Does lending denominated in a foreign currency, taking into account currency risk, generate a significantly higher overall level of credit risk compared to lending in domestic currency?
For example, lending denominated in foreign currency generates additional currency risk so it may increase the overall level of credit risk compared to lending in domestic currency. In addition, sometimes commercial banks also use abusive clauses in their loan agreements when granting business, investment or mortgage loans in foreign currency, which are the result of unethical business practices by the bank and can result in a strong asymmetry of information between the bank and the borrower, the bank taking advantage of a much weaker negotiating position of its clients and hidden, additional costs being charged to the borrower. Such practices were used by a significant part of commercial banks in Poland in the period of several years just before the onset of the global financial crisis of 2007-2099. At that time some commercial and investment banks predicted the occurrence of this crisis on the basis of an analysis of their lending activity, the determinants of the macroeconomic environment and the situation and changes in trends on capital markets. The banks operating in a developing country such as Poland, a country characterised by its own characteristics, knew that by applying unreliable, unethical business practices towards borrowers, by having incompletely secured credit positions, the highly and historically overvalued market valuations of real estate and securities would soon start to fall, that the trend of several years of a bull market in capital markets would change to a stock market crash, which would result in a significant change in trends on currency markets as well. In contrast, borrowers taking out such mortgages denominated in foreign currencies, especially CHF, did not have this kind of knowledge. This is due to the fact that most borrowers do not deal on a daily basis with the analysis of banks' lending activities, the procedures for examining the borrower's creditworthiness and the bank's credit risk, the problems of credit risk management, both on an individual basis with regard to a single credit transaction and on a portfolio basis, i.e. in terms of managing the credit risk of entire portfolios of loans granted by the bank. Banks, on the other hand, are familiar with this issue because they deal with it on a daily basis and are obliged to do so by banking supervisory institutions. However, apparently these banking supervisory institutions as well as consumer and competition protection authorities, bank arbitrage institutions, central banks, etc. are not able to fully verify on an ongoing basis, as part of their ongoing monitoring, the issue of the integrity of commercial and investment banks' application of banking practices in lending, including the application of business ethics, the non-application of abusive clauses in loan agreements, the application of too much asymmetry of information to customers, the use of their advantage at the negotiating level. In order for these mortgages denominated in a foreign currency, in CHF, to sell well, so banks constructed models for calculating the creditworthiness of a potential, individual borrower in such a way that mortgages granted in a foreign currency turned out to be cheaper for borrowers than analogous loans granted in the domestic currency, i.e. in Poland in PLN. The results of the calculated creditworthiness presented to potential borrowers were such that the calculated creditworthiness for a loan granted in CHF was set at a significantly higher maximum loan amount that could be granted compared to an analogous loan granted in the domestic currency of PLN.
In view of the above, I would like to address the following question to the esteemed community of scientists and researchers:
Does the granting of loans denominated in a foreign currency, taking into account currency risk, generate a significantly higher overall level of credit risk compared to loans granted in domestic currency?
What do you think about it?
What is your opinion on this subject?
Please respond,
I invite you all to discuss,
Thank you very much,
Best regards,
Dariusz Prokopowicz
Imo, the credit risk depends mainly on the overall strength of a national economy; if the national economy of a country is significantly weaker, the lending practice in foreign currency leads to greater credit risk than in domestic currency.
It is never good to put a strong and weak horse in a harness.
————-—
https://www.mnb.hu/letoltes/mnb-wp-2022-1-final.pdf
https://www.swissinfo.ch/eng/bloomberg/hungary-s-orban-makes-world-s-best-trade-on-swiss-franc-loans/41220616
https://www.nytimes.com/2014/11/14/business/hard-lessons-for-borrowers-in-hungary.html
https://www.ft.com/content/fd6e3b54-b2c7-3da9-af80-9f0d9a4d7e6f
https://abouthungary.hu/issues/how-hungary-eliminated-foreign-exchange-loans-and-averted-a-crisis
——————————————
The links, dear Dariusz Prokopowicz , are documenting one recent lesson of transition economics as per contemporary experience.
Foreign denominated loans are exposed to foreign exchange risk and credit risk. The extent of the exposure to either of the two risks will depend on country risk factors and quality of risk management (particularly hedging practices)
Lending denominated in a foreign currency can generate a higher overall level of credit risk compared to lending in domestic currency due to currency risk. Currency risk refers to the risk that the exchange rate between the foreign currency and the domestic currency will fluctuate, causing the value of the loan to decrease in domestic currency terms. This can occur due to a variety of factors, including changes in interest rates, political events, and economic conditions.
If the exchange rate between the foreign currency and the domestic currency becomes unfavorable, the borrower may face difficulty in repaying the loan, leading to higher credit risk for the lender. In extreme cases, the borrower may default on the loan, leading to losses for the lender.
Therefore, lending denominated in a foreign currency carries an additional level of risk compared to lending in domestic currency, and lenders should carefully assess the creditworthiness of borrowers and their ability to service the loan in both foreign and domestic currency terms. Lenders may also take steps to mitigate currency risk, such as entering into hedging transactions or limiting exposure to borrowers in certain foreign currencies.
- A study by the International Monetary Fund (IMF) published in 2017 found that foreign currency borrowing by non-financial firms in emerging market economies (EMEs) was associated with higher credit risk and increased likelihood of default, especially during times of currency depreciation. The study suggested that policy measures such as macroprudential regulation and exchange rate flexibility could help mitigate these risks. Source: "Foreign Currency Borrowing and Risk Management in Emerging Market Economies", IMF Working Paper, May 2017.
- Another study by the Bank for International Settlements (BIS) published in 2018 examined the impact of exchange rate movements on bank lending in foreign currencies. The study found that exchange rate movements can have a significant impact on the credit risk of banks, especially in countries with high foreign currency lending ratios. The study also highlighted the importance of monitoring and managing foreign currency exposure for banks and regulators. Source: "The Impact of Exchange Rate Movements on Bank Lending in Emerging Market Economies", BIS Working Papers No. 707, December 2018.
- A review of literature by the European Central Bank (ECB) published in 2019 analyzed the relationship between foreign currency borrowing and credit risk. The review found that foreign currency borrowing can increase credit risk due to the potential for currency mismatches and the impact of exchange rate movements on borrowers' debt service capacity. The review also noted that factors such as borrower creditworthiness, macroeconomic conditions, and regulatory frameworks can influence the credit risk associated with foreign currency borrowing. Source: "Foreign Currency Borrowing and Household Credit Risk", ECB Occasional Paper No. 230, May 2019.
It does. We experienced something like that in Ecuador at the end of the 90s. We had continous devaluations due to outflows of domestic capital (but that's for another day), and some sectors are highly dependent on imports, like cars for taxi drivers. Banks began to lend in dollars, but most prices, credit sales and salaries were still denominated in our domestic currency. The outflows continued, so, devaluations continued and credits couldn't be duly paid, and we ended (for multiple reasons) with 18 finantial institutions broken in 1999.