The purpose of this paper is to stress test the resilience of Croatian households with debt to economic shocks. The shocks not only impact a household's welfare, but also increase the probability of loan default. As a result, there is a direct link between these stress-testing exercises and financial stability risks. The authors find that very few households are at risk as a result of the shocks experienced over the past few years; new vulnerable households represent about 2 percent of all households, 6 percent of households with debt, and 2-3 percent of aggregate banking system assets. This suggests that household over-indebtedness in Croatia is unlikely to become a drag on aggregate economic activity and that financial stability risks remain manageable.
One caveat should be noted. Some 27-31 percent of households with debt, representing 8-9 of banking system assets, are vulnerable even before being subjected to an economic shock. Since NPLs were low before the global financial crisis, it can be argued that banks knew something about some of these households that is not captured by household budget surveys. It follows that the calculations in this paper should primarily focus on the increased vulnerability of households as a result of shocks and are likely to represent an upper bound to the financial stability risks faced by Croatia on account of household indebtedness.
This paper assesses the financial stability risks that arise from the high debt levels accumulated by Croatian households in the pre-crisis period. As opposed to relying on banking sector data, this paper puts forward a methodology that uses household budget surveys (HBS). In particular, the vulnerability of indebted households to changes in economic conditions is explored. This includes shocks that impact only some households (or household members), such as the loss of income that arises as a result of becoming unemployed, as well as shocks that arise from changes to the terms in which loans have been extended. The latter includes changes in exchange rates and their impact on the debt service of foreign currency (or foreign currency linked) loans and changes in interest rates and their impact on the debt service of variable interest rate loans. The effect of these shocks on households’ vulnerability depends not only on the size of the shocks simulated, but also on the risk thresholds that are used to tag a household as vulnerable.
The use of HBS has limitations. To begin, they cover only a small subset of all households―0.2 percent. But the sampling methodology involved limits the concerns that arise from small samples. Another limitation is that the coverage of these surveys has some weak aspects. For example, while incomes, expenditures and household characteristics are covered in detail, information on financial assets is largely absent. But these limitations should be gauged against the alternative; namely, detailed loan-by-loan borrower information is lacking in macroeconomic data and this also hampers a thorough assessment of household vulnerability. Also, the lack of data on the stocks of household financial assets suggests that the risks identified in this paper are likely to be upper bounds to concerns about household over-indebtedness and its potential implications for financial stability. Finally, the use of HBS allows a distinction between households with and without debt and the characteristics of those that do hold debt, thus enabling an assessment of the impact of debt on aggregate economic activity (Albacete and Fessler, 2010).
The vulnerability exercises carried out highlight that low income households are particularly vulnerable. However, the financial distress of these households appears to precede the economic shocks that Croatian households might be going through as a result of the global financial crisis—what this paper refers to as risk loans at origination. The economic shocks, be these through increased unemployment, changes in interest rates, or changes in exchange rates appear to have limited additionality in terms of new vulnerable households. That so many households are at risk at loan origination raises questions as to what banks know about their borrowers that is not captured in Croatia’s HBS—a subject to which the paper devotes some attention. The primary focus of this paper is, however, the impact of plausible crisis-related economic shocks on financial stability; i.e., new vulnerable households.
A second conclusion is that household debt is concentrated in few households and largely in upper income quintiles. In part this is because credit growth took place from low levels and was brought to an abrupt and early end by the financial crisis. For example, only 7 percent of all households in Croatia have mortgage debt; the equivalent figure for France, Germany, the UK, Sweden and Italy averages 40 percent (EBRD and World Bank, 2011). Since in the worst case only 1 of every 10 households faces financial distress, this is unlikely to result in a drag on aggregate economic activity. Moreover, two-thirds of these households are at risk at loan origination and, as discussed later, this results in an upward bias on household vulnerability.
On the whole, the risks to financial stability arising from household debt appear to be manageable despite Croatia’s large increase in household debt in the years preceding the financial crisis. To reach this conclusion, this paper begins by describing household debt developments over the past decade. It then presents a methodology to tag indebted households as vulnerable to financial distress and further stress tests the balance sheets of households to changes in economic conditions. The implications for financial stability are then discussed by assessing the impact of household debt problems on banks’ loan portfolio.
World Bank.Author:Sugawara,Naotaka;Zalduendo,Juan.Document Date:2011/12/01.Document Type:Policy Research Working Paper.Report Number:WPS5906.Volume No:1 of 1