Abstract
This paper deals with prepayment risks in banking and provides empirical evidence from the Czech banking sector. The prepayment risk of a loan can be viewed as an embedded option for a client to refinance his mortgage with a lower interest rate. Conversely, it holds that the clients’ profit means a loss to the bank as a mortgage provider. Our analysis quantifies the impact of early repayment of a mortgage on the balance sheets of three different types of banks, which differ in the structure of their financing. In particular, we examine the negative effects of prepaid mortgages on the interest margins of these banks. The results of models have shown that these prepayments risks not only were theoretical, but they were also reflected in the decreasing net interest margin of the Czech banking sector in the 2019–2020 period.
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Notes
- 1.
It means that the Bank was receiving a variable rate based on a 1-month Prague Interbank Offered Rate (PRIBOR), for instance. In practice, banks are hedging their fixed-rate assets, such as mortgages, by entering into fixed-rate payer swaps, while the actual funding of the balance sheet comes either from deposits or issued (covered) bonds.
- 2.
The nominal value of the mortgage is not important for our illustrative calculation. Also, for simplification, we neglect the amount of the fee paid by the client for this prepayment on December 31, 2015 (i.e., the Bank’s compensation costs payable by the client—the option adjusted spread (OAS) rate—is equal to 0).
- 3.
3.7% = 7.2% − 3.5% (loss on funding = funding costs − a new swap interest rate). In fact, the total loss for the bank is 4.7% = 3.7% + 1 % (loss on funding + margin).
- 4.
These are real-time expert estimates.
- 5.
This is an illustrative example of an analysis of different levels of risk from different banks, which is reflected in the cost of financing. Assuming the same risk, banks should theoretically have the same financing costs (i.e. the possibility of financing for the same market yield curve). The only difference is in the yield curve (riskier banks should pay more upward on the credit margin). The increase and fall in interest rates on the market would then be the same for all banks, it would be a parallel shift in the yield curve.
- 6.
The Czech consumer credit law approved in 2016 allows the client to prepay up to 25% of the mortgage a year free of charge. However, we do not expect that the 25% ratio would have materialized, so provide a robust scenario analysis for 10%, 20%, and 50% shares of prepaid mortgages.
- 7.
For comparison, Wüstenrot Mortgage Bank a.s., a small Czech bank, reported an overall interest margin of 1.79% as of December 31, 2014. The computed 0.53% loss would represent 29.6% of the 1.79% total margin. Overall, the net interest rate margin of the Czech banking sector fell down from 2.48% as of 31 December 2008 to 1.53% as of 30 September 2020 (i.e. a 37.3% decrease, see Fig. 9.5).
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Acknowledgments
This research was supported by the Czech Science Foundation (Project No. 20-00178S) and Prague University of Economics and Business (Project No. VŠE IP100040).
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Hanzlík, P., Teplý, P. (2022). Prepayment Risk in Banking: Empirical Evidence from the Czech Republic. In: Procházka, D. (eds) Regulation of Finance and Accounting. ACFA ACFA 2021 2020. Springer Proceedings in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-030-99873-8_9
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