Stress testing household indebtedness:

impact of financial vs labour market shocks

Dawid Żochowski, European Central BankSławomir Zajączkowski, National Bank of

PolandWorkshop on Macro Risks and Micro Responses

Washington, 15th February 2008

Disclaimer: Views and theses expressed in this paper are those of the authors and not necessarily represent the official standpoint of the institutions they represent.

• Recent developments in lending to households:

– Easing lending policies

– Acceleration in housing loans, relative high rate of growth of consumer loans

– Most of housing loans in floating IR and in Swiss Frank

• Is the growth excessive in Poland?

– No (Boissay, Calvo-Gonzalez and Kozluk, 2005; Kiss, Nagy and Vonnak, 2006)

– From a financial stability perspective: both the pace of credit growth matters and the distribution of debt and debt servicing costs matter

Motivations

Distribution of debt matters for the overall debt burden

0

20

40

60

80

100

120

Individual households

exem

plar

y le

vel o

f deb

t

0%

5%

10%

15%

20%

25%

30%

1 2 3 4 5 6 7 8 9 10<-- - The low es t inc ome group The h ighes t inc ome group - - ->

Deb

t ser

vici

ng b

urde

n

• Idea: Compare implications for banks (measured by the number of defaults) of the three different types of shocks of a comparable magnitude

– FX shock

– Interest rate shock

– Shock to the labour market (unemployment shock)

• We use the micro data from Household Budged Surveys (HBS) from years 1998-2006. The survey is conducted on a sample of over 30 thousands of households.

Assessing the vulnerability of households to different types of shocks

The distribution of loan outstanding across income groups

0%

10%

20%

30%

40%

50%

60%

70%

80%

0-20% 20-40% 40-60% 60-80% 80-100%

Quantile icome groups

Mortgage loans Other loans

• Household’s margin is defined as „what is left” from its current income after covering the basic living cost (such as rents, food or medicines) and debt repayments

where:

Mi- Margin of i-th household,

DIi- its disposable income,

BLCi– its basic living costs

DSEi – its debt expenditures.

Household’s margin as the measure of household’s ability to repay debt

iiii DSEBLCDIM

Negative margin = default

Households’ margin across different income groups

0%10%20%30%40%50%60%70%80%90%

100%

0-25% 25-50% 50-75% 75-100%Quartile groups by income per capita

% o

f hou

seho

ld in

com

e

Basic living costs Loan servising payments Safety bufferDebt service payments Margin

The idea of stress testing – shifting the cumulative distribution of margin

0%

20%

40%

60%

80%

100%

-1,000 zł 0 zł 1,000 zł 2,000 zł 3,000 zł 4,000 zł 5,000 zł

Before the shock After the shock

Stress-test – shifting the distribution

• Measure of the vulnerability to shocks - increase in percentage of loans extended to households which fell into negative margin after the shock

• In case of interest rate and exchange rate shocks we estimate the margin after shock whereby we recalculate instalments taking into account higher interest rates or increased exchange rate of the zloty

• In case of unemployment shock, we draw randomly so many „new” unemployed persons to raise the unemployment rate by a given amount. Then we recalculate the margin of each household decreasing the incomes of every drawn unemployed person by the amount of their previous salary. As an option the income is increased by the unemployment benefit

Methodology in details (1)

• The simulations are repeated 250 - the result of stress test is the average of these simulation

• Various methods of drawing

– The simplest one is to assume that probability of become unemployed is equal for every person („random method” of choosing the unemployed).

– In the second method of drawing the unemployed (“the elaborate method”) we assume that this probability is proportional to the relation of unemployment rates in cross section with a given age group, education level, gender and size of a place of residence to the unemployment rate in the whole sample (before stress test)

Methodology in details (2)

• In order to compare the implications of different shocks we use the historical method of defining the scale of shocks. We define the scale of shock as the maximum increase of given indicator (interest rate, exchange rate or unemployment rate) in two years period in the past.

– 33,3% of zloty depreciation in case of fx shock

– 3,9 pp. of interest rate in case of interest rate shock

– unemployment rate increase by 4,7 pp. in case of labour market shock.

Methodology in details (3)

Results

 

33.3% FX

shock

Interest rate rise by 3,9 pp.

Unemployment rate increase by 4.7 pp. – “elaborate method”*

Unemployment rate increase

by 4.7 pp. – “random method”*

All bank loans

1.6 2.8 3.3 4.5

Mortgage loans

3.1 4.6 3.4 5.2

Non-mortgage loans

0.6 1.53.3

(2.6)4.0

By how much would increase the share of loans extended to households (in pp.) with negative margin after the shocks?

• The impact of fx shock to household ability to repay debt is lower than the impact of interest rate shock. The impact of both shocks is considerably higher in case of households that repay mortgage loans

• The impact of unemployment shock for banks can be considerably higher than in case of financial shocks, especially in case of households which have non-mortgage loans (lower income groups)

• The ability of household that fell into negative margin (default) after unemployment shock to repay debt is much higher than in case of financial shocks. This is because of a large decrease in households’ incomes caused by unemployment shock

Results

• It seems that the labour market shock (irrespectively what could be the source of it) could cause the largest losses on portfolios of household loans

• Non-mortgage loans are concentrated among the lower income groups of households

– and at the same time they have smaller margins and

– higher probability of becoming unemployed

These group of households would particularly suffer from the possible downturn in the economic activity

• Financial deepening process in developing countries starts with higher income groups and spreads gradually to lower income groups amid lowering interest and easing credit standards

Conclusions

Stress testing household indebtedness:

impact of financial vs labour market shocks

Dawid Żochowski, European Central BankSławomir Zajączkowski, National Bank of

PolandWorkshop on Macro Risks and Micro Responses

Washington, 15th February 2008

Disclaimer: Views and theses expressed in this paper are those of the authors and not necessarily represent the official standpoint of the institutions they represent.