign currency loans National supervisory authorities are invited to monitor whether foreign currency loans induce a general phenomenon of excessive credit growth and, if so, to adopt new or stricter rules than those referred to in Recommendation B.

IV.3.1. Economic reasoning
Smoothing cyclical fluctuations through more balanced credit volumes can help minimize intertemporal output losses as well as the probability and severity of asset price bubbles. The rules provided for in this recommendation have a countercyclical effect during the expansion phase, a time when it may be prudent to apply credit restriction measures, both in local currency and foreign currencies.

IV.3.2. Assessment, including benefits and drawbacks a. The main advantage of this recommendation is that it has the effect of avoiding a credit cycle boom when it is caused by foreign currency loans, which curbs exuberance and inflationary pressures and, consequently, reduces the risk of a bubble forming and bursting. From an intertemporal perspective, one might expect more stable credit flows and less severe value losses (for example, for collateral) over the entire cycle. Because it exerts downward pressure on economic growth in the short term, this recommendation encourages supervisory authorities to go against the current, i.e., to apply stricter measures when market actors, including political figures, are excessively prone to taking risks or even euphoric. It also offers authorities the flexibility required if it is necessary to adopt even stricter rules regarding the solvency of borrowers in foreign currencies. b. The main drawback of this recommendation, compliance costs, should be negligible if authorities have already adopted measures aimed at ensuring borrower solvency.

IV.3.3. Monitoring
IV.3.3.1. Calendar
Recipients are invited to submit a report to the ESRB by 31 December 2012 on the measures taken to implement this recommendation.

IV.3.3.2. Compliance criteria
With regard to Recommendation C, the compliance criteria are defined as follows:
a. monitoring of the share of foreign currency loans in overall credit growth, on the one hand, the volume of foreign currency loans, broken down by major currencies (loans granted by both national and foreign financial institutions), and, on the other hand, foreign currency asymmetries in the non-financial private sector (monitoring households and non-financial companies separately).
The indicators mentioned in point IV.2.3.2 may be used for this purpose. b. Definition, at the national level, of the threshold at which foreign currency loans induce excessive credit growth.
c. Justification of the threshold at which authorities believe that credit growth is induced solely by certain types of foreign currency loans to the non-financial private sector.
C 342/38 Official Journal of the European Union 22.1 FR 1.2011 (
42) See footnote 36.
(
43) See proposed Article 15, paragraph 1.

d. When foreign currency loans induce excessive credit growth, the introduction of new or stricter measures than those adopted to restrict foreign currency loans, for example debt-to-income ratios, loan-to-value ratios, or others.

IV.3.3.3. Monitoring communication
The communication must cover all compliance criteria. The report must present the following:
a. an indication of the growth of foreign currency loans, compared to overall credit growth; b. a definition of the threshold at which foreign currency loans induce excessive credit growth;
c. a justification of the threshold at which authorities believe that credit growth is induced solely by certain types of foreign currency loans to the non-financial private sector;
d. the measures adopted, if it is found that foreign currency loans contribute to excessive credit growth; where applicable, a description of the strengthening of measures taken; e. the legislative or regulatory texts supporting these measures.

IV.3.4. Relations with the EU legal framework
The countercyclical capital buffer, as proposed by the capital requirements regulation (44), is the only prudential measure that can, as a side effect, help curb excessive credit growth during an expansion period. The recommendation differs from this mechanism, however, as it directly targets credit growth induced by foreign currency loans.

RISK MISPRICING AND RESILIENCE
IV.4. Recommendation D – Internal risk management National supervisory authorities are invited to issue guidelines to financial institutions so that they better integrate the risks associated with foreign currency loans into their internal risk management systems. These guidelines should cover at least internal risk pricing and internal capital allocation. Financial institutions should be required to implement these guidelines in a manner proportional to their size and complexity.

IV.4.1. Economic reasoning
This measure encourages institutions to better identify hidden risks and extreme loss risks, and to internalize their costs. Where there are differences among national credit institutions in the integration of risks related to foreign currency loans, this recommendation also establishes a more homogeneous approach to the elements taken into account in risk pricing.

IV.4.2. Assessment, including benefits and drawbacks The benefits of this recommendation are as follows:
a. the publication of guidelines would clearly signal the authorities' position, namely that foreign currency loans must be duly taken into account by credit institutions in their internal risk management systems, which implicitly conveys the idea that foreign currency loans are perceived as riskier than local currency loans. To the extent that these guidelines would cover, at a minimum, internal risk pricing and capital allocation, they would encourage institutions to adopt risk-adjusted pricing. They would also allow the relevant authorities to take into account the specificities of each financial sector's risk management systems. b. This recommendation would lead financial institutions to better internalize the costs of risks inherent to foreign currency loans by integrating these costs into their internal risk management systems. The more these costs are internalized, the less other economic agents bear the cost of externalities.
22.11.2011 Official Journal of the European Union C 342/39
(
44) See proposal for a Regulation of the European Parliament and of the Council on prudential requirements applicable to credit institutions and investment firms, COM(2011) 452 final, 20 July 2011. This proposal incorporates global standards on capital and liquidity applicable to credit institutions, developed and agreed upon globally, known as Basel III.

c. In the medium and long term, it can be expected that, thanks to better risk assessment, the number of unviable operations would decrease. This should result in reduced losses for financial institutions and a reduction in revenue losses for borrowers who can no longer repay when risks materialize and they may then lose the collateral property.
It also has, however, drawbacks:
d. This measure requires recipients to establish "guidelines," which are not legally binding. Compliance by credit institutions therefore depends on the degree of moral pressure exerted by the authorities. Consequently, their implementation will likely vary within a banking sector and between countries. e. The recommendation entails compliance costs for financial institutions and supervisory authorities, insofar as they must integrate these guidelines into their internal risk management systems and assess their adequacy. The additional costs should, however, be quite limited, as this is only a component of risk management systems, which are expected to already be in place within financial institutions and assessed by supervisory authorities (see section IV.4.4).

IV.4.3. Monitoring
IV.4.3.1. Calendar
Recipients are invited to report to the ESRB on the measures taken to implement this recommendation, in two stages: the first report will be submitted by 30 June 2012 and the second by 31 December 2012 at the latest.

IV.4.3.2. Compliance criteria
With regard to Recommendation D, the compliance criteria are defined as follows:
— For authorities that have already published guidelines covering the points mentioned in the recommendation:
a. assessment of the need to revise published guidelines, in light of what is requested of authorities that have not yet published such guidelines; b. if it turns out that the published guidelines are not sufficient to ensure compliance with Recommendation D, authorities should revise them so that all compliance criteria are covered.
— For authorities that have not yet published such guidelines:
c. drafting and publication of guidelines.
d. these guidelines must include at minimum:
(i) the obligation, for financial institutions granting foreign currency loans to uncovered borrowers, to integrate the specific risks of this activity into their internal risk management systems; (ii) the obligation for financial institutions to integrate risks related to foreign currency loans into both their internal risk pricing and their internal capital allocation.

IV.4.3.3. Monitoring communication
The communication must cover all compliance criteria.
C 342/40 Official Journal of the European Union 22.1 FR 1.2011

The first report, to be submitted by 30 June 2012 at the latest, must contain the following:
— For authorities that have already published guidelines:
a. the previously adopted guidelines; b. an assessment of the need to revise these guidelines in light of the compliance criteria.
— For authorities that have not yet published such guidelines:
c. no report to be submitted.
The second report must present the following:
— For authorities that have already published guidelines:
d. the revised guidelines, if authorities concluded that the previously adopted guidelines needed to be revised.
— For authorities that have not yet published such guidelines:
e. the guidelines issued following this recommendation.

IV.4.4. Relations with the EU legal framework
Internal risk management has been examined in numerous reports by the European Banking Committee (EBC/EBI). Furthermore, the Capital Requirements Directive (CRD) (45) and the Capital Adequacy Directive (CAD) (46) contain provisions on this matter. Finally, the European Commission has drafted a Green Paper on corporate governance in financial institutions and remuneration policies (47), which is general in nature and does not contain concrete proposals. Regarding the publications of the EBC/EBI on the issue of corporate governance, they contain references to internal risk management, but not specifically to foreign currency loans. It can be considered that the ESRB recommendation complements the EBC/EBI publications.

IV.5. Recommendation E – Capital requirements

1. National supervisory authorities are invited to implement the specific measures provided for by the second pillar of the revised Basel II framework (48), and in particular to require financial institutions to hold a sufficient level of capital to cover the risks associated with foreign currency loans, in particular the risks resulting from the non-linear relationship between credit risk and market risk. This assessment should take place within the framework of the supervisory review and evaluation process described in Article 124 of Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 concerning the taking up and pursuit of the business of credit institutions (49) or under equivalent Union regulation establishing capital requirements applicable to credit institutions that would be adopted in the future. It is recommended in this regard that the authority responsible for the establishment of the credit institution concerned first take regulatory measures; if the authority responsible for consolidated supervision considers that these measures are insufficient to adequately counter the risks associated with foreign currency loans, it may take appropriate measures to mitigate the observed risks, including by imposing additional capital requirements on a parent credit institution located in the Union.
2. The European Banking Authority (EBA) is invited to issue guidelines to national supervisory authorities regarding the capital requirements referred to in paragraph 1.
   To assess the effectiveness of the recommended measures, the ESRB will use the information transmitted by national supervisory authorities as part of the monitoring communication. Based on this assessment, the ESRB will return, by the end of 2014, to the issue of the non-linear relationship between credit risk and market risk.
   22.11.2011 Official Journal of the European Union C 342/41
   (

45. Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 concerning the taking up and pursuit of the business of credit institutions (recast) (OJ L 177 of 30 June 2006, p. 1).
    (
46. Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions (recast) (OJ L 177 of 30 June 2006, p. 201).
    (
47. COM(2010) 284 final.
    (
48. The pillars are defined in accordance with the Basel II framework, see Basel Committee on Banking Supervision, International convergence of capital measurement and capital standards, June 2006, available on the website of the Bank for International Settlements (www.bis.org).
    (
49. OJ L 177 of 30 June 2006, p. 1.

IV.5.1. Economic reasoning
The purpose of this measure is to adjust the pricing of foreign currency loans through the internalization of risks inherent to these loans. These higher capital requirements also strengthen the system's resilience to negative shocks, through an increased capacity to absorb losses.

IV.5.2. Assessment, including benefits and drawbacks The benefits of this recommendation are as follows:
a. Holding higher capital allows financial institutions to be more resilient to unfavorable exchange rate movements, as they can absorb more losses. Indirectly, this confers greater stability (over the entire cycle) on credit flows to the economy. b. An increase in capital requirements, in the form of capital adequacy requirements under Pillar 2, creates incentives for risk-adjusted pricing and produces, ceteris paribus, a slowing effect on foreign currency loans. The effect of an increase in capital on pricing, however, depends on the elasticity of demand and supply, capital scarcity, and competition. If competition is intense, capital is easily available, and supply is too elastic, capital increase requirements would have to be very high to influence pricing.
c. The more costs are internalized, the less the cost of externalities must be borne by other economic agents. Financial institutions may or may not pass on internalized costs to their clients. Regarding loan balances, passing on these costs to clients means that they should pay higher interest rates, in addition to the exchange rate risk they already assume, which would harm their repayment capacity. For new loans, if these costs are passed on to clients, fewer loans will be granted, or the borrowed amounts will be lower. If the costs are not passed on to borrowers, financial institutions may realize lower profits during expansion periods. The impact over the entire cycle is difficult to evaluate, but it could be positive.
It also has, however, drawbacks:
d. If the recommendation constitutes an active constraint, institutions will face, at least during the first phase, higher costs, corresponding to the difference between the cost of additional capital and the "new" cost of debt (which is likely to decrease due to the improved resilience of institutions). e. The recommendation entails compliance costs for supervisory authorities, related to the execution of their supervisory process. f. Explicitly requiring more capital to cover unexpected losses on foreign currency loans amounts to clearly asking institutions to consider the potential costs that could materialize in case of unfavorable exchange rate movements. However, for institutions holding a capital amount significantly higher than regulatory minimums, the provision of this additional capital may not be an active constraint. This is why Recommendations D and E should be implemented jointly.

IV.5.3. Monitoring
IV.5.3.1. Calendar
Recipients are invited to submit a report to the ESRB by 31 December 2012 on the measures taken to implement this recommendation. The EBA is invited to submit two reports, the first by 31 December 2012 and the second by 31 December 2013 at the latest.

IV.5.3.2. Compliance criteria
With regard to Recommendation E, the compliance criteria are defined as follows:
a. authorities should conduct a supervisory review process to verify whether institutions granting foreign currency loans hold sufficient capital to cover the risks resulting from this activity; b. if authorities believe that the capital held does not reflect these risks, they should invite financial institutions to increase the capital they hold for this purpose.
C 342/42 Official Journal of the European Union 22.1 FR 1.2011

For the ESRB:
c. guidelines should be issued and published.
IV.5.3.3. Communication regarding monitoring
The communication must cover all compliance criteria.
The report from national recipients will contain:
a. elements demonstrating the implementation of the prudential supervision process regarding institutions whose portfolio has a high percentage of loans in foreign currencies ("foreign" from the perspective of an uncovered borrower); b. information on how supervisory authorities assess, under the second pillar, the capital shortfall of institutions granting foreign currency loans to uncovered borrowers;
c. information on the aggregate amount of this capital shortfall at the level of the entire national financial system (capital required after the prudential supervision process minus capital held before prudential supervision).
The ESRB report must present the following:
d. an indication of measures taken for the adoption of guidelines (deadline December 31, 2012); e. the guidelines (deadline December 31, 2013).
IV.5.4. Relations with the European Union legal framework Capital requirements are currently governed by the CRD and CAD and, in the future, by the Capital Requirements Regulation (CRR) (50). This recommendation relies on tools proposed within an existing (but undergoing revision) framework designed to manage risks associated with foreign currency lending. The development of the CRR proposal is at an advanced stage. However, Member States should have the possibility to maintain or introduce national provisions aimed at managing exchange rate risks borne by borrowers under the standard approach to credit risk, provided that loans are granted to uncovered borrowers, as long as these national provisions do not contradict Union legislation. LIQUIDITY AND FUNDING RISKS IV.6. Recommendation F – Liquidity and Funding National supervisory authorities are invited to closely monitor the funding and liquidity risks taken by financial institutions in the context of foreign currency lending, as well as their overall liquidity positions. Particular attention should be paid to risks related to:
a) any progression of maturity and currency asymmetries between assets and liabilities; b) dependence on foreign markets for currency swaps (including interest rate and currency swap operations); c) concentration of funding sources.
National supervisory authorities are invited, before exposures to the aforementioned risks reach excessive levels, to consider limiting exposures while avoiding a sudden unwinding of ongoing financing structures.
22.11.2011 Official Journal of the European Union FR C 342/43
(50) See the proposal for a Regulation of the European Parliament and of the Council on prudential requirements applicable to credit institutions and investment firms, COM(2011) 452 final, July 20, 2011. This proposal incorporates the global capital and liquidity standards developed and agreed upon internationally, known as Basel III.
To evaluate the effectiveness of the recommended measures, the ESRB will use information transmitted by national supervisory authorities within the framework of the monitoring communication. Based on this evaluation, the ESRB will revisit this issue by the end of 2014.
As referenced in the Commission's proposal on capital requirements (51), the EBA will collect information on the implementation of the Union-wide liquidity regime, including short-term liquidity and stable funding (52). The EBA will take into account the concerns expressed in the recommendation and may consider developing guidelines prior to the official application date of the regulation.
IV.6.1. Economic Reasoning
Given that short-term funding is less expensive than long-term funding, institutions sometimes tend to finance themselves excessively in the short term. This is due to the moral hazard phenomenon; indeed, financial institutions rely on public intervention, particularly through central banks (53), to obtain foreign currency resources when markets do not function correctly. This problem creates a distortion because institutions do not expect to bear the full risks they take. In this context, this recommendation aims to remedy this market failure. To do so, it limits refinancing and concentration risks to achieve a more sustainable degree of maturity asymmetry and better resilience to negative developments in funding markets. It also aims to minimize contagion through the liquidity channel. IV.6.2. Assessment, including benefits and drawbacks The implementation of this recommendation on funding and liquidity presents the following advantages:
a. It mitigates the moral hazard problem by imposing limits on the funding and liquidity risks that institutions can take. b. It strengthens the capacity to withstand instability in funding markets by limiting refinancing risks and maturity transformation levels, as well as concentration. This means that, during market crises, financial institutions i) would not see their funding costs increase as much, because they would not be forced to refinance as frequently or in such proportions under unfavorable conditions; and ii) would be able to continue their activities for longer without resorting to drastic measures such as asset sales or interruption of credit flows. The drawbacks of this recommendation could be the following:
c. During periods of abundant and inexpensive funding, there is an increase in funding costs, corresponding to the difference between "new" funding costs, resulting for example from longer debt instrument durations, and the funding costs that would be borne in the absence of regulatory intervention.
d. Ultimately, this rise in funding costs could result in an increase in the cost of credit for clients. If this consequence may initially appear negative, it could actually contribute to correcting the pricing of these loans. e. Uncertainty exists regarding the sufficiency of long-term resource supply in the foreign currency market. f. The recommendation entails compliance costs for supervisory authorities, insofar as they must monitor and assess exposure levels. IV.6.3. Monitoring IV.6.3.1. Calendar Recipients are invited to send a report to the ESRB by December 31, 2012, on the measures taken to implement this recommendation. C 342/44 Official Journal of the European Union 22.1 FR 1.2011 (51) Proposal for a Regulation of the European Parliament and of the Council on prudential requirements applicable to credit institutions and investment firms, COM(2011) 452 final, and proposal for a Directive of the European Parliament and of the Council concerning the access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms and amending Directive 2002/87/EC of the European Parliament and of the Council on the supplementary supervision of credit institutions, insurance undertakings and investment firms belonging to a financial conglomerate, COM(2011) 453 final. (52) See: a) Basel Committee on Banking Supervision, "Basel III: International framework for measurement, standardization and monitoring of liquidity risk", December 2010, sections II.1 and II.2, available at http://www.bis.org/publ/bcbs188_fr.pdf and b) proposal for a Regulation of the European Parliament and of the Council on prudential requirements applicable to credit institutions and investment firms, COM(2011) 452 final, sixth part, ninth part, article 444 and tenth part, title II, article 481. (53) This expected support may vary depending on the mandate of the concerned central bank. IV.6.3.2. Compliance Criteria Regarding Recommendation F, the applicable compliance criteria are defined as follows:
a. monitoring of the funding and liquidity conditions of financial institutions, which must include, at minimum, the control of the following indicators (54):
(i) funding liabilities / significant counterparty / total assets (55); (ii) amount of currency swaps (gross) / total liabilities, broken down by currency; (iii) maturity asymmetries between foreign currency assets and foreign currency liabilities (for each relevant currency), compared to maturity asymmetries between local currency assets and local currency liabilities, for the most relevant maturity buckets (56) (57); (iv) currency asymmetries between assets and liabilities. b. Limitation of exposures, whenever national supervisory authorities deem liquidity and funding risks to be excessive. IV.6.3.3. Communication regarding monitoring The communication must cover all compliance criteria. The recipients' report will contain:
a. an indication of the liquidity and funding conditions of the financial system and the influence of foreign currency lending activities on these conditions; b. a reference to the indicators defined in point IV.6.3.2;
c. where applicable, the limits set for exposure to funding and liquidity risks;
d. where applicable, a copy of the regulatory text or official decision setting limits.
IV.6.4. Relations with the European Union legal framework To date, there has been no European Union regulation regarding liquidity and funding. The transposition of Basel III (58) into European legislation will make it mandatory to hold sufficient liquid assets to overcome a liquidity crisis lasting one month. Other monitoring tools will be added – including communication on stable funding, notably – which concern more structural aspects mentioned in the recommendation (such as maturity asymmetries). However, these monitoring tools will only be used, initially, for observation purposes. Authorities must therefore use the monitoring tools provided by European regulations when they are available, but go further to integrate all other aspects of the recommendation, for example those exceeding the one-year threshold. Furthermore, there are differences in the implementation schedule. Regarding liquidity buffers, the ECB Guidelines on liquidity buffers and survival periods mention that, when an entity responsible for liquidity management holds substantial assets in a currency, it consequently bears a substantial level of liquidity risk in that currency and should hold a liquidity buffer for this purpose (59). In this regard too, the ESRB recommendation takes a more structural perspective.
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(54) Indicators i) and iii) are similar to the indicators used as monitoring tools, as proposed by the "Basel III: International framework for measurement, standardization and monitoring of liquidity risk", December 2010, available at http://www.bis.org/publ/bcbs188_fr.pdf.
(55) This indicator corresponds to monitoring tool III.2.2.A on funding concentration in "Basel III: International framework for measurement, standardization and monitoring of liquidity risk", December 2010, pp. 33 and 34.
(56) Maturity buckets will be defined by national authorities in each country.
(57) This indicator corresponds to monitoring tool III.1 on contractual maturity asymmetry in "Basel III: International framework for measurement, standardization and monitoring of liquidity risk", December 2010, pp. 32 and 33.
(58) See footnote 54.
(59) http://www.eba.europa.eu/documents/Publications/Standards—Guidelines/2009/Liquidity-Buffers/Guidelines-on-Liquidity-Buffers.aspx. See paragraph 75.
COORDINATION AT THE UNION LEVEL AND SCOPE
IV.7. Recommendation G - Reciprocity

1. National supervisory authorities of the Member State of origin of the concerned financial institutions are invited to impose measures concerning foreign currency lending that are at least as strict as the measures in force in the host Member State where these institutions operate via cross-border services or branches. This recommendation applies only to foreign currency loans granted to borrowers domiciled in the host Member State. Where appropriate, these measures should be applied at the individual, sub-consolidated, and consolidated levels.
2. National supervisory authorities of the Member States of origin of the concerned financial institutions are invited to publish on their websites the measures adopted by the supervisory authorities of the host state; supervisory authorities of the host state are invited to communicate all measures, present and future, concerning foreign currency lending, to all supervisory authorities of the home states, as well as to the ESRB and the EBA.
   IV.7.1. Economic Reasoning
   The effectiveness of measures implemented by national authorities has been weakened by the high level of integration of the financial sector in the Union. The regulatory framework can only achieve its objective of financial stability at the Union level if it is applied uniformly and without gaps in all Member States.
   Remarks:
   Under such circumstances, it is necessary to adopt a comprehensive approach at the Union level (or even international level). Measures adopted at the national level should be observed by home country authorities, and home and host country authorities should strive to improve their cooperation. To facilitate the reciprocity of measures and obtain appropriate coordination between home and host country authorities, discussions on prudential measures may take place within supervisory colleges. For the clear implementation of the principle of reciprocity, some clarifications and examples are provided below. In practice, this recommendation means that if Member State A applies a macroprudential measure to prevent risks associated with foreign currency lending, then the national authorities of all other Member States should require institutions under their supervision to apply this measure when they grant foreign currency loans to clients in country A, including when these loans are granted by branches or in the context of cross-border activity. This does not, however, encroach upon the consolidated-level supervisory power exercised by the home country supervisory authority. The obligation to apply all measures at the individual, sub-consolidated, and consolidated levels does not mean that, in the case of a cross-border banking group, a measure applied by a home country to borrowers in that country must be applied to borrowers in all other countries where this banking group is active (and which are consolidated in the respective banking groups' balance sheets). For example: if Blue Country imposes a stricter funding ratio on foreign currency mortgage loans, this measure does not apply to foreign currency mortgage loans granted in other countries (host countries, non-Blue) by a bank from Blue Country. However, the principle of reciprocity requires all foreign banks operating in Blue Country (via branches or directly from their headquarters) to apply this stricter funding ratio to all foreign currency mortgage loans they grant in Blue Country. Hypothetical example: Blue Country detects systemic risks emanating from foreign currency lending and adopts a stricter funding ratio regarding foreign currency mortgage loans granted to borrowers in the country. White, Orange, and Violet Countries are the home countries of establishments granting foreign currency loans in Blue Country (via subsidiaries and branches, and directly from their headquarters). After approving the increase in the funding ratio and before the entry into force of this measure, Blue Country communicates the content of this measure and its application date to White, Orange, and Violet Countries. By means of their choice, these countries request institutions under their supervision that grant foreign currency loans in Blue Country to apply this higher funding ratio to all operations they conduct on the territory of Blue Country. The higher funding ratio would thus apply to the territory of
   Blue Country, regardless of the creditor (provided it belongs to the European Union). IV.7.2. Assessment, including benefits and drawbacks The main advantages presented by this recommendation are the following:
   a. it minimizes possibilities of cross-border regulatory arbitrage, thereby strengthening the effectiveness of measures taken by national authorities regarding foreign currency lending. Moreover, the need to communicate adequate information to the concerned supervisory authorities allows for additional experience in cross-border coordination.
   C 342/46 Official Journal of the European Union 22.1 FR 1.2011 b. The fact that recommendations apply at the individual, sub-consolidated, and consolidated levels ensures that exposures are covered and treated in the same way, wherever they are located within financial groups.
   It also carries, however, drawbacks and costs:
   c. compliance costs for supervisory authorities: after the adoption of a new macroprudential measure to manage risks associated with foreign currency lending, national authorities (of the host country) must get in touch with all home country authorities so that they request financial institutions under their supervision to apply the host country's standards. A difficulty lies in the need for timely intervention and informing home country authorities of planned measures.
   IV.7.3. Monitoring
   IV.7.3.1. Calendar
   Recipients must send a report to the ESRB by December 31, 2012, on the measures taken to implement this recommendation.
   IV.7.3.2. Compliance Criteria
   Regarding Recommendation G, the compliance criteria are defined as follows:
   a. elimination of the practice of regulatory arbitrage; b. evidence of requests for the application of the reciprocity principle addressed to institutions operating in other countries. Such evidence can be memoranda of understanding, agreements concluded within supervisory colleges, official decisions, or any other text sufficient to guarantee reciprocity;
   c. amount of direct cross-border loans denominated in currencies other than the borrower's country currency (data to be provided by home country authorities);
   d. regarding the scope of all recommendations, the compliance criterion is the application of Recommendations A to F at the individual, sub-consolidated, and consolidated levels.
   IV.7.3.3. Communication regarding monitoring
   The communication must cover all compliance criteria.
   The recipients' report will contain:
   a. a copy of the text showing that reciprocity applies; b. a brief assessment of its effectiveness.
   Reports relating to Recommendations A to F must specify the scope covered.
   GLOBAL ASSESSMENT OF PROPOSED MEASURES
   For all the above recommendations, costs are compensated by the benefits of their implementation.
   Overall, these measures primarily aim to reduce systemic risk through various means, the necessity being to correct imperfections that contribute to systemic risk.
   One of the main expected advantages is the mitigation of moral hazard, resulting either from a correction of incentives (for example, improved internal risk management and capital requirements) or another form of risk-taking limitation (for example, requirements regarding borrower solvency). Due to the very nature of this phenomenon, i.e., major repercussions in case of risk realization, it is possible that financial institutions disregard the most adverse scenarios because they rely on authority support. Another major advantage lies in strengthening the resilience of the financial sector and limiting credit flows during periods of euphoria. The result should be beneficial from an intertemporal point of view – less loss of value, for example when a bubble bursts. Finally, and always among the major advantages, these recommendations indirectly encourage authorities to conduct other economic policies more effectively. The costs incurred are primarily increased costs in terms of capital and funding for financial institutions, and a potential lack of viable substitutes in case the ability to grant foreign currency loans to certain uncovered borrowers is eliminated or reduced to an insufficient level. In this case, a relative decrease in the credit flow granted during certain periods of the cycle could be observed, which could hinder short-term economic growth. However, in the medium and long term, these measures should be favorable to economic growth. Finally, these measures entail compliance costs for both financial institutions and supervisory authorities.
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