In the past week there has been tremendous unrest linked to the evolution of the Swiss Franc (CHF) and its value against the Euro and, subsequently, to other EU currencies (Polish Zlot, Romanian Leu etc.).
In a nutshell, the Swiss Franc skyrocketed in about two weeks. According to the European Central Bank (ECB), on Jan 2nd 2015, 1 Euro was equivalent to 1.2 Swiss Francs. On the 20th of Jan 2015 there was (almost) equality between the Euro and the CHF.
For some hundreds of thousands of people in the EU this meant a surge of their payments for returning bank loans. Poland, Romania and Croatia being hit very hard. In these countries the effect is amplified because they do not use the Euro and whenever there is a shock on the financial markets, the national currencies loose value against the Euro. In turn, all other exchange rates are computed using the Euro as a reference. For example, the Romanian Leu (Lion in English) also known as RON uses the Euro as a reference. Thus the exchange rate between the CHF and the RON is computed as: CHF exchange rate to the EURO – EURO exchange rate to the RON.
But enough with the background information.
The evolution of the CHF is what Nasim Taleb calls a Black Swan – a High-Impact event that was fully unpredictable.
Yes, many financial analysts will (do) come forward and explain what has already happened. Though they didn’t predict it….
Naturally, the people having loans in Swiss Francs feel cheated and demand action from the governments and national (central) banks to protect them from the outrageous loan conditions that they face now.
Some governments (e.g. Croatia) decided to impose a fixed exchange rate between the Swiss Franc and their local currency, thus softening some of the pressure the citizens deal with. Though this measure is temporary (1 year).
Other governments (e.g. Hungary) automatically converted the loans in CHF to loans in the local currency … and that was done about one year ago…
Other government (Romania) are still mumbling and debating, arguing whose responsibility it is and who should bear the costs.
Yet, none of these measures and debates focus on the real problem and its solution.
In very abstract terms, the problem is the massive exposure to Black Swans. Rare, High-Impact and completely unpredictable events will happen always. 2014 provided several such events (e.g. Ukrainian-Russian conflict and its economic implications). We know that some Black Swans will happen in the future and we know that we cannot predict them. What we can do is to minimize massive exposure to such events.
Let’s look a bit in recent history and understand the back-workings of the problems generated by the Swiss Franc. I’ll use the example of Romania because it is closer to me, and I believe the situations in other countries (Poland, Hungary, Croatia) was more or less similar.
In 2006-2008 there was a frenzy in taking loans, buying cars, houses etc. The banking sector was booming and there was a gold-rush in getting market share (handing out as many loans as possible).
Due to the high interest rates for loans in the local currency, the majority of loans was in Euros. Surprisingly or not, the prices for houses, cars etc. were also in Euros. The local currency was at a good level against the Euro and loans in Euros were cheaper than the ones in the national currency.
Unrelated to central and eastern Europe, the Libor (interest rate for inter-banks loans) for the Swiss Franc was very low (approx. 1.8%). Remember that in those days the reference interest rates set by central banks were much higher than they are nowadays. The Libor for Euros was approximately 2.8% and higher.
To put things simply, on the inter-banks market Swiss Francs were cheaper than Euros. For us mere mortals, a difference of one percentage point might not seem like a lot, but in the financial sector it means a great deal.
Since the CHF was cheaper than the Euro banks could hand out larger loans if they did so in Swiss Francs than they could if they used Euros.
For example, if someone needed 100.000 Euros to buy a house, there was a good chance that they would not qualify to get the loan in Euros. The local regulations and the interest rates for Euros would prevent the wannabe clients from taking a loan of 100.000 Euros in Euros.
Some banks used the following artifice: They converted the 100.000 Euros in Swiss Francs (approx. 155.000 CHF at 2006 exchange rate) and because the CHF was cheaper than the Euro (interest rates were smaller), they gave the loan in CHF.
Moreover, since the Swiss Franc was cheaper than the Euro, banks had an incentive to use it in the loans they handed out since they could acquire the capital at lower costs.
At first glance, this was in the clients’ advantage because it allowed them to buy whatever they wanted, say a house, and it provided better loan conditions (smaller interest rate).
In more depth, this was a time-bomb for clients. Switching from Euros to Swiss Francs completely changed the game (not only the rules of the game).
To a regular bank client, the change between CHF and EUR might have looked like some mumbo-jumbo financial bullshit that didn’t change too much what they wanted – buying a house / car. After all, it’s just a difference in some letters.
And here is where all things went bad.
I believe that many regulators have no idea on how decision-making works. They believe that people are well informed, understand risks, think hard before signing anything, make tremendously complicated calculations to see all possible scenarios.
Banks hid behind the fact that their contracts were very clear… Which is more or less true. But what is not said is that the contracts were often signed on the spot, often without being read. OK… this might be the client’s fault, but not entirely.
When signing a contract for a bank loan, the client usually doesn’t give a damn about the loan conditions. The client wants the thing she wants to buy with the money from the loan.
Scarcity, cognitive overload, fatigue, emotional load - finally having you own house etc. make the future financial consequences seem insignificant at the moment of signing the documents.
Add to this present bias the fact that the banks were not providing working scenarios with how much one will have to pay depending on fluctuations of the exchange rate and of the interest rate.
The true poison was (is) that the banks took zero responsibility (risk) during the execution of the loan contract.
The interest rate for the loan was not fixed… this is not necessarily surprizing for a 20-30 years loan. The problem was that there was no clear formula for computing the interest rate for the loan such as Libor+2 percentage points. It was the banks privilege to set the interest rate for the loan during the contract (20 years!!!!).
The client had to return the loan in the currency in which it was given, in this case the Swiss Franc. This means that the exchange-rate risk is entirely in the client’s backyard.
So, a client who wanted to buy a 100.000 Euros house, took a loan in Swiss Francs of 155.000 CHF. The client had to take the risks associated with the Libor level for CHF plus the banks (arbitrary) margin. The client had to take the risks associated with the exchange rate between the CHF and the Euro and the exchange rate between the Euro and the national currency (since their income was in the national currency).
On the other hand, the banks took no risks, except that of people not being able to pay their loans… but, in Romania, even if you lose everything you have to the bank and this doesn’t cover the debt, you still have to repay the remainder of the debt.
So, on one hand the banks gained market share and their employees were incentivized to do so. On the other hand, the clients took on huge risks that were conveniently not shown clearly.
So, what is the solution?
The solution, too, comes from the same Nasim Taleb: Skin in the Game or Neck in the Line.
In a nutshell, when dealing with risk, especially compound risk – having more risk factors combined – both (all) parties have to share the responsibility and outcomes (consequences).
Indeed, clients who signed loan contracts without understanding what they involve are responsible.
At the same time, Banks who promoted – encouraged loans in Swiss Francs are equally responsible.
I believe that banking regulations should introduce the Skin in the Game principle in all contracts (past, present and future).
If an institution has an incentive to expose their clients to compound risk, then the same institution should take responsibility for the consequences of those risks.
It is easy (and fun) to play Russian Roulette when you are pointing the gun to someone else’s head.
This is what happened with the poisonous Swiss Francs loans and with other toxic financial products.