The historically low interest rates at present make buying a house very attractive. Why? Low interest rates mean that people can take out loans – including mortgage loans – at very favourable conditions. Owning becomes more attractive than renting. In this kind of low interest rate environment, more households can afford real estate than they can when rates are higher. Furthermore, higher incomes, the desire for more living space, population growth and overly optimistic expectations about real estate value can also boost demand. However, if vigorous demand is not met with an immediate increase in the supply of real estate on offer, property prices rise.
It is hard to gauge whether climbing real estate prices are justified by fundamental factors like rising income or population growth. An increase in real estate prices that far exceeds what can be justified by fundamentals is commonly referred to as a price bubble.
Experience in Switzerland and abroad has shown that when price bubbles on the real estate market develop and eventually burst, a protracted crisis usually follows. This is because a real estate bubble that bursts takes a toll on banks, households and the economy overall.
Real estate prices and mortgage loans have grown significantly faster than Switzerland’s GDP over the past few years. Rather than speaking of a ‘bubble’, the SNB refers to ‘imbalances’ in these markets. Since the SNB has a constitutional mandate to ensure the stability of the financial system, it advocates the implementation of precautionary measures. These are aimed at countering the build-up of imbalances – or at least seeing to it that the banking sector’s resilience is strengthened, so that a potential correction of these imbalances causes as little damage as possible.
The SNB is required by law to contribute to the stability of the financial system. When the banking system takes on too much risk, the SNB calls attention to this situation and recommends precautionary measures in good time – through a variety of channels, not least its financial stability report. Aside from communication, the SNB has no instruments of its own in this area – rather, it coordinates its activities with federal authorities. Thus for example, the SNB can propose the activation, adjustment or deactivation of the countercyclical capital buffer (CCyB) to the Federal Council.
Banks play a major role in the real estate market because they grant mortgages. In so doing, they must assess how the value of the property will develop over the next few years and whether the client will be able to make interest and amortisation payments. This risk assessment involves a high degree of uncertainty. In recent years, these risks might have been underestimated, with mortgages being granted to households that could struggle to meet their obligations in the event of an interest rate rise. If rising interest rates coincide with falling real estate prices, the situation could become especially critical; when borrowers are unable to meet their obligations and their house is worth less than the mortgage, the bank incurs a loss.
However, the mortgage and real estate markets are significant not just for individual banks, but indeed for the entire banking system, as well as for the Swiss economy. On the one hand, since many banks are active on the mortgage market, any problems arising there or on the real estate market could potentially affect them. On the other, overall indebtedness in Switzerland – as measured by the mortgage-to-GDP ratio – is very high by historical standards. Furthermore, real estate often accounts for a large share of a homeowner’s assets. So if interest rates were to rise and the real estate market to dip sharply, the consequences would be felt not just by individual banks, but also by the banking system, households and the entire Swiss economy.
The 1987 stock market crash prompted central banks around the world to pursue expansionary monetary policies and keep interest rates low. In Switzerland, this contributed to an exceptionally rapid rise in house prices towards the end of the 1980s. However, conditions changed. Faced with the threat of inflation, the SNB had to raise interest rates sharply at the beginning of the 1990s. At the same time as mortgage rates went up, the economy weakened – and the value of real estate tumbled.
As a consequence, many home owners and companies found themselves in trouble. Not only were they suddenly burdened with higher mortgage payments, but in some cases, banks demanded a further injection of capital, since the real estate – which serves as the banks’ collateral – was now worth less on the market. The result? Demand for real estate tapered off, and prices fell further. This substantial decline in real estate value also had serious repercussions for the banks. According to the Swiss Federal Banking Commission’s 1997 annual report, the banks had to write off almost 10% – about CHF 40 billion – of their credit volume between 1991 and 1996. The consequences of the real estate crisis were protracted and serious; a decade would pass before the Swiss economy recovered from below-average growth.
Higher monetary policy rates can contribute to alleviating the situation on the mortgage and real estate markets. Banks, in turn, pass on these higher rates to their customers by charging more interest on loans. The result is less demand for mortgages and more difficulties in financing real estate purchases. Sometimes, however, raising interest rates is not an option from a monetary policy perspective. For instance, when the Swiss franc is substantially overvalued, higher interest rates would cause further appreciation, with adverse effects for price stability and economic growth. Imbalances on the mortgage and real estate markets must therefore be tackled with other measures.
The countercyclical capital buffer has been available to Swiss authorities since 2012. It can be activated, adjusted or deactivated by the Federal Council following a proposal by the SNB. The principle behind the currently activated sectoral countercyclical capital buffer (CCyB) is simple: when it is activated, banks must provide more capital backing for mortgage loans on residential real estate. This not only expands their capital buffer and strengthens their resilience in the event of crises, but it counteracts excessive lending by making mortgages more expensive and limiting the overall potential for lending.
In response to a proposal by the SNB, the Federal Council activated the CCyB for the first time in February 2013. Accordingly, as of the end of September 2013, banks were obliged to hold additional capital amounting to 1% of their risk-weighted mortgage loans for residential property. In January 2014, again following a proposal by the SNB, the Federal Council increased the sectoral CCyB from 1% to 2%, with effect from the end of June 2014.
The CCyB is intended as a precautionary measure, and should as such be activated in good time, i.e. before imbalances become critical and a crisis materialises. Furthermore, it is designed to be temporary – once imbalances have disappeared, the CCyB is deactivated and the banks can release the additional capital buffer.
In addition to the CCyB decisions, the Federal Council tightened capital requirements for mortgages with high loan-to-value ratios. And in fact, the banks themselves have, on several occasions, revised and tightened the so-called self-regulation. For example, borrowers must now make a down payment of at least 10% of the lending value out of their own funds, without recourse to their pension assets. Furthermore, the mortgage must be amortised down to two-thirds of the lending value of the property within fifteen years. These measures are also designed to reduce risks arising from developments on mortgage and real estate markets.