A recent Slovak ruling and consultation means that banks are likely to become more restricted in how they can make unilateral changes to mortgage loans (for example, to raise an interest rate in a floating rate loan).  Slovak banks and covered bondholders holding bonds from Slovak banks need to be aware of the changes, and how the risk of mortgage provisions being invalidated can be mitigated (Slovak Regional Court in Zilina, 10 February 2016).

Interest rates at historical lows, but not forever

In March 2016 a new Act on Housing Credits came into effect in Slovakia. A new feature introduced by the Act has been a statutory cap on fees that Slovak banks may impose on clients for moving their mortgage loans between them, ie early repayment of a mortgage loan through refinancing by another bank. The market reacted by vigorous competition leading to a steep drop in interest rates. As a result, mortgage loan interest rates are currently at historic lows.

When lowering their interest rates many banks seemed to assume that, should the underlying economic reality of low ECB interest rates and persisting deflation change, they would be able to unilaterally increase interest rates on existing mortgage portfolios (most Slovak mortgages are floating rate loans with three or five year fixed periods). A recent judgment of the Regional Court in Zilina in a consumer protection case has shown that this assumption may not always be correct.

Ruling of the Regional Court in Zilina

In a judgment of 10 February 2016, ref no. 7Co/563/2015, the Slovak Regional Court in Zilina invalidated 24 provisions used by Prima banka (a Slovak bank) in its standard mortgage loan agreements.

Most of the invalidated provisions relate to an aggressive set of covenants and events of default. The ruling seems to limit the ability of the bank to accelerate the loan and enforce the mortgage in a number of “soft” default situations. However, the most important invalidated provision was supposed to allow the bank to “adequately change the interest rate (...) if the risk associated with the client changes.” The court stated that the clause was not sufficiently clear and could be interpreted in different ways. It did not allow a client to understand exactly how the interest rate would change in the future and it effectively allowed the bank to change the interest rate at will. This caused a significant imbalance in the rights and obligations of the parties, to the detriment of the consumer. Hence, according to the court, the provision was an unfair term in a consumer contract and was null and void.

The ruling has become effective and cannot be challenged by an ordinary judicial appeal. Consequently, Prima banka is now barred from enforcing the invalidated provision against the claimants as well as against all its other customers. According to press reports, this should concern approximately 5,000 individual cases. The bank indirectly confirmed that it would seek to reverse the decision by making an extraordinary appeal to the Slovak Supreme Court.

The judgment is an important precedent and a symptom of growing pro consumer judicial activism in the Slovak courts.

One court decision, more to come?

This is the first time a Slovak court has invalidated a provision of this type. However, this does not necessarily mean that the unilateral change provisions used by Slovak banks are generally compliant with consumer protection legislation. One has to factor in that so far Slovak consumers have rarely sued banks and, given the current market climate, interest rates are currently declining (not rising).

In fact, based on the prevailing market practice, problematic provisions allowing the banks to change their interest rates eg due to “change in the business strategy of the bank” or “changes in the economic conditions” are widely used by the Slovak banks.

Future rises in inflation and ECB interest rates may induce unilateral increases of interest rates by Slovak banks. These increases may potentially be challenged by consumers claiming invalidity of the unilateral change provisions in their contracts.

The risk is exacerbated by the fact that, since 1 July 2016, the National Bank of Slovakia (NBS) and consumer protection organisations, both acting at their own discretion and in their own name, may petition a court to invalidate an unfair term in a consumer contract even if affected consumers remain silent.

Unilateral changes of interest rates under closer regulatory scrutiny

The pressure on banks is also mounting on the regulatory front. On 8 October 2015, the NBS published a consultation on unilateral changes in financial services contracts. Banks and other stakeholders have been invited to comment. The consultation document suggests that the NBS is taking a very restrictive stance to unilateral changes in consumer contracts.

Once the consultation is finished, the NBS is likely to issue guidelines. Banks and other market players will have to align their practices with it. Such guidelines are an instrument used by the NBS in its market supervision and are de facto binding on the banks.

It is therefore reasonable to expect that, in the near future, the NBS will start imposing regulatory sanctions on banks for using unfair unilateral change provisions. The NBS can impose fines up to EUR 700,000 ( in case of repeated breach up to EUR 1.4 million), an administrative ban on using a specific unfair term, a withdrawal of a banking license and other measures.

Legal conditions for unilateral change of interest rates

So when does Slovak law allow a bank to unilaterally change its mortgage loan interest rate? Based on the current status of the public consultations, it seems that the conditions and grounds for unilateral change should be as specific as possible in order to mitigate the risk of challenge in the Slovak courts. For example, the contract could state that the bank is allowed to increase the interest rate proportionally to the increase in a specified reference rate. Also, in certain cases (eg should the cost of money borrowed by the client significantly increase as a result of the unilateral change), the consumer should be entitled to withdraw from the contract without charge. Upon such withdrawal, the bank should offer to the client a reasonable repayment schedule.

Systemic implications

Unlike in some other CEE jurisdictions, the Slovak residential loan market has not experienced significant systemic issues so far, such as massive accumulation of FX risks associated with granting mortgage loans. However, the NBS has already warned that there are signs of imbalance and future risks to financial stability. Interest rates on Slovak mortgage loans are currently at historic lows and, at the same time, the total volume of mortgage loans (and retail loans in general) is rising sharply. Most mortgage loans are granted for decades and key interest rates, as well as inflation, are bound to go up at some point during this period.

In managing their portfolios and funding, the banks rely on their ability to increase the interest rates in the future, should the conditions on the broader financial market change. But there may be significant consequences for the whole banking sector if that ability is restrained by the courts striking down the provisions in the contracts which purport to entitle banks to increase the interest rates on mortgage or other loans. The impact may be aggravated by the massive and rising volumes of retail debt as well as by the fact that the borrowers may have difficulties paying higher interest in the future.

Mortgage loans are also used as cover assets for covered bonds issued by Slovak banks. Although the proceeds from the cover assets are not directly linked to payments under the covered bonds, the legal issues pertaining to the underlying mortgage loans do affect the quality of the cover and thus may have indirect implications for covered bondholders as well.