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The problem with foreign currency loans

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About The Author

Rowan Clapp (Former Public Law & Human Rights Editor)

Rowan graduated from Durham University in 2013 with a First Class degree in Philosophy and Theology. He completed the GDL at BPP University on a Lord Haldane Scholarship and Hardwicke Entrance Award from Lincoln’s Inn. He is currently undertaking an LLM at University College London and working as a volunteer caseworker at Reprieve.

Hungary is very similar to Bulgaria. I know they’re different countries

Kevin Keegan.

Loans are fundamental to the way most modern people finance their lives. In particular, the acquisition of the mortgage is associated with the first step towards establishing a stable lifestyle, and for many, particularly in the UK, getting on the property ladder is a huge achievement.

The last ten years in many Eastern European states has seen a rise in a very particular kind of mortgage facilitated by a foreign currency loan (FCL). Many were encouraged to take out loans in stable foreign currencies (such as the franc) as opposed to fluctuating domestic ones (like the forint). The logic was simple: predictability and stability are probably the two words you most want to hear in association with a mortgage other than ‘paid’ and ‘off’. Further, FCLs boast the advantage of lower interest rates. But what was in it for the banks? Well, simply put, it protected them from domestic risk by shifting it onto the mortgagors.

As anyone who has recently seen (or read) The Big Short will know, this is not the first time that banks have leapt upon the humble mortgage as a means of exploitation. Somewhat unsurprisingly, numerous horror stories are now emerging in countries like Poland and Hungary where fluctuation in exchange rates between domestic currency and the franc has left them liable to repay, at times, nearly double the loan they originally took out.

The reaction of many mortgagors has been extreme and troubling, which is unsurprising given they have effectively been told they have to pay for two houses instead of one. The Russian government has recently agreed to allocate $60m to assist homeowners with their FCL mortgages. FCL protesters seek the recalculation of their debt at the exchange rate the contract was signed, plus an additional 30%. Alternatively, they are happy to repay at the current rate of exchange but with a 60% ‘haircut’ (percentage reduction) to the debt. These may be reflective of the kind of terms sought by those in Hungary and other Eastern EU FCL victims.

Given that most people will take the majority of their working lives to chip away at the constant debt of a mortgage, which anchors them geographically and financially, leaving the amount repayable to the fluctuation of the international currency market seems enormously callous. In fact, doing so seems to accord absolutely no mind at all to the affairs of the little guy, the individual, the regular bank customer. But then again, what did you expect? As one senior official at an Austrian bank conceded, ‘[m]ost of the clients did not recognise the risk and in some cases we did not inform them properly’. However, banks will be unsurprisingly reluctant to call it quits, recent estimates by the Polish banking supervisor predicted that a forced, artificially low conversion of francs to zloty could cost banks as much at $13m. As such, mortgagors are searching for some kind of legal response.

Foreign Currency Loans (FCL)

Throughout 2008, many Hungarian loans were paid out in foreign currency with the loan fixed such that the amount of money loaned was agreed in the foreign currency (usually Swiss francs [CHF]), but the repayments made in the national currency (Hungarian forints).

This quirky state of affairs was due to Art. 231(2) of the Hungarian Civil Code of 1959 which stipulates that ‘[a] debt specified in a different currency … shall be converted on the basis of the exchange rate prevailing at the place and time of payment’. Therefore, as the Recent Developments in the ECL blog helpfully explains, ‘foreign currency loans concluded at the time contained a foreign currency exchange clause that set out the exchange rate’, which would usually be the bank’s fixed buying/selling rate of exchange at that time. These loans protected Hungarian banks from the currency risks associated with capital markets by ‘transferring this risk on consumers in return for a favourable interest rate’.

Glossary

Before turning to the next section, there are several terms it is important to explain which are relevant to the current discussion of Hungarian FCLs. Essentially, what is mooted is whether the FCL itself is an entity which must be subject to scrutiny by a body external to the bank. If it is a financial product which should have been somehow regulated, and this regulatory check was not conducted, then the loan will be void and the Hungarian citizens having to metaphorically pay for two houses instead of one can breathe a sigh of relief. However, for this to operate, it is to be established whether the exchange of the loan money from one currency into another is in itself a ‘derivative’. I will turn to a fuller discussion of this below, but first it is important to understand these key terms:

‘Financial Instrument’ – These can be any kind of tradable assets. They can range from cash to credit to a contractual right to receive some other benefit. A derivative instrument is one which derives its value, or supervenes on the performance of some other financial entity. An example of this is a ‘futures contract’, a contract between two parties to buy or sell a specified asset for a price agreed on at time 1, for delivery at time 2. The ‘future’ contract is a derivative because it is a contract dependent on the existence of the underlying asset.

Spot transaction – Where the currency being sold is payable within two days, whilst the currency being bought is receivable in two days. There is an agreement to buy or sell the asset at a particular ‘spot price’ and then this trade actually occurs at the present time. This is to be distinguished from a forward foreign exchange contract where the money does not change hands until a date in the future, but the exchange rate is agreed at the time specified in the contract.

‘Suitability check’ – Under the MiFID (Markets in Financial Instruments Directive 2004/39/EC) rules, when a firm provides investment advice or portfolio management services to a private customer, it must also “perform suitability assessments” of that customer. This creates an obligation on firms to obtain information “necessary” to assess suitability.  As such, a “firm must obtain sufficient information regarding the client’s knowledge and experience, financial situation and investment objectives to enable it to recommend investment services and financial instruments suited to the client.”

The Problem

As a result of the FCL, the Swiss franc went from strength to strength. As it grew stronger, so did the rationale for taking out loans in francs as a more stable currency. However, due to the disparity between the domestically weak forint and the internationally strong franc, some EU citizens utilising this loan arrangement have been left repaying 100% more than they borrowed in the first instance.

As Polish legal academic, Michal Buszko explains in Foreign Currency Loans in Poland and Hungary, ‘[b]ecause repayment of FCL is strictly dependent on the exchange rate of foreign currencies, the considered loans had exposed a large group of domestic borrowers to FX risk which they could not effectively hedge’.

In this context, FX risk essentially means the risk open to those who bet on whether a currency will increase or decrease in value in the global foreign exchange market. To hedge this risk would be to attempt to mitigate it via the existence of some other financial instrument. Yet the risk becomes ever more prominent with the rising valuation of CHF (and Euro, a currency in which some FCL’s are issued).

It would be difficult for the individuals subject to the loan agreements to take steps to hedge these risks because a) they did not know that they were subject to them – they were convinced that their money would not be subject to fluctuation due to the strength of the franc and b) because they are not bankers and have no idea all of this is going on in the first place.

It seems that pragmatically, and morally, there should be some sort of release mechanism to assist consumers who are struggling to repay disproportionate sums of money in this scenario.

It is not just that the mortgagors were unaware that their money was subject to the changing tides of the global FX market, but quite the opposite, they thought that by taking out a loan in a foreign currency they were inoculated against any such risk. One might argue that this represents a somewhat familiar duplicity on the part of banking establishments keen only to hedge their own exposure to the risk as far as possible, often at the expense of clients. However, all that really matters is whether there is any legal mechanism through which the mortgagors might have recourse. In the alternative, it seems they must either admit defeat and pay back twice what they borrowed or admit defeat and enter bankruptcy. So, the case was brought before the Hungarian court.

At domestic level, the Hungarian court found there to be two elements to the foreign currency loan identifying both a loan contract, and a derivative forward currency transaction. As Advocate General (AG) Jääskinen explains at paragraph 16 of his Opinion, ‘the … loan agreement … has a money market dimension (consisting of the loan), and a possible capital markets dimension (consisting of the currency exchange rate transactions).’ This is because at the time the loan was granted:

The bank calculated the equivalent amount in foreign currency of the amount that it was to advance in forints […] [Next,] the bank purchased from the client that currency […] using the actual exchange rate for purchases of foreign currency that was applicable at the time of the advance of the loan […] and paid the equivalent amount in forints to the client. [Later,] the bank sold to the client the registered currency in exchange for forints, using the actual exchange rate for sales of foreign currency that was applicable at the time of the repayment of the loan

As such, the Hungarian national court referred four questions to the CJEU for preliminary ruing:

  1. Was the offer of an exchange rate transaction, which constituted a spot transaction at the time of the advance of the loan, and a forward transaction at repayment constitutive of a financial instrument?
  2. Must it be held that the carrying out of ‘proprietary trading in respect of the financial instrument’ is an investment service or activity?
  3. Must, therefore, the financial institution perform the ‘suitability check’ required by Article 19(4) and (5) of Directive [2004/39]?
  4. Where this suitability check is not provided, does the circumvention of Article 19(4) lead to the annulment of the loan agreement?

The implication from points 1-4 is that whoever can be deemed an investor (i.e. someone investing in financial instruments) for the purposes of Directive [2004/39] should enjoy the protection of a suitability check. Where this has not been conducted, the Bank may find the loan agreement annulled. It seems that if the FCL can be construed as a financial instrument then it should be subject to strict regulatory measures which are absent here.

Advocate General Jääskinen’s answer to the admissibility question is fairly straightforward. At paragraph 29, he affirms that questions (3) and (4) are essentially ‘impossible to answer due to insufficient information in the order for reference’. This is difficult to accept, given that he then proceeds to analyse the relative merits of both (3) and (4), suggesting how the CJEU might see the case if it were to proceed. On a broader level, it seems odd that the FCL could be imposed by banks, and marketed to consumers without any need for external regulation at all.

Jääskinen follows this with an explanation of how the fixed loan transaction is not a derivative contract or a forward currency transaction. This, he believes, is because ‘derivative instruments are those which can be used for hedging or speculative purposes because a future price, rate or value of the underlying asset is fixed beforehand’. This creates in the derivative instrument, he notes at paragraph 42, ‘the prospect of the actual price, rate or value of the underlying asset diverging from the contracted future one’. However, AG Jääskinen goes on, in paragraph 43, to emphasise that this was not evident in the Hungarian-Franc arrangement due to the fact that any liquidation of Swiss Franc denominations took place in forints at a ‘rate applicable at the time of the repayment of the loan.’ As a consequence:

a loan expressed in foreign currency but advanced and repayable in national currency at the actual rate on the day of payment is neither itself, and nor does it contain, a financial instrument or a financial service in the sense of Directive 2004/39, and therefore the directive is not applicable to the arrangement.

Therefore, so the argument goes, the ‘consumers of foreign currency loans are not considered to be investors, and do not enjoy the protection [of] Article 19.’ Jääskinen held that ‘we do not have an added economic value because the actual price and the contracted one are not different due to the fixed exchange rate in the contract’. However, it is not exactly clear what the term ‘fixed’ means in this context; there is a difference between giving an exact value, and giving a benchmark. Perhaps this is the kind of inaccuracy that the AG held the reference to be inadmissible in the first instance, yet it also seems odd not to have it formally resolved if it is such an important issue.

The decision of the court broadly followed the same lines as the AG’s Opinion. However, it did differ from his opinion in several key areas. On the question of admissibility, the court held that it was ‘bound to give a ruling’ because the matter raised involved the interpretation of a provision of EU law. As such, the court did consider the questions raised. However, they returned a similar response to questions one and two, albeit for slightly different reasons.

The court held the FCL to ‘consist … of exchange activities which are entirely incidental to the granting and repayment of a foreign currency dominated consumer loan’ [at 55]. As such, the transaction is simply a ‘manner of performing the fundamental payment obligation under the loan agreement’. Crucially, the ‘transactions do not have as their purpose the completion of an investment’ [at 57] because ‘these types of foreign exchange transactions serve merely to secure the granting and repayment of the loan’ [at 61]. It therefore follows that ‘the clauses of […] a loan agreement relating to currency conversion accordingly do not constitute a financial instrument distinct from the operation which is the object of that agreement, but merely a term of the agreement which is an inseparable part of its performance’ [at 72]. The result, much like that of the AG’s opinion, is that the mortgagors could not seek to avoid their repayments. Accordingly, the court held that there is no need to answer the third and fourth questions which are predicated on a positive answer to questions one and two.

Also diverging from the AG’s opinion and the CJEU’s judgment, in a more substantial sense, was the Spanish Supreme Court, which, on 30th June 2015 ruled that a mortgage loan denominated in a foreign currency was a financial instrument, and specifically, a derivative financial instrument. As such, said the court, the derivative was subject to Directive 2004/39/EC in stark contrast to the provisions of the European Commission:

Mortgages are not financial instruments as defined in MiFID, irrespective of the currency in which they are denominated.

This runs directly contrary to the CJEU decision in Banif Plus Bank Zrt v Lantos and another [2015] WLR (D) which held that foreign exchange transactions ‘served merely to secure the granting and repayment of the loan’ and were not in themselves financial instruments within the meaning of article 4(1)(2) of Directive 2004/39, but were instead transactions not constitutive of financial instruments as defined in article 4(1)(17).

It’s unclear whether the Spanish court will accept the December 2015 preliminary reference from Banif which followed its decision in June 2015. The Court was not obliged to agree with the AG’s reference. However, there can be little doubt that it is now bound by the Banif preliminary reference, as the scope of the reference for a preliminary ruling is outlined relatively starkly in the EU summary of its legislation. This document provides that:

The Court of Justice Decision has the force of res judicata. It is binding not only on the national court on whose initiative the reference for a preliminary ruling was made but also on all of the national courts of the Member States.

There can be little disagreement over the meaning of the above summary. It seems that in future, the Spanish court is obliged to contradict its earlier assertion that FCLs can be subject to the MiFID suitability checks.

Conclusion

The result of this case is worrying, not only for the individuals who will now have to repay their mortgages twice over. Some states have attempted quite controversial means to attempt to offset this apparent inequality.

Yet more troubling is that the foreign loan crisis presents yet another instance of a bank using its superior understanding of the technicalities of financial agreements to the disadvantage of its clients. How the mortgagors were ever expected to know the risk they were exposing themselves to in taking out an FCL is unclear. The result however, is a familiar one. 

In perhaps the most memorable moment of The Wolf of Wall Street, Jordan Belfort is strolling through the offices of his million-dollar investment firm detailing his exploitation of clients and companies alike. He asks the audience, “was all of this legal?” This time, apparently, yes. 

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Tagged: Banking & Finance, Commercial Law, European Union

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