26 October 2019

ECB: Working Paper: Fixed rate versus adjustable rate mortgages: evidence from euro area banks

Authors find that the share of new loans with a fixed rate is larger when: the historical volatility of inflation is lower, the correlation between unemployment and the short-term interest rate is higher, households’ financial literacy is lower, and the use of local mortgages to back covered bonds and mortgage-backed securities is more widespread.

Using granular bank level information from 103 banks belonging to 73 different banking groups across twelve countries in the euro area, authors provide a comprehensive analysis of the determinants of mortgage choice in the euro area. In particular, they investigate to what degree the wide cross-country heterogeneity in the share of fixed rate mortgages to total new mortgages is driven by differences in demand or supply conditions. Relying on a prudent identification strategy, they are able to explore the role of country demand and bank supply factors in determining households’ mortgage choice.

Specifically, they assume that lending policies are set at the consolidated level and can disentangle demand from supply by comparing the lending patterns observed for the same cross-border banking group in different euro area economies, as well as the lending patterns observed across different cross-border banking groups operating in the same economy. Country demand conditions results to have a prominent role in driving the prevalence of mortgages extended at a fixed rate. In particular, they are able to explain almost 72% of the total variation of the share of fixed rate to total new mortgages observed in the sample.

Factors such as the historical volatility of inflation rates, the correlation between unemployment and the short-term interest rate, households’ financial literacy, and the volume of outstanding mortgage covered bonds and mortgage-backed securities exhibit a high correlation with the estimated demand component of fixed rate mort gages, relative to adjustable rate ones.

A predominant role for demand factors is documented also when focusing on the sensitivity of the share of fixed rate mortgages to the slope of the yield curve, as well as when analyzing lending conditions, that is the spread between the interest rate on fixed rate mortgages and that on adjustable rate mortgages.

By showing the relevance of country demand factors, a policy implication of their analysis is that it would not make sense to try to influence the share of fixed rate mortgages by pressing banks to take on more duration risk. This would be ineffective and, presumably, even not desirable. Indeed, the heterogeneity in the share of fixed rate mortgages across economies seems to reflect an optimal allocation of interest rate risk, given the asynchronous business cycles and the expectations that monetary policy will operate in a way that stabilizes disposable income net of housing costs.

Full working paper on ECB

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