1. 1 Contract Savings for Housing (Bausparen) - Subsidies and System Performance - IFC & Russian Banking Association Workshop March 12, 2008 Moscow Hans-Joachim Dübel Finpolconsult.de, Berlin

2. 2 List of Contents Rationale for savings subsidies in general and CSH in particular Mechanics of CSH subsidies & fiscal costs, comparison to Russian Law Proposal Case study Czech Republic vs. Slovakia – impact of subsidies and system performance Discussion

3. 3 1. Rationale for Savings Subsidies

4. 4 Rationale for Savings Subsidies in General Reduce leverage and risk of overindebtedness (US crisis) Level playing field with mortgage subsidies (e.g. interest deduction) Reduce default incentives Reduce loss given default for the debt investor Create access to finance for low-income households Improve ‘ownership’ of the financing, incentives for borrower to behave financially responsible Milton Friedman: “There are only two types of money: my money and your money”

5. 5 A Specific Rationale for Supporting CSH? Pro: CSH is an access to credit mechanism like mortgage insurance (protecting first mortgage holder), which often are publicly provided/subsidized. CSH creates unique long-term prepayable fixed rate mortgage (comparable to main US product), which private sector otherwise doesn’t deliver. Subsidy may be the only means to reduce mismatch risk (CSH daily callable). Con: CSH often primarily used for non-access purposes (e.g. modernization). Capital markets may offer long-term fixed-rate mortgages. CSH may lead to fragmentation of the financial market (esp. if special bank) Actual lending and access performance very difficult to monitor. Principle should be to treat access/high-LTV mechanisms alike – esp. CSH and mortgage insurance and high-LTV bank lending. Problem: mismatch risk.

6. 6 2. Mechanics of CSH Subsidies

7. 7 Main types of CSH subsidies Tax exemption on savings interest CSH premium subsidy CSH loan interest tax deduction Subsidies on the institution level Often cumulations without consideration to distortions, total fiscal costs, targeting

8. 8 CSH Premium Subsidies – Key Questions Where are subsidy rules laid down? CSH enabling act or annual budget? Defines ability of policymaker to change economics. Minimum savings period? Decisive about ‘subsidy yield’. Basis of subsidy payments? New savings vs. savings plus accrued interest. Subsidy ratio, max premium level? Income limits, age limits for children? Shall good brothers (savers-only) be entitled to subsidies? Devil lies in the details, as will be shown shortly..

9. 9 Slovakia: Subsidies in the Annual Budget Law Allowed for downward adjustment as rates declined from the late 1990s on.

10. 10 Czech Republic: Subsidies in the Enabling Law Created huge excess subsidies as market interest rates declined. SAME Enabling Law as Slovakia *1992

11. 11 Fiscal Costs Compared Slovakia subsidies initially huge, then much reduced Started with 40% premium level, reduced already around 98 to 15%. Czech Republic continued moderately high subsidy, which became large as market interest rates declined. Started with 25% premium level, reduced in 2004 to 15%

12. 12 Minimum Savings Period is a Crucial Parameter – a Simulation Subsidy is given only ONCE per savings cohort, i.e. the last is always the most profitable The longer the savings must be held in the account, the lower is their return.

13. 13 Minimum Savings Period – 2 Years is too Short In CZ tied to takeout of an interim/advance loan, i.e. dual excess subsidy: CSH institution can invest CSH deposits at market rates Borrower receives large subsidy for short savings period. Solution is to allow for interim/advance loans but force savers to continue to save, later prepay (Germany), OR reduce subsidies for shorter savings periods. Return per savings cohort by holding period

14. 14 Subsidy Structures Compared Premiums often lead to returns exceeding market deposit rates. Fairly generous premium levels – esp. considering income levels. No income targeting outside Germany.

15. 15 Czech Republic: Growth without Limits At peak time, numerically 63% of Czech inhabitants had CSH contracts. Children, elderly enrolled to maximize subsidies per household. In 2004 reform, despite changes in subsidies, government was unable to impose minimum age for children. Means also limited screening function of pre-savings for mortgage lenders.

16. 16 Limit Subsidies to Loan Takers only? 2006 French Epargne Logement reforms tied savings premia to actual loan takeout. In open systems rational, as savings premia are mere subsidies distorting competition of deposits with capital market funding further. In France EL funds were channeled to non-EL mortgage uses, at some point supported 30% of mortgage lending. In closed systems, good brothers (savers-only) are needed to stabilize liquidity and minimize waiting periods. System would require much higher reserves without. Subsidy also reduces mismatch risk. Government should tie support to global loan-deposit ratio, generate incentives to keep good brother ratio low (e.g. min savings period).

17. 17 3. CSH System Impact: Case Study Czech Republic vs. Slovakia

18. 18 Dimensions of CSH System Impact Profitability impact Financial sector structure impact Housing sector structure impact Fiscal impact

19. 19 Profits of CSH Institutions Compared Czech CSH institutions ran into market rate decline 2000/01 with too high deposit rates. PSS quasi- monopoly. Return on equity

20. 20 Slovakia: MOF Opposed Repatriation of Profits Source: P.S.S., author’s calculations. Notes: EBTD – Earnings before Taxes and Depreciation. P.S.S. CSH institution with RoE of 40-60% initially. Reason: ‘Austrian’ subsidy model - up to market deposit rate. No CSH borrowing initially.

21. 21 Czech Republic Created Strong Financial Market Distortions SlovakiaCzech Republic CSH deposits in excess of demand leads to reinvestment into other eligible asset, esp. covered bonds. CZ as a result has some of the lowest covered bond interest rates.

22. 22 When CZ Was Forced to Reform, new Contract Originations Collapsed Demand stop-and-go not healthy for liquidity management. Wider distortions for financial system and savings ratio.

23. 23 Reducing Subsidies Takes Time due Lag Effects Still under new subsidy formula (2004) considerable subsidies, as these are paid over 5 years per cohort

24. 24 Incentive and Performance Problems of Czech CSH Institutions Extremely low loan-to-deposit ratio due to excessive subsidies, absence of second mortgage concept, no pressure on institutions to lend directly (  securities). PSS Slovakia, German Bausparkassen run almost 100% loan-to-deposit ratio. Government indirectly stimulated interim loans. System cannibalized itself by depressing market rates indirectly – interim loans per 07 almost same rate as CSH loans.

25. 25 As before, in total CZK million

26. 26 Portfolio Composition of CSH Lenders Primary business is modernization and small real estate transactions (old housing, land). 100,000s of small loans. Per 2007 relevance also in rental housing modernization. Reason for low new construction relevance is absence of option to finance ‘senior-sub’ with a first mortgage lender. Possible in Russia?

27. 27 Czech Republic: Dynamics of CSH and Mortgage Lending has Diverged Outstanding loan volumes in billion CZK

28. 28 Positive Spillover Effects for Stability of the Mortgage Market? Czech market more stable than neighbours (related also to use of covered bonds, fixed-rate system), but also more subsidized. CSH savers receive “ca 50bp” margin discount from mortgage lenders (lender). Distribution system is enhanced(Slovakia better than Czech Republic) Modernization lending important in ageing economies. Small loans support lower-income households without access to credit. House price income ratio in Czech RepHouse price income ratio in Poland

29. 29 Russia Considerations Pro Con Banks require partly large downpayments – CSH facilitates In some corners, unsound practices (high LTV, CHF/JPY lending) Foreign bond markets volatile, accessible only to few banks Deposit funding share too low High RUR interest rates, CSH can isolate for a part of the financing High house price inflation makes high LTVs and pre- savings attractive.. This may lead to risky CSH practices (high multipliers, low ISFERs) Recent banking crisis (2004), i.e. how many banks can credibly handle scheme? Small branch networks, high distribution costs of deposits

30. 30 Russia Mortgage Funding Structure

31. 31 System has Value, But the Costs must be Contained Avoid new banking and insurance sector fragmentation Integration into universal banking framework Capital, investor regulation delicate (high-LTV market) Sound regulatory structure to contain crisis costs Special regulation needed Create legal preconditions CSH needs possibility for senior-sub legal structure, stand alone problematic Limit and target subsidies

32. 32 END Hans-Joachim (Achim) Dübel Finpolconsult.de aduebel@finpolconsult.de www.finpolconsult.de