The Bank of Spain today pays special attention to ensuring that new mortgage loans issued by the country's financial institutions are not provided at too low interest rates, trying to return the demand for credit resources. The central bank is concerned about the potential unprofitability of such practices.
The Bank of Spain found that rates on new loans, which averaged 2.91% in December and 3.54% in March, suddenly slowed their growth. They began to grow more slowly than the key rate. Because of this, the spread between them "benchmark" and real rates began to narrow.
This represents a potential risk for the sector. Angel Estrada, head of financial stability at the central bank, indicated a few weeks ago that the organization is now closely monitoring the unfolding events and is trying to make sure that Spanish banks are not trying to set too low interest rates on loans.
Mortgage interest rates are set on the basis of base rates, to which a margin is added to cover various expenses incurred by banks when issuing loans, as well as a premium, in particular, for the risk of default by the client, which they assume.
A small spread between these two rates, which is commercially attractive to attract business, may not pose a problem in the short term, especially if the base rates are stable. But this poses a risk for banks when rates are rising rapidly, which has been happening since mid-2022.
In its latest report on the financial stability of the banking sector, the Bank of Spain also warned that profitability from such practices could easily fall to a very low level, even bring losses. The events of the last half of the year in the USA and Europe clearly show the vulnerability of the financial sector in such situations.
The situation of a sharp economic downturn, which will lead to a drop in household incomes, is particularly dangerous. A narrow spread between the mortgage rate and the base rate implies a greater risk of losses for both microfinance institutions and the largest banks.
Sharp decrease in the spread
The Bank of Spain evaluates mortgage loans issued, weighted by the amount of capital lent, based on the interest rate swap index (IRS). It measures the average percentage of financial derivatives that banks can use in order not to lose money, to create a hedge in case of a sudden increase in key rates and subsequent financial problems.
This index reflects the value of money for a certain period of time without a risk premium. Between 2004 and 2022, the average spread between new mortgages and the IRS was 194.4 points. Nevertheless, there was a noticeable big jump by the end of 2020, which amounted to 218.2 points. However, by the end of 2021, it fell to 157.1 points, and in 2022 it dropped sharply from 127.1 points in Q1 to only 21.1 points in the fourth quarter.
All this strongly correlates with the movement of the key rate and the actions of the ECB: historically low interest rates during the pandemic and a sharp increase in rates over the past year as part of the fight against inflation. The Central Bank in its report stressed that the reduction of the spread "implicitly implies a softening of mortgage lending standards." The Bank of Spain hopes that this is only a temporary phenomenon.