Is the rise in interest rates on loans justified? The Borrower's Possible Defenses

Legal Insight

April 2023

George Psarakis LL.M. (mult.), PgCert

(republished from Euro2day.gr)

Summary: For the past few weeks we have been observing the following concern everywhere: is the rise in interest rates on mortgages and business loans justified? Or in other words: why should the increase in the 3-month Euribor and the interest rate of the ECB's main refinancing operations (MRO) affect the variable interest rate of a loan granted by a Greek bank? This paper describes the operation of the deposit/lending system and identifies the problem in the interest rate terms of credit agreements.

For a few weeks now, we have been seeing the following concern everywhere: is the rise in interest rates on mortgage and business loans justified? Or in other words: why should the increase in the 3-month Euribor and the ECB's main refinancing operations (MRO) rate affect the variable interest rate of a loan granted by a Greek bank? Below are some assumptions to understand the basic principles of the system:

1. When banks lend at a variable interest rate, it is logical that they link the change in the interest rate to certain factors/criteria that are relevant to their refinancing costs. In earlier years the link was made with completely vague criteria such as 'the cost of money', 'market conditions', etc. The regulatory framework of the Bank of Greece, however, since 2002 (PD/TE 2501/2002 and ETF 178/3/19.7.2004) provides that the change in the variable interest rate must be linked exclusively to indicators of a general and widely accessible interest rate character, such as the ECB's intervention rates, Euribor, etc.

2. The bank therefore links its variable rate to some of the above indices. The most representative indicator will, of course, be the one corresponding to the cost of money for the credit institution in question. And we come to the key question: where do banks in general and where do the systemic Greek banks in particular borrow from? 

3. Banks in Europe derive their funding mainly from 3 sources: a) from their depositors, b) from the interbank market, c) and from the ECB through, mainly, i) main funding, ii) marginal funding, iii) longer-term funding and iv) exceptional funding (see TLTROs, PELTROs, etc.). 

4. Based on a Fitch study in 2022, most of the money available to the 4 systemic banks in Greece comes from deposits, followed immediately by the ECB's exceptional funding mechanisms. We read from the Bank of Greece's May 2022 Financial Stability Report: 'The upward trend in deposits continued throughout 2021, amid a decline in deposit rates, resulting in the amount of deposits from businesses and households reaching EUR 180 billion in December 2021, a historic 10-year high. [...] At the same time, banks' liquidity continued to be boosted by their participation in the Eurosystem's Targeted Longer Term Refinancing Operations (TLTROs III), as well as the acceptance of Greek government securities as collateral in Eurosystem credit operations and recent issuances in international markets." Morningstar rating agency DBRS said in a report on 21/3/2023: "Greek banks are largely funded through deposits. Their customers' deposits account for about 81% of their total funding at end-2022... About 80% of these are demand deposits with the remainder being time deposits." And according to the 31/3/2023 Bank of Greece press release, "In February 2023, the weighted average interest rate on all existing deposits increased to 0.18%, while the corresponding interest rate on existing loans increased to 5.52%. The interest rate spread between existing deposits and loans increased to 5.34 percentage points."

5. So we have the following fact: the four systemic banks borrow mainly from their depositors at a cost of 0,18%, while they receive interest rates on the loans they grant of more than 5% (up to 8-9%). A few days ago, the issue was raised in the Parliament with a relevant question by the Deputy Speaker of the Parliament, Mr Konstantinopoulos, with the following title: "The disproportionate and outrageous profits of banks at the expense of borrowers". The BoE's November 2022 financial stability report itself states the following: "The positive contribution of interest rate hikes to the effort to tackle inflation and to boost banks' profitability in the short term is undeniable." 

6. Banks, however, do not proceed with corresponding increases in deposit rates for two main reasons: "The increase in retail deposits in previous years ensured improved liquidity conditions for credit institutions, allowing them to maintain deposit rates at very low levels despite increases in the Eurosystem's key interest rates"); and b) secondly, depositors have nowhere else to put their money anyway since the differences in interest rates between the systemic banks are very small. 

7. And while this is the case today, in the years of the crisis, even though the benchmark interest rates (ECB, EURIBOR) have been continuously decreasing since the end of 2008, banks' business lending rates have in some cases followed a stable and in others even a reverse trend. At that time, banks, for a large part of their loans, did not make a corresponding downward adjustment of the conventional interest rates. This ability of banks to keep conventional interest rates constant when reference rates fall but to increase them when reference rates rise is based on the problematic wording of the variable-rate clauses. The latter are usually worded in the contracts in such a way that they simply allow banks to follow the reference rates when and if they wish. Such clauses have been held invalid by the Greek judiciary (see the recent decision of the Athens Court of Appeal in this respect): "Furthermore, according to the aforementioned clauses, the bank 'had the possibility' and not the obligation, to unilaterally adjust the interest rate in case market conditions favoured it or when the ECB's intervention rate increased, but also to keep it stable in case of a decrease, disproving the plaintiff's reasonable expectations for a decrease of the interest rate in that case..."; see also. see also the relevant judgment of the Court of First Instance of Thessaloniki: "That is to say, although the disputed clause of the loan agreement provided that the adjustment of the bank's base rate would be based on general and widely accessible interest rate indices, as required by PTE2501/2002, namely the changes in the one-month Euribor index, in order to reflect market conditions, the disputed clause makes no reference to the time when that interest rate adjustment would take place, despite the fact that the reference to the monthly Euribor index gives the consumer-debtor the impression that the interest rate will be adjusted every month, a fact which is not borne out by a careful reading of the clause, according to which the defendant bank may at any time and at its discretion change the interest rate on the basis of the monthly Euribor index in force at the time when it decides to make that adjustment'). 

8. But how can the borrower react? A) He can simply repay the loan if he has the possibility to do so. B) He can obviously negotiate a reduction in his margin to compensate for the increase in the reference rate, but this is also up to the bank itself to agree. C) It can take legal action to have the judge set an equitable interest rate charge, claiming that the credit institution, while it had the discretion not to 'follow' the increases in the base rate, did so with perfect timing despite the lack of correlation between the benchmark rate and its funding costs (cf. Article 371 of the Civil Code, which provides that where it has been agreed that a term of an agreement is to be determined by one of the parties, this must be done in good faith; in the present case, the term left to the bank's discretion is whether and when the contractual lending rate is to be synchronised with the reference rate). 

9. The government is now trying to solve the problem by reaching a compromise with the credit institutions by setting a relevant ceiling on mortgage loans, etc. Already one non-systemic credit institution announced a few days ago that it would keep its base lending rate unchanged despite the adjustment of the minimum bid rate for the European Central Bank's main refinancing operations. For businesses, however, the problem will hardly be addressed in a horizontal manner, and this is already creating huge liquidity problems.