## _cr07103

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---

### Major issues addressed
- Two main issues:
  - Why the recent pace of financial catching-up has been so much slower in Poland than in its regional peers, and whether this might hamper Poland’s long-term economic prospects.
  - How significant the prudential risks associated with rapid growth in housing loans are.

### Key descriptive findings on credit dynamics
- Private sector credit:
  - Following rapid expansion in the 1990s, lending to the private sector stalled in the early 2000s.
  - Since then, nominal private sector credit has been growing only marginally faster than nominal GDP—the lowest rate among new member states of the European Union (NMS).
- Sectoral composition:
  - Corporate credit growth fell since the late 1990s, bottomed out in early 2005, and was slow to recover thereafter.
  - Household credit remained positive and overtook corporate credit as a share of total outstanding credit to the private sector.
  - Housing loans to households grew at an average annual rate of close to 40 percent in the last four years.
  - About two thirds of housing loans to households have been indexed to foreign currency—one of the highest shares in Europe and among the NMS.
- Asset quality:
  - Share of nonperforming loans in total corporate loans rose from 13 percent in 1998 to almost 30 percent in 2003.
  - Deterioration concentrated in distribution and construction sectors; household repayment capacity weakened as unemployment rose and wage growth slowed.

### Drivers of slow credit growth (aggregate and cross-country)
- Demand-side factors:
  - Weak economic activity in early 2000s reduced corporate loan demand.
  - High corporate liquidity and weak corporate investment allowed internal funding, depressing corporate credit demand.
  - Household loan demand slowed for consumer durables, while housing credit remained robust.
- Supply-side factors:
  - Banks became more cautious as loan defaults rose and banks restructured.
  - Overly lenient prior lending practices contributed to subsequent asset quality deterioration.
- Cross-country econometric findings:
  - In 2001–04, credit growth in Poland was 14⅔ percentage points per year lower on average than expected given structural determinants.
  - Structural determinants important: real GDP growth, profitability (net interest margin), real exchange rate changes.
  - Bank soundness had a positive and statistically significant impact on credit growth in Poland during 2001–04, unlike in other NMS.
  - Institutional impediments: enforcement of pledges and collateral weakest among NMS per EBRD; difficulties collecting accurate information about prospective corporate borrowers.

### Econometric analysis: monthly Poland models (1998–2005)
- Model setup:
  - Dependent variables: monthly percent change in real credit to households (Dtlhr) and to nonfinancial corporations (Dtlcr).
  - Explanatory variables (seasonally adjusted): Dip (industrial production), Dwr (real average gross wages), DRUP (month-on-month change in unemployment rate), DRPR (real policy rate change), NPLRT (nonperforming loans share).
  - Sample period: January 1998 to December 2005. Estimation: OLS; parsimonious dynamic models from general-to-specific starting with 12 lags.
- Selected statistics:
  - Household Credit Growth model:
    - Adjusted R-squared: 0.43
    - Observations: 96
    - Chow test statistic 1.328 (probability 0.239)
  - Corporate Credit Growth model:
    - Adjusted R-squared: 0.58
    - Observations: 96
    - Chow test statistic 0.564 (probability 0.822)
- Long-run signs and interpretation:
  - Household credit growth positively associated with industrial production, lower real interest rates, and stronger bank balance sheets.
  - Corporate credit growth stimulated by lower wages, unemployment and real interest rates and stronger bank balance sheets; corporate credit growth negatively correlated with industrial production growth (interpreted as internal financing via retained earnings).
  - Robustness: results hold using distance to default as alternative bank soundness measure.

### Distance to default (DD) as bank soundness measure
- Definition and formula:
  - DD ≡ (k + μ) / σ, where k is equity capital as percent of assets, μ is average return as percent on assets, and σ is the standard deviation of return on assets.
  - DD measures number of standard deviations a return must fall to deplete equity; higher DD implies lower probability of insolvency.
- Measurement approaches:
  - Market-based DD (option-pricing/Merton) and accounting-based DD (z-score).
  - Accounting-based DD (z-score) chosen as primary measure due to relative illiquidity of NMS stock markets; standard deviation computed over the entire sample period.
  - Monthly aggregate credit analysis also used a DD combining accounting and stock data per De Nicoló and others (2005) for robustness.

### Risks from rapid foreign-currency housing lending
- Growth and composition:
  - Housing loans grew at an average rate of 40 percent per year during the last four years.
  - Share of foreign currency–denominated or indexed loans in total loans in Poland was 25 percent at end-2005 and declining.
  - About 64 percent of housing loans were indexed to or denominated in foreign currency at end-2005.
  - Most housing loans are variable rate; typical maturities up to 30 years.
  - Swiss franc loans popular due to lowest interest rate among foreign currency loans.
  - Typical mortgage amounts roughly zloty 70,000–200,000 (US$25,000–75,000 or 2.0–5.5 times GDP per capita).
  - Initial LTV ratios tend to be around 70 percent–85 percent (partial information).
- Borrower vulnerability and risk factors:
  - Households typically unhedged and vulnerable to significant zloty depreciation.
  - Customer base may be shifting toward lower income groups after sustained double-digit growth.
  - Rising share of housing loans classified as satisfactory but repaid with a delay (up to 3 months).
  - Risk management practices in banks active in FX mortgage lending might have weakened under competitive pressure.
  - Enforcement systems for collateral largely untested; concerns about recovery of housing assets after large shocks.

### Mitigating considerations on FX housing exposure
- Factors providing comfort:
  - Outstanding mortgage loans ~6 percent of GDP in mid-2006, covering about 3 percent of the population.
  - Borrowing in foreign currency for housing reportedly concentrated in upper middle income group.
  - Income eligibility requirements for FX loans typically higher than for zloty loans, resulting in a buffer of up to 20 percent depreciation.
  - Asset quality indicators for FX housing loans so far better than for zloty-denominated loans and total household loans.
  - Housing contracts often allow currency denomination changes during loan period, though unlikely to be effective in a sharp unexpected depreciation.

### Housing prices and data limitations
- Data limitations:
  - Nationwide real estate data sketchy; secondary market time series available only for Warsaw since 2002.
  - Broader data only available as snapshots; data limitations hindered stress testing.
- Observed patterns:
  - Housing prices increased steadily since 2000, reflecting shortages and rising incomes.
  - During 2003–05, housing price growth slowed but remained above consumer price inflation.
  - Housing price growth in 2004–05 marginally higher than EU-15 average and below growth rates in France, Ireland, and Spain.

### Liquidity, foreign currency funding, and bank resilience
- Liquidity positions:
  - System-wide, customer deposits exceed loans, though individual banks differ substantially.
  - Most small banks rely on funding beyond customer deposits.
  - Liquid assets rising as proportion of total assets and recently exceeded liabilities toward the financial sector.
  - Short-term foreign currency claims constitute about one third of liquid assets; foreign currency liquidity rising as banks increased short-term external borrowing alongside domestic FX lending.
  - NBP reports banks obtain foreign currency liquidity via FX swaps without excessive costs (NBP, 2005).
  - Banks tend to hedge direct exchange rate risk from FX mortgages using short-term FX swaps—requires monitoring of FX liquidity.

### Household sector balance sheet and indebtedness
- Aggregate indicators (2005 and related):
  - Household indebtedness about 15 percent of GDP in 2005.
  - Household borrowing corresponded to 21 percent of annual gross disposable income and 36 percent of households’ financial assets in 2005.
  - Households’ debt service ratio was 16 percent of disposable income.
- Caveat: aggregate indicators may mask pockets of vulnerability in low income households or SMEs; disaggregated household balance sheet data not readily available.

### Financial soundness indicators (FSIs) and selected banking sector performance (Table 3, selected series 1998–2005, in percent)
- Regulatory capital to risk-weighted assets: 11.7, 13.1, 12.9, 13.5, 14.2, 13.8, 15.4, 14.5
- Regulatory Tier I capital to risk-weighted assets 1/: 14.0, 14.7, 14.1, 14.1, 14.2, 13.9, 15.3, 14.4
- Capital to assets: 7.0, 7.1, 7.2, 8.0, 8.7, 8.3, 8.0, 7.8
- Classified loans net of provisions to capital 2/: 33.2, 54.3, 59.4, 58.9, 63.6, 68.7, 36.8, 21.4
- Classified loans to gross loans 2/: 10.5, 13.3, 15.0, 17.9, 21.1, 21.2, 14.9, 11.0
- Loan to households 4/: 33.8, 37.0, 39.7, 42.4, 41.4, 43.7, 48.0, 52.3
- Loans to non-financial corporations 4/: 66.2, 63.0, 60.3, 57.6, 58.6, 56.3, 52.0, 47.7
- Return on average assets (after-tax): 0.6, 0.9, 1.1, 0.9, 0.5, 0.5, 1.4, 1.6
- Return on average equity (after-tax): 9.1, 13.2, 15.4, 12.4, 6.1, 5.8, 17.1, 20.7
- Interest margin to gross income 5/: 70.3, 63.7, 60.8, 53.3, 54.4, 55.7, 56.4, 57.7
- Liquid assets to total assets (liquid assets ratio) 8/: 28.8, 15.6, 17.0, 17.8, 24.1, 26.1, 26.2, 26.2
- Net open positions in foreign exchange to capital: ... -1.5, 5.3, 2.1, 1.1, 0.3, 1.5, 2.5
- Notes: 1/ Tier 1 definition; 2/ classified loans definition changed in 2004; 3/ nonperforming loans defined as arrears over 90 days; 4/ sector definitions changed in 2002; 8/ liquid assets definition.

### Market indicators and ratings
- Banking stock performance:
  - WIG-Banking index averaged an increase of 32 percent per annum between end-1998 and mid-2006; WIG general index about 23 percent.
- Ratings:
  - Fitch’s Banking System Indicator ranks Poland D (low quality), same as Hungary, Latvia, Lithuania, and the Slovak Republic; below Czech Republic, Estonia, and Slovenia.
  - Moody’s financial strength ratings lower for Polish banks than CEEC peers.

### Stress tests and scenario analysis
- Supervisory stress tests:
  - If about one fifth of loans classified as satisfactory and special mention migrated to doubtful (a major shock), capital adequacy ratios would drop to 8 percent in banks with assets representing about one fifth of total banking sector assets.
  - If 10 percent of performing foreign currency loans to households became classified, banking sector capital would decline only by about 2 percent, and all banks would remain solvent.
  - Interbank contagion tests suggest a random bank failure would result in only very small losses as a percent of total banking system assets.

### Poland-specific econometric modeling of credit risk
- Regressions model nonperforming loan shares for corporates and households as functions of ip (industrial production), wr (real wages), RUP (unemployment), reer (real effective exchange rate), and RPR (real policy rate).
- Findings:
  - Household credit risk negatively correlated with exchange rate depreciation—interpreted as depreciation boosting incomes via competitiveness, offsetting higher debt service on FX-indexed loans.
  - Economic growth and income proxies are the most important determinants of credit risk for both sectors.
- Estimation details:
  - Sample January 1998–December 2005; OLS; observations 96; Adjusted R-squared: 0.44 (corporates) and 0.51 (households).
  - Sensitivity analysis examples reported (means, standard deviations, 1 STD adverse shock impacts for corporates and households).

### Bank-level and cross-country bank-level analyses
- Bank-level findings:
  - Rapidly expanding FX housing lending does not seem to have come at the expense of financial soundness.
  - No strong relationship between credit growth and capital adequacy at individual bank level; banks with high shares of irregular loans experienced slow credit growth.
  - Exception: one small domestically owned bank with irregular loans ~50 percent of its portfolio.
- Cross-country and Poland-specific results:
  - In 2001–04, stronger banks expanded more rapidly; distance to default coefficient in credit-growth equation positive and significant.
  - Loan growth in banks with large and rapidly growing FX portfolios positively correlated with bank soundness; no identifiable adverse effect on bank soundness so far.
  - Banks with large and rapidly growing household loan portfolios appear generally weaker (dummy coefficient negative and significant) and require close supervisory attention.

### Policy approaches, actions in Poland, and recommendations
- General policy guidance:
  - Regulatory measures alone may be insufficient; can encourage circumvention (offshore or nonbank sector).
  - If risks localized in individual institutions, enhanced supervision preferred to broad restrictions.
  - Preference for risk-based regulatory measures combined with stronger supervision and institutional improvements.
- Actions taken by Polish authorities:
  - 2005: Commission for Banking Supervision increased risk weight on housing loans with LTV >50 percent to 100 percent (from 50 percent previously); weight remains 50 percent for LTV <50 percent.
  - Prudential recommendations for lending in foreign currency introduced and effective July 2006—aim to improve risk management and disclosure.
  - CBS recommended strengthening default risk assessments, regular stress tests for mortgage portfolios, and better borrower information on exchange rate exposures.
  - Authorities to follow up through on-site and off-site supervision and indicated readiness to introduce additional quantitative restrictions if necessary.
- Staff analysis conclusions and recommendations:
  - No specific evidence for administrative regulations to slow overall FX credit growth.
  - Ensure sound credit assessment and risk management, especially in banks active in FX and household lending.
  - Enhanced supervision of weaker institutions recommended to avoid broad regulatory burdens that could slow financial deepening or drive activity offshore.
  - With expected convergence of interest rates to euro-zone levels, incentives for FX lending likely to diminish naturally.
  - Continued strengthening of financial sector surveillance needed, including improved stress testing and credit risk modeling using disaggregated FX loan and household balance sheet data.

### Conclusions
- Without improvements in institutional framework for sound lending, Poland may continue to lag other NMS in financial deepening.
- Slow credit growth reflects slow economic growth, earlier bank balance sheet improvements, and institutional/structural factors.
- Needed institutional improvements include:
  - process-related aspects of collateral enforcement;
  - quality of company accounting and auditing;
  - availability of reliable information on prospective corporate borrowers.
- Exchange rate-related credit risk and liquidity risk currently contained at the aggregate level.
- Financial soundness and market indicators generally favorable, though Poland lags other NMS.
- Household indebtedness and currency mismatches not excessive at aggregate level.
- Main source of credit risk is overall state of the economy rather than the exchange rate.
- Bank-level analyses show rapid credit growth concentrated in relatively sound banks and not weakening bank soundness so far.
- Emphasis on sound lending practices, effective supervision, vigilance for weakening credit standards and rising LTVs, adequate credit assessment and disclosure, and improved stress testing and disaggregated data.

### Appendix — Country measures used to address foreign currency lending risks (selected examples)
- Improved monitoring: Croatia, Hungary, Romania increased off-site reporting, targeted surveys, and on-site focus on FX exposures.
- Better disclosure: Hungary required banks (from January 2005) to specify risks in FX mortgage contracts and disclose APRC.
- Public awareness: central banks in Greece, Norway, Spain highlighted credit risks; Spain monitored forward-looking indicators and used moral suasion.
- Limiting incentives: Estonia reduced mortgage interest deductibility.
- Stricter risk management enforcement: Croatia issued guidelines for systems to identify, measure, monitor, and control currency-induced credit risk.
- Higher risk weights: examples include Croatia (+25 percentage points for unhedged FX loans), Ireland (100 percent weight on portion of mortgages above 80% LTV effective May 2006), Estonia (50→100 percent for loans secured by residential mortgages), Georgia (unhedged FX loan weights increased to 200 percent).
- Minimum prudential norms: payment-to-income limits (e.g., 35 percent in Romania, 50 percent in China), higher down payments (25 percent Romania, 30 percent China).
- Higher provisions and stricter loan classification: Romania refined provisioning and classification to account for FX risk.
- Reserve requirements: Romania increased FX reserve requirements from 30 percent to 35 percent in December 2005 and to 40 percent in February 2006; Estonia increased reserve requirement from 13 percent to 15 percent from September 1, 2006.
- FX liquidity requirements: Croatia introduced/tightened minimum FX liquidity against FX liabilities.
- Ceilings on exposures: Romania introduced ceiling on FX credit exposures to unhedged borrowers at 300 percent of own funds.

*Source: _cr07103*

### References..............................................................................................................

### _cr07103 - References

### Major issues addressed
- Two main issues at the interface between economic growth and financial stability:
  - Why the recent pace of financial catching-up has been so much slower in Poland than in its regional peers, and whether this might hamper Poland’s long-term economic prospects.
  - How significant the prudential risks associated with rapid growth in housing loans are.

### Key descriptive findings on credit dynamics
- Private sector credit trends:
  - Following rapid expansion in the 1990s, lending to the private sector stalled in the early 2000s.
  - Since then, nominal private sector credit has been growing only marginally faster than nominal GDP—the lowest rate among new member states of the European Union (NMS).
- Sectoral composition:
  - Corporate credit growth fell since the late 1990s, bottomed out in early 2005, and was slow to recover thereafter.
  - Household credit remained positive and overtook corporate credit as a share of total outstanding credit to the private sector.
  - Housing loans to households grew at an average annual rate of close to 40 percent in the last four years.
  - About two thirds of housing loans to households have been indexed to foreign currency—one of the highest shares in Europe and among the NMS.
- Nonperforming loans (NPLs) and asset quality:
  - The share of nonperforming loans in total corporate loans rose from 13 percent in 1998 to almost 30 percent in 2003.
  - Deterioration concentrated in distribution and construction sectors; household repayment capacity also weakened as unemployment rose and wage growth slowed.

### Drivers of slow credit growth (aggregate analysis)
- Demand-side factors:
  - Weak economic activity in early 2000s contributed to reduced corporate loan demand.
  - High corporate liquidity and weak corporate investment allowed firms to fund internally, depressing corporate credit demand.
  - Household loan demand slowed for consumer durables, while housing credit remained robust.
- Supply-side factors:
  - Banks became more cautious about lending as loan defaults rose and banks restructured.
  - Overly lenient lending practices during prior credit expansion contributed to subsequent deterioration in asset quality.
- Overall conclusion from aggregate data:
  - Both demand- and supply-side variables significantly affected credit growth, with demand-side factors generally more important during 1998–2005.

### Econometric analysis: model and estimation
- Model specification and data:
  - Dependent variables: monthly percent change in real credit to households (Dtlhr) and to nonfinancial corporations (Dtlcr).
  - Explanatory variables (all seasonally adjusted): monthly percent change in industrial production (Dip), real average gross wages (Dwr), month-on-month change in unemployment rate (DRUP), real policy rate change (DRPR), and nonperforming loans as a share of total household or corporate loans (NPLRT).
  - "D" denotes a one-period difference; lower case letters indicate logarithms.
  - Sample period: January 1998 to December 2005.
  - Estimation method: ordinary least squares; parsimonious dynamic models obtained using general-to-specific modeling starting with 12 lags.
  - Long-run solution form: Dtlhr or Dtlcr = β1 + β2*Dip + β3*Dwr + β4*DRUP + β5*DRPR + β6*DNPRT.
- Main econometric results (selected statistics from Table 1):
  - Household Credit Growth model:
    - Adjusted R-squared: 0.43
    - Observations: 96
    - Specification and diagnostic tests: Chow test statistic 1.328 (probability 0.239); autocorrelation tests and heteroskedasticity test reported.
  - Corporate Credit Growth model:
    - Adjusted R-squared: 0.58
    - Observations: 96
    - Specification and diagnostic tests: Chow test statistic 0.564 (probability 0.822); autocorrelation tests and heteroskedasticity test reported.
  - Long-run signs and significance:
    - Household credit growth positively associated with industrial production, lower real interest rates, and stronger bank balance sheets.
    - Corporate credit growth stimulated by lower wages, unemployment and real interest rates and stronger bank balance sheets; corporate credit growth negatively correlated with industrial production growth (interpreted as internal financing via retained earnings).
  - The model’s findings are robust to using distance to default as an alternative bank soundness measure.

### Distance to default (DD) as a bank soundness measure (Box 1)
- Definition and formula:
  - DD ≡ (k + μ) / σ, where k is equity capital as percent of assets, μ is average return as percent on assets, and σ is the standard deviation of return on assets (proxy for return volatility).
  - DD measures the number of standard deviations a return realization must fall to deplete equity; higher DD implies lower probability of insolvency.
- Measurement approaches:
  - Market-based DD: combines daily market equity data with annual accounting data using option-pricing/Merton framework—requires liquid bank stock markets.
  - Accounting-based DD (z-score): uses annual balance sheet and income statement data; chosen here as primary measure because NMS stock markets may be relatively illiquid.
- Implementation in this chapter:
  - Main analysis uses the accounting-based DD (z-score) calculated using annual data on equity capital and return on assets; standard deviation of returns calculated over the entire sample period.
  - Monthly aggregate credit econometric analysis uses a DD measure combining accounting data with stock market data per De Nicoló and others (2005) for robustness checks.

### Methods and sources
- Data sources: National Bank of Poland, Polish Statistical Office, IMF staff estimates, national central banks, IMF's International Financial Statistics.
- Analyses draw on aggregate and bank-level data for Poland and comparator countries; econometric modeling, graphical analysis (Figures 1–4), and bank-level soundness measures.
- Consultations and cross-references: discussions with policymakers and market representatives during the FSAP Update; analysis draws on Financial Stability Reports, Reports on Developments in the Financial System, and Summary Evaluations of the Financial Situation of Polish Banks prepared by the NBP.

*Italic: Source: _cr07103 - References*

### 10.      This section explores the reasons for slow credit growth in Poland by drawing

### 10.      This section explores the reasons for slow credit growth in Poland by drawing on a cross-country study on credit growth and bank soundness in the NMS.

### Cross-country econometric framework and purpose
- Analysis based on a simultaneous equation framework using bank-level data for New Member States (NMS) to account for feedback between credit growth and financial stability and to enable joint estimation of their determinants.
- Model estimated using three-stage least squares. Dependent variables:
  - Equation 1: annual percent change in outstanding bank loans, deflated using the CPI index.
  - Equation 2: distance to default (DD), calculated using bank account data.
- Exogenous variables (lagged by one year) include: annual real GDP growth, GDP per capita in U.S. dollars, real lending interest rates, annual percent change in the real exchange rate, net interest margin, cost-to-income ratio, liquidity ratio, bank size (total assets in U.S. dollars), shares of bank capital held by foreign institutions and by the government, a dummy for Polish banks, and two interaction terms.

### Key econometric findings on Poland’s credit growth
- Poland’s credit growth has been “underperforming” in recent years by NMS standards:
  - In the second half of the 1990s credit growth in Poland was consistent with structural determinants (Polish bank dummy statistically insignificant in Table 2, Column 3).
  - During 2001–04, credit growth was 14⅔ percentage points per year lower on average than expected given structural determinants (Polish bank dummy negative and statistically significant in Table 2, Column 7).
- Structural determinants with importance in recent years included:
  - Real GDP growth.
  - Profitability (approximated by the net interest margin).
  - Real exchange rate changes.
- The importance of level of economic and institutional development, bank efficiency (cost-to-income ratio), and real interest rates weakened in 2001–04 compared to 1994–2000.
- Bank soundness appears to have had a positive and statistically significant impact on credit growth in Poland during 2001–04, unlike the insignificant impact found in other NMS.
- The deterioration in bank balance sheets triggered by the 2001–02 economic slowdown had a larger impact on credit growth in Poland than in other NMS, possibly because:
  - It coincided with restructuring by new foreign owners of several key banks.
  - It followed rapid credit expansion in the early 1990s amid weak lending practices.
- Data for an outlier—a rapidly growing but reportedly weak small domestically owned Polish bank—were excluded from the data set; regular loans accounted for about half of this bank’s loan portfolio.

### Institutional impediments to credit growth
- Weaknesses in enforcement of pledges and collateral identified as a possible reason for slow credit growth:
  - According to the EBRD, Poland scores the worst among NMS on process aspects relating to enforcement of pledges and collateral: (i) time, amount, and simplicity of enforcement; (ii) debtor obstruction; (iii) creditor control over enforcement; and (iv) institutions (reliability of courts and other institutions).
- Weak enforcement likely reduces banks’ willingness to lend, lowering loan growth and slowing financial deepening.
- Reported difficulties in collecting accurate information about prospective corporate borrowers, especially small and medium-size enterprises, might have discouraged credit growth.
- Although progress has been made recently, “there is still considerable room for improvement.”

### Risks from rapid growth of foreign currency housing lending
- Housing loans were the fastest growing component of private sector credit in the last decade:
  - During the last four years, housing loans grew at an average rate of 40 percent per year.
- Foreign currency exposure in housing lending:
  - Share of foreign currency-denominated or indexed loans in total loans in Poland was 25 percent at end-2005 and declining.
  - About 64 percent of housing loans were indexed to or denominated in foreign currency at end-2005—significantly more than in other NMS and one of the highest percentages in the EU.
  - Most housing loans are at variable interest rates; typical maturities up to 30 years.
  - Swiss franc loans have become a currency of choice because they carry the lowest interest rate among foreign currency loans.
  - Typical mortgage loan amounts roughly zloty 70,000–200,000 (US$25,000–75,000 or 2.0–5.5 times GDP per capita).
  - Based on partial information, initial loan-to-value ratios (LTV) tend to be around 70 percent–85 percent.
- Concerns about indirect exchange rate risk and borrower vulnerability:
  - Households typically unhedged; vulnerable if the zloty significantly depreciates.
  - Customer base may be shifting toward lower income groups after sustained double-digit growth.
  - Rising share of housing loans classified as satisfactory but repaid with a delay (up to 3 months) is a potential warning sign.
  - Risk management practices in banks aggressively engaged in foreign currency mortgage lending might have weakened under competitive pressure.
  - Enforcement systems for collateral are largely untested; EBRD assessment raises concerns about recovery of housing assets after large shocks.

### Mitigating considerations regarding foreign currency housing loans
- Factors providing some comfort about exchange rate-related credit risks:
  - Market penetration still low—outstanding mortgage loans accounted for about 6 percent of GDP in mid-2006, covering about 3 percent of the population.
  - Borrowing in foreign currency for housing reportedly concentrated in the upper middle income group.
  - Income eligibility requirements for foreign currency loans are typically higher than for zloty-denominated loans, resulting in a buffer of up to 20 percent depreciation.
  - Asset quality indicators for foreign currency housing loans have so far been better than for zloty-denominated loans and total household loans.
  - Housing loan contracts typically allow individuals to change the currency denomination of loans freely during the loan period, giving borrowers an opportunity to offload exchange rate risks (but these provisions are unlikely to provide a “safety valve” in the event of a sharp unexpected depreciation).

### Housing price developments and data limitations
- Data on nationwide real estate developments are sketchy; secondary market time series available only for Warsaw since 2002; broader data available only as snapshots.
- Based on partial data:
  - Housing prices have increased steadily since 2000, partly reflecting housing shortages and rising incomes.
  - During 2003–05, growth of housing prices slowed but remained above consumer price inflation.
  - Recent housing price growth in Poland was not excessive by comparison with other EU countries: annual growth rates of housing prices in 2004–05 in Poland were only marginally higher than the EU-15 average and below growth rates in France, Ireland, and Spain.
- Data limitations hindered stress testing for housing price risks in the FSAP Update.

### Liquidity, foreign currency funding, and bank resilience
- Liquidity risks appear under control but require close monitoring, especially for foreign currency liquidity:
  - System-wide, deposits taken from customers exceed loans granted to customers, though individual banks differ substantially.
  - Most small banks rely on additional funding beyond customer deposits.
  - Liquid assets have been rising in proportion to total assets and recently exceeded liabilities toward the financial sector.
  - An important part of total liquidity is foreign currency liquidity; short-term foreign currency claims constitute about one third of liquid assets.
  - Foreign currency liquidity has been rising as banks increased short-term external borrowing in tandem with domestic foreign currency lending.
  - NBP reports banks have been able to obtain foreign currency liquidity through foreign exchange swap transactions without incurring excessive costs (NBP, 2005).
  - Banks tend to hedge direct exchange rate risk from foreign currency mortgages using short-term foreign currency swaps—this necessitates continued monitoring of foreign currency liquidity.

### Household sector balance sheet and indebtedness
- Aggregate household indebtedness:
  - Household indebtedness gradually rising from a low base; about 15 percent of GDP in 2005.
  - In 2005, household borrowing corresponded to 21 percent of annual gross disposable income and 36 percent of households’ financial assets.
  - Households’ debt service ratio was 16 percent of disposable income.
- Caveat: Aggregate indicators may mask pockets of vulnerability in low income households or among small- and medium-size enterprises; disaggregated household balance sheet data are not readily available.

*Source: _cr07103 - 10.      This section explores the reasons for slow credit growth in Poland by drawing*

### 23.      Aggregate currency mismatches in household balance sheets also do not appear

### _cr07103 - 23.      Aggregate currency mismatches in household balance sheets also do not appear

### Household currency mismatches
- Households are unlikely to be able to borrow directly from nonresidents, and their external currency mismatches can be assumed to be negligible.
- Assuming domestic foreign currency liabilities of households are unhedged and not matched by foreign currency assets, outstanding foreign currency liabilities of households to domestic banks are used as a proxy for total household sector currency mismatches.
- Foreign currency liabilities of households rose from less than ½ percent of GDP in 1996 to about 4 percent of GDP in 2005.
- A 30 percent depreciation would raise the household foreign-currency mismatch proxy to 5½ percent of GDP.
- As domestic interest rates converge further to the euro area levels, the interest rate differential on zloty- and foreign-currency-denominated loans should narrow, stabilizing currency mismatches.
- Data limitations noted:
  - Lack of data on foreign currency assets of households.
  - Lack of subsectoral breakdowns for the nonfinancial private sector in the international investment position data.
  - A full national balance sheet would be needed for a complete picture of sectoral mismatches and inter-sectoral linkages.
- Households likely hold wealth mostly in zloty-denominated nonfinancial assets (particularly, real estate); some households might receive foreign currency–denominated remittances.

### Financial soundness indicators (FSIs) and banking sector performance
- Macroprudential indicators suggest the banking system is sound, liquid, profitable, and well capitalized.
- FSIs deteriorated temporarily in 2002–03 and have been improving steadily thereafter; broadly in line with regional peers.
- Aggregate distance to default measures imply Polish banks have on average lagged behind banks in other central and eastern European countries (CEECs) and the Baltics in recent years.
- Dispersion of distance to default in Poland has been the lowest among the NMS, implying greater homogeneity of bank soundness indicators.
- Table 3 (selected indicators, 1998–2005, in percent, Source: National Bank of Poland):
  - Regulatory capital to risk-weighted assets: 11.7, 13.1, 12.9, 13.5, 14.2, 13.8, 15.4, 14.5
  - Regulatory Tier I capital to risk-weighted assets 1/: 14.0, 14.7, 14.1, 14.1, 14.2, 13.9, 15.3, 14.4
  - Capital to assets: 7.0, 7.1, 7.2, 8.0, 8.7, 8.3, 8.0, 7.8
  - Classified loans net of provisions to capital 2/: 33.2, 54.3, 59.4, 58.9, 63.6, 68.7, 36.8, 21.4
  - Classified loans to gross loans 2/: 10.5, 13.3, 15.0, 17.9, 21.1, 21.2, 14.9, 11.0
  - Loan to households 4/: 33.8, 37.0, 39.7, 42.4, 41.4, 43.7, 48.0, 52.3
  - Loans to non-financial corporations 4/: 66.2, 63.0, 60.3, 57.6, 58.6, 56.3, 52.0, 47.7
  - Return on average assets (after-tax): 0.6, 0.9, 1.1, 0.9, 0.5, 0.5, 1.4, 1.6
  - Return on average equity (after-tax): 9.1, 13.2, 15.4, 12.4, 6.1, 5.8, 17.1, 20.7
  - Interest margin to gross income 5/: 70.3, 63.7, 60.8, 53.3, 54.4, 55.7, 56.4, 57.7
  - Liquid assets to total assets (liquid assets ratio) 8/: 28.8, 15.6, 17.0, 17.8, 24.1, 26.1, 26.2, 26.2
  - Net open positions in foreign exchange to capital: ... -1.5, 5.3, 2.1, 1.1, 0.3, 1.5, 2.5
- Notes attached to Table 3:
  - 1/ Tier 1 capital consists of core capital reduced by a shortfall in specific / impairment provisions.
  - 2/ The definition of classified loans was changed in 2004.
  - 3/ Nonperforming loans defined as arrears over 90 days.
  - 4/ The definition of the sectors changed in 2002.
  - 5/ No deductions of income from other deposit takers.
  - 6/ No deductions of expenses paid to other deposit takers.
  - 7/ Noninterest expenses comprise fees and commission costs, other operating costs, depreciation, personnel costs, and other general expenses.
  - 8/ Liquid assets comprise cash, balances at the NBP accounts, placements at banks maturing in up to 1 month, debt securities admitted to public trading, and units in open-ended investment funds. Borrowed funds are all liabilities other than provisions, capital, and earnings.

### Market indicators and ratings
- Polish banking stock prices have grown rapidly in recent years, faster than the general Polish stock market index (WIG-Banking index averaged an increase of 32 percent per annum between end-1998 and mid-2006; WIG general index about 23 percent).
- Fitch’s Banking System Indicator (BSI) ranks Poland the same as Hungary, Latvia, Lithuania, and the Slovak Republic, but below the Czech Republic, Estonia, and Slovenia; Poland’s BSI ranking is D (low quality).
- Financial strength ratings by Moody’s are lower for Polish banks than for CEEC peers, consistent with distance-to-default measures.

### Stress tests and scenario analysis
- Stress tests by Polish authorities during the FSAP Update suggested banks could withstand a major increase in credit risk associated with housing loans.
- If about one fifth of loans classified as satisfactory and special mention migrated to doubtful (described as a major shock compared to historical experiences), capital adequacy ratios would drop to 8 percent in banks with assets representing about one fifth of total banking sector assets.
- If 10 percent of performing foreign currency loans to households became classified, banking sector capital would decline only by about 2 percent, and all banks would remain solvent.
- Interbank contagion stress tests suggest contagion through the interbank market currently does not present a systemic risk: a random failure of a bank is expected to result in only very small losses as a percent of total banking system assets.

### Poland-specific econometric modeling of credit risk (Table 4)
- Regression models default risk on corporate and household loans (share of nonperforming loans) as a function of: industrial production (ip), real average gross wages (wr), unemployment rate (RUP), real effective exchange rate (reer), and policy rate in real terms (RPR).
- Main findings:
  - Credit risk in the household sector is negatively correlated with exchange rate depreciation, possibly because depreciation increases household incomes via greater competitiveness and higher economic growth, compensating for increased debt-service on foreign currency–indexed loans.
  - Variables proxying economic growth and income are the most important determinants of credit risk for household and corporate loans.
- Caveats:
  - Analysis uses monthly data on classified loans while Polish banks review portfolios quarterly.
  - Aggregate results do not capture distribution of risks across banks; individual-bank exposures may be significant.
- Model estimation details:
  - Sample: January 1998 to December 2005.
  - Method: OLS with parsimonious dynamic models obtained from general-to-specific modeling starting with 12 lags.
  - Observations: 96; Adjusted R-squared: 0.44 (corporates) and 0.51 (households).
  - Static long-run equation forms reported; sensitivity analysis reports mean, standard deviation, 1 STD adverse shock impacts for corporates and households on selected variables (examples: Dip mean 0.005, Stand. Deviation 0.03, 1 STD Adverse Shock -0.03 -> Corporates 0.89, Households 0.31; DRUP mean 0.078, Stand. Deviation 0.27, 1 STD Adverse Shock 0.34 -> Corporates 0.50, Households 0.30).

### Bank-level and cross-country bank-level analyses
- Bank-level analysis using Bankscope data (covering about 60 percent of commercial banks, ~85 percent of banking assets) finds:
  - Rapidly expanding foreign currency housing lending does not seem to have come at the expense of financial soundness.
  - No strong relationship between credit growth and capital adequacy at individual bank level; credit growth in banks with a high share of irregular loans has been slow.
  - Distance to default vs. bank credit growth plotting does not suggest rapid credit growth associated with individual-bank weaknesses, with one exception: a small domestically owned bank with irregular loans ~50 percent of its portfolio.
- Polish authorities’ supervisory data reached similar conclusions: banks actively engaged in foreign currency lending are well capitalized and sound; a small negative but statistically insignificant correlation exists between foreign currency lending measures and bank soundness.
- Cross-country econometric analysis for NMS and Poland-specific results:
  - In Poland, stronger banks have been expanding more rapidly in 2001–04; coefficient on distance to default in the bank credit growth equation was positive and statistically significant in 2001–04, unlike other NMS.
  - Recent credit growth in Poland does not seem to have weakened banks; results robust using Polish banks sample only.
  - Bank soundness positively correlated with economic growth, real interest rates, bank profitability and liquidity; negatively correlated with GDP per capita. Exchange rate depreciation has not had a significant impact on bank soundness in recent years.
  - Banks with large and rapidly growing foreign currency loan portfolios: loan growth in such banks has been positively correlated with bank soundness; loan growth in such banks has not had an identifiable effect on bank soundness so far.
  - Banks with large and rapidly growing household loan portfolios: these banks seem generally weaker than other Polish banks (dummy coefficient negative and statistically significant); such banks require close supervisory attention independent of loan currency denomination.
- Table 5 (modeling credit growth and bank soundness in Poland, 2001–04; sample covers banks accounting for more than 85 percent of assets):
  - Selected coefficients and notes:
    - Bank credit growth (lagged): 0.142**, 0.121*, 0.149**
    - Distance to default (lagged) in Distance-to-default equation: 1.137***, 0.868***, 1.429***, 0.914***, 1.423***, 0.906***
    - Net interest margin (lagged): 3.233***, 0.248**, 5.887***, 0.545***, 3.411***, 0.251**
    - Liquidity ratio (lagged): -0.442**, 0.095***, -0.508**, 0.075***, -0.515**, 0.068**
    - Real exchange rate depreciation (lagged) coefficients vary; e.g., -13.606 (Column 3), -6.526** (Column 4)
    - Observations: 96 (columns 1–2), 81 (columns 3–6)
    - R-squared: 0.36, 0.84, 0.42, 0.87, 0.44, 0.87
  - Model estimated using three-stage least squares; dependent variables: annual percent change in outstanding loans (real) and distance to default; exogenous variables lagged one year include annual real GDP growth, GDP per capita (USD), real lending interest rates, annual percent change in real exchange rate, net interest margin, cost-to-income ratio, liquidity ratio, bank size, foreign and government ownership shares.
- Box 2: cross-country experience of foreign banks’ strategies for foreign currency mortgage lending in NMS:
  - Italian-owned banks generally more cautious in offering foreign currency mortgages through CEEC subsidiaries.
  - Austrian banks have been promoting such mortgages aggressively in the CEECs.
  - Italian experience: early 1990s exchange rate depreciation led to higher loan payments and reputational damage, making Italian banks averse to foreign-currency mortgage lending.
  - Austrian experience: foreign currency lending prevalent and risks managed, but many borrowers are not hedged; recommendations included customer education and improved risk management, particularly for smaller banks.

*Source: _cr07103 - 23.      Aggregate currency mismatches in household balance sheets also do not appear*

### 32.      Experiences of other European countries where housing lending in foreign

### _cr07103 - 32.      Experiences of other European countries where housing lending in foreign

### Experiences in other European countries
- Ex post losses from exchange rate-related credit risk in countries where foreign-currency housing lending was popular (for example, Austria, Ireland, and Italy) were fairly small, largely because exchange rate depreciation did not persist for long.
- Ex post small losses do not imply negligible ex ante risks; a priori risks may be larger in Poland because:
  - legal and risk management frameworks in Poland are likely to be weaker than in the industrial countries cited;
  - foreclosure practices in Poland have largely been untested, given the short lending history in this country.
- Cross-country analysis suggests priority on encouraging proper credit assessment and risk management by banks and individuals in an environment of rapid credit growth.
- Supervisory, regulatory and administrative measures have been used in various countries to manage rapid credit growth in foreign currency; these measures are most effective when part of a broad policy package addressing regulatory flaws, strengthening supervision, and introducing institutional arrangements for market infrastructure.

### Policy approaches and limitations
- Regulatory measures alone may be insufficient if incentives for foreign-currency lending reflect macroeconomic factors; attempts to limit such lending by regulation can encourage circumvention (for example, moving business offshore or to the nonbank sector).
- If risks are localized and concentrated in individual institutions, enhanced supervision of those institutions is preferable to broad regulatory restrictions.
- When underlying macroeconomic imbalances cannot be addressed and risks to financial and/or macroeconomic stability are significant, regulatory measures may be a second-best response.
- Preference should be given to risk-based regulatory measures, in conjunction with strengthening supervision.

### Policy response in Poland
- Actions taken by Polish authorities:
  - In 2005, the Commission for Banking Supervision (CBS) increased the risk weight on housing loans with loan-to-value ratios exceeding 50 percent to 100 percent (from 50 percent previously). The weight remains at 50 percent for loans with LTV ratios below 50 percent.
  - Prudential recommendations for lending in foreign currency were introduced and came into effect in July 2006; they aimed to improve risk management and disclosure in line with good international practices.
  - The CBS recommended that banks strengthen default risk assessments, conduct regular stress tests for the mortgage portfolio, and better inform borrowers about exchange rate exposures.
  - Authorities intend to follow up on recommendations through regular on-site and off-site supervisory processes and indicated readiness to introduce additional, quantitative restrictions on foreign currency lending if necessary.
- Staff analysis conclusions:
  - No specific evidence suggesting the need for administrative regulations to slow foreign currency credit growth.
  - Ensuring sound credit assessment and risk management practices is needed, especially in banks active in foreign currency and household lending.
  - Risks from rapid credit growth appear localized and concentrated in individual institutions and are contained; enhanced supervision of weaker institutions is recommended to avoid increasing the overall regulatory burden.
  - Regulatory restrictions risk slowing financial deepening and driving business offshore or to the nonbank sector.
  - With interest rates expected to converge to the euro-zone levels in the coming years, incentives for foreign-currency lending are likely to diminish naturally.

### Conclusions
- An econometric comparison with other NMS suggests that, without continued improvements in the institutional framework for sound lending, Poland will continue to lag behind other NMS in financial deepening.
- Slow credit growth reflects slow economic growth in recent years, efforts to improve banks’ balance sheets earlier in the decade, and institutional and structural factors.
- Needed institutional improvements include:
  - process-related aspects of collateral enforcement;
  - quality of company accounting and auditing;
  - availability of reliable information on prospective corporate borrowers.
- Statistical and econometric analysis indicates exchange rate-related credit risk and liquidity risk are currently contained.
- Financial soundness and market indicators for Polish banks are generally favorable, though Poland lags other NMS.
- Household indebtedness and currency mismatches do not seem excessive at the aggregate level.
- Econometric analysis suggests the main source of credit risk is the overall state of the economy rather than the exchange rate.
- Bank-level analyses show rapid credit growth concentrated in relatively sound banks and not weakening bank soundness so far.
- There is not a strong policy case for administrative restrictions to reduce the overall rate of foreign currency and/or housing credit growth; overly intrusive measures might drive activity offshore or to the nonbank sector, increasing supervisory challenges without reducing risks.
- Rapid growth of foreign currency loans increases the importance of:
  - sound lending practices and risk management;
  - effective supervision, vigilance for weakening credit standards, rising loan-to-value ratios, and excessive concentration of risk;
  - ensuring banks have adequate credit assessment and risk management systems and disclose sufficient information to customers;
  - continued strengthening of financial sector surveillance, including improved stress testing and credit risk modeling using disaggregated data on foreign currency loans and household balance sheets.

### Appendix — Country measures used to address foreign currency lending risks
- Improved monitoring of exposures:
  - Examples: Croatia, Hungary, and Romania increased off-site reporting, targeted surveys, and on-site focus on borrowers’ foreign exchange exposures.
- Better disclosure of risks to customers:
  - Example: Hungary required banks (from January 2005) to specify risks in mortgage contracts in foreign currency and disclose APRC on foreign currency loans; information also published on the financial supervisory authority’s web page.
- Raising public awareness:
  - Central banks in Greece, Norway, and Spain highlighted credit risks in financial stability reports and public statements; Spain closely monitored forward-looking indicators of potential debt-servicing difficulties and used moral suasion.
- Limiting incentives to borrow:
  - Example: Estonia reduced mortgage interest deductibility.
- Stricter enforcement of prudent risk management practices:
  - Example: Croatia issued guidelines requiring comprehensive systems for identification, measuring, monitoring, and controlling currency-induced credit risk and integrating risk management into credit policies and procedures.
- Higher risk weights:
  - Examples and specifics:
    - Croatia increased the risk weight of unhedged foreign currency-denominated and indexed loans by 25 percentage points; loans to debtors with foreign exchange assets covering less than 80 percent of foreign exchange liabilities are considered unhedged.
    - Ireland: Effective May 2006, for mortgage loans with LTVs above 80 percent, a risk weight of 100 percent applies to the portion of the loan exceeding this threshold.
    - Estonia: increased risk weighting from 50 percent to 100 percent in capital adequacy calculation of all loans secured by mortgages on residential property; regulators were asked to consider applying 100 percent risk weighting to loans granted to residents of Estonia; credit institutions required to include 50 percent of total loans secured by mortgages on residential property in calculation of reserve requirement unless 100 percent risk weighting applied.
    - Georgia: risk weights for unhedged foreign exchange loans recently increased to 200 percent.
  - Constraint: From January 2007, increases must be consistent with the EU Capital Requirement Directive of Basel II, limiting discretion for EU member countries.
- Minimum prudential norms:
  - Examples: limits on loan eligibility such as monthly payment not exceeding a proportion of income (35 percent in Romania and 50 percent in China), higher required down payments (25 percent in Romania and 30 percent in China), requirement that all mortgages be repaid before selling a home.
- Higher provisions and stricter loan classification:
  - Example: Romania refined regulations on provisioning and loan classification to account for exchange rate risk.
- Reserve requirements:
  - Examples: Romania increased reserve requirements on foreign currency-denominated liabilities from 30 percent to 35 percent in December 2005, and to 40 percent in February 2006.
  - Estonia increased reserve requirement from 13 percent to 15 percent from September 1, 2006.
- Foreign exchange liquidity requirements:
  - Example: Croatia introduced and tightened minimum requirements on foreign exchange liquidity held by banks against foreign exchange liabilities to manage aggregate FX liquidity mismatch.
- Ceilings on exposures:
  - Example: Romania introduced a ceiling on foreign exchange credit exposures arising from loans to unhedged individuals and legal persons (other than credit institutions) in the amount of 300 percent of own funds; the measure reduced the share of foreign currency loans in total loans and had limited effect on the rate of credit growth but may have encouraged transfer of credit activity to the nonbank sector.

*Source: _cr07103 - 32. Experiences of other European countries where housing lending in foreign*

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