Forced Conversion of Consumer Loans in Croatia – Care About Consumers or Just a New Issue?

In expectation of parliament elections, Croatian financial market and its participants experienced a dynamic end of 2015 with the latest amendments to the Consumer Lending Act and the Credit Institutions Act. The amendments introduced a legal framework for forced conversion of loans denominated in CHF („CHF Loans“) and loans denominated in HRK and indexed to CHF („HRK/CHF Loans“)

The amendment had been welcomed by the majority of population that saw this as an opportunity to decrease their over indebtedness, whereas it had fallen under scrutiny of expert-public eye. Expectedly, the latter saw the amendments rather as an increased risk factor for banking operations in Croatia, than a fair and equitable solution in overcoming consumer indebtedness.

Being aware of practical importance and great complexity of an issue for banking operations in Croatia, the authors will cope with the issue in a limited manner – to give a glance as to how the amendment was structured and how it impacts certain constitutional principles. Having this in mind, the authors will start by taking a closer look at the measure introduced by the amendments, and mentioning briefly certain structural issues. Furthermore, the authors will briefly present certain procedural solutions that had been considered so far.

1. Background

Swiss franc denominated or indexed loans (the “Swiss Loans”) were very attractive in Central and Eastern Europe during the credit boom in the 2000s, including Croatia, as they offered lower rates than those in national or euro currencies. It is estimated that 55,000 holders of loans are denominated in CHF and worth roughly HRK 25 billion. A majority of those loans were granted in the 2000s and were primarily used for mortgages or buying commercial property. Accordingly, it is estimated that 38% of mortgages in Croatia were denominated or indexed in CHF. When the Swiss National Bank lifted its cap on the value of Swiss franc allowing the currency to surge, many borrowers were caught out and forced to fork out more Croatian Kuna to cover payments. After the Swiss National Bank announced on 23 January 2015 it will no longer hold the Swiss franc at a fixed exchange rate against the Euro (a decision from 2011), the Swiss franc dramatically appreciated making the Swiss loans far more expensive to service, especially for consumers in countries such as Croatia which are relying on income in Croatian Kuna.

Although there were some legislation measures introduced in Croatia from 2013 onwards[1], the latest amendment enjoyed the greatest public attention. In September 2015, Croatia adopted additional amendment No. 102/2015 entered into force on 30 September 2015 (the “Amendment”). Based on the Amendment, the lenders were obligated to convert the CHF loans to EUR denominated loans and HRK/CHF loans to EUR indexed HRK loans according to the exchange rates applicable on the disbursement date or the date of entry into the loan agreement, as the case may be. The idea of the Amendment was to put borrowers of the CHF Loans and HRK/CHF Loans in the same position that they would have been had their loans, from the start, been denominated in EUR or EUR index.

Reflecting this basic purpose, the Amendment obliged banks to convert CHF Loans to EUR denominated loans and the HRK/CHF loans to EUR indexed HRK loans, and to provide respective consumer with the new repayment schedule within 45 days as of the Amendment entering into force. The consumers had 30 days to notify the lenders whether they opt to accept the loan conversion calculation by way of accepting the annex to the loan agreement; otherwise the loans continued to subsist.

The cost of the exchange rate fluctuations was expected to be absorbed by the banks whereas the financial loss that banks might incur from such conversion shall be tax deductible. The Amendment has a retroactive effect having an impact on the loans entered into prior to the entry in the force of the Amendment.

The Amendment for sure had both legal and financial adverse impact. As for the former, the measure invasively intruded into contractual relationship leaving behind certain consistency gaps. For instance, the Amendment applies to all types of Swiss Loans, regardless of their purpose, i.e. to loans granted for acquisition of second homes, property for investment purposes or even luxury goods. On the other hand, no relief is offered to consumers who have repaid the loans prior to this Amendment being introduced or who are subject to the enforcement proceedings conducted against them.

As for the financial side, the Croatian National Bank estimated the measure will incur costs of HRK 8.5 billion ($1.26 bln) on Croatian banks, which is equivalent to their combined profits over three years.

The European Central Bank (the “ECB”) anticipated that the conversion of the loans as envisaged by the Amendment may result in a decline in the international reserves of the Republic of Croatia, which may in turn have undesired consequences on the country’s macroeconomic stability. Moreover, a lower level of international reserves as a result of the conversion might impair the functional independence of Croatian National Bank, in particular the central bank’s ability to set its policy instruments with the aim of achieving its objectives. According to the ECB, the Amendment might also have some negative effects if it were to lead to a deterioration of foreign investor sentiment due to a perceived increase in legal uncertainty and country risk.

1. Remedies

Given the nature of the issue – serious constitutional concerns and widespread effects of the challenged legislation – there was a possibility of Amendment to be challenged before the Croatian Constitutional Court by invoking a breach of certain rights and principles guaranteed under the Constitution of the Republic of Croatia (the “Constitution”), such as, for example, principle of legal certainty and prohibition of retroactive effect, breach of free enterprise and market and property ownership. Moreover, the applicants were entitled to request suspension of the Amendment due to possible irreversible losses that might occur for the bank concerned and the Croatian banking system as a whole in the period before the final decision on constitutionality of the Amendment is brought.

Given the specific conversion mechanism envisaged by the Amendment and the fact that no individual act of competent bodies will be required to perform conversions, banks could hardly benefit from the remedies that are usually available to the applicants when the act is repealed i.e. possibility to repeal the individual acts that are based on the repealed general act. In other words, the main goal of the constitutionality review procedure in the matter at hand was to suspend the Amendment i.e. to suspend the forced conversion to be performed under the Amendment, and ultimately, to repeal the Amendment.

To this date, several Croatian banks have submitted requests to the Constitutional Court to assess the constitutionality of the Amendment. The Constitutional Court had not suspended the Amendment before it entered into force (30 September 2015). Therefore, some of the banks found ways to mitigate the risks of uncertainty of the subsequent effects of the repealing decision on the conversions carried out in the period between the date on which the Amendment entered into force and the date as of which the Amendment will be repealed, by inserting certain limitation language in the amendments to the loan agreements.

3. Conclusion

Unequivocally, the Amendment appears to be of significant practical importance for banking business, and introduced several issues that are yet to be resolved by the Constitutional Court. It admittedly has its pitfalls, standing at the edge, or even over the edge, of constitutional boundaries. Apart from the potential unconstitutionality of the Amendment, and potential adverse financial effects it might have for the bank system and the state budget, the Amendment seems to endanger one of the basic principles of every modern and civilized legal system – the principle of legal certainty.

As from the consumer perspective, looking at a greater picture, it may be noted that the loss which banks might incur due to the conversion shall be tax deductible. That being said, it might be expected that the measure will leave the state budget without the inflow it would have normally received had there been no amendment in place. Therefore, the measure that may appear as a benefit for some consumers, may in the long run potentially adversely affect a larger number of other consumers (those who were not indebted in CHF), which brings the consumer care in question.

It yet remains to be seen whether the Amendment has been introduced having in mind only the short-sighted goals, or not.

[1] Even before the Swiss National Bank unpegged the Swiss franc, Croatia started to deal with the consumer loans. Consequently, in November 2013 introduced an amendment (No. 143/2013) to the Consumer Lending Act in a way of fixing the maximum interest rate for CHF denominated loans. Furthermore, upon the announcement of the Swiss National Bank in January 2015, Croatia introduced another amendment (No. 9/2015) to the Consumer Lending Act which fixed the CHF/HRK exchange rate in loans with a currency clause for a period of 12 months despite of the fact that the Croatian courts[1] assessed the currency clauses in loan contracts as valid. The rate was fixed considerably below the market exchange rate with the lenders bearing the difference between the market exchange rate and the fixed rate.