The procyclical nature of the financial sector tends to amplify cycles and may turn a severe downturn into a financial crisis. One of FI’s tasks is to mitigate this pro-cyclicality.
Thedéen started his speech by discussing the mandate of FI and the cooperation between the institutions responsible for different areas of financial stability. The rest of the speech focused on the mortgage market.
The traditional bank-based model in Sweden for granting and financing mortgages is being challenged by actors offering alternative financing models. Greater competition on the mortgage market is fundamentally positive but not at the expense of stability or consumer interests, which the regulations related to the mortgage market are intended to protect. “A well-functioning mortgage market must have responsible actors who will be there for their customers in the long term,” Thedéen emphasised when discussing new actors in the mortgage market.
The financial sector and the mortgage market are procyclical in their nature. Banks tend to increase the supply of credit and face little incentive to force their customers to amortise in an upturn. In a downturn, the reverse if often true, especially if house prices fall since the houses are used as collateral for mortgages. This pro-cyclical nature tends to amplify cycles and may turn a severe downturn into a financial crisis. One of FI’s tasks is to mitigate this pro-cyclical behaviour. “When systemic risks are building up, as they have been in the current environment with strong growth and low interest rates, we have worked with two types of measures. First, we have raised capital requirements for banks and proposed a further increase in the countercyclical capital buffer to build resilience in the banking sector. Second, we have introduced borrower-based measures, like the LTV cap and the amortisation requirements, to slow the build-up of systemic risks,” Thedéen said.
The amortisation requirements can mitigate the procyclicality of households’ debt service payments. Households are forced to amortise during an upturn and can be given a grace period under special circumstances that include, for example, a drop in income. Since banks face no incentive to force a foreclosure when house prices are falling, banks can allow such grace periods for households unable to fully service their debt due to unemployment. The amortisation requirement therefore mitigates the procyclicality of households’ debt payments.
Because these measures are already in place, it also means that FI has more tools at its disposal in a severe downturn. The capital buffers that banks build up during an upturn provide a cushion that can absorb credit losses. “FI can, for example, reduce or remove the countercyclical capital buffer to provide more usable capital in a severe downturn. This capital relief will help banks continue to supply credit to households and firms and thereby reduces the risk of a credit crunch that further amplifies the downturn. Capital buffers therefore mitigate the procyclicality of the credit supply,” Thedéen concluded.