Researchers’ view: Household risks in times of financial stress
Our researchers discuss how rising interest rates, high inflation, and low growth affect the financial health of households, and how the current economic climate may impact wealth inequality as a whole.
Labor market effects of credit market information may impact households for years to come – Marieke Bos, Untenured Associate Professor (Docent), Swedish House of Finance
“In Sweden, information on outstanding claims can be collected from the Swedish national enforcement agency (Kronofogden), and private credit bureaus that gather information from actors in the economy that signed a contract with consumers. This includes among others the tax authority, banks, telecommunications providers, and credit institutions.
Even after consumers have repaid their outstanding claim, a negative flag on their credit records will impact their economy for several years. In Sweden, past defaults can be remembered for three years from the day that the consumer repaid its outstanding claim. In countries like the United States, for example, it is seven years. The impact of having a negative flag on your credit record has increased as more and more actors in the economy, like landlords, insurance companies and telecommunication firms use credit information to decide who to have as clients. Even employers use credit records to decide who to hire.
In our paper (Bos, Breza and Liberman, 2018) we investigate the impact of a negative flag on consumers labor market in Sweden. We estimate that one additional year of negative credit information reduces employment by 3 percentage points. Wage earnings fall by SEK 10,600 (US $1,019) while the decrease in credit is only one-fourth as large. Negative credit information also causes an increase in self-employment and a decrease in the ability to relocate.
Currently, less than 400,000 from the 8 million adults registered in Sweden have a negative flag on their credit records. With lower buffers and an increased risk for unemployment, more households will have trouble to meet their monthly commitments and will end up with a negative flag on their credit records.”
Lessons from the COVID-19 pandemic: existing buffers may not be enough to protect the most vulnerable households - Paula Roth, Postdoc Fellow
“The pandemic hit the Swedish labor market hard, leading to an increase in unemployment of 1.5% in 2020. Unemployment is one of the most common causes of financial distress.
During the pandemic there was also a slight increase in individual insolvencies. Between 2019 and 2020, the number of unpaid debt claims received by the Swedish Enforcement Authority increased by 3.3%. Among young adults (aged 18-25), who were particularly hurt by the worsened labor market, the increase was almost 6%. Most applications considered individuals who were already financially distressed, leading to a marginal increase in applications but an almost 18% increase in the total debt amount.
There was also a significant increase in applications for debt restructuring, rising by 38% compared to the average yearly change of 12% since 2007. This indicates that the pandemic made the financial burden overwhelming for many individuals.
Individual insolvency is most often caused by economic shocks, such as unemployment, sickness, and divorce, and is rarely about large debts. The median debt amount in 2020 was 6,000 SEK and 90% of all claims are less than 100,000 SEK. This implies that the existing buffers like unemployment insurance and benefits were not enough to protect the most vulnerable households. Even though several measures were taken to compensate for income losses, post-tax inequality increased by almost 4% during this period. This was mainly driven by a decrease in average earnings among low-income groups.
In a working paper, I show that inequality increases the risk of individual insolvency, partly explained by an increased pressure to consume above your means. This is supported by the fact that 75% of all claims comes from consumption related debts.”
Swedish banks’ exposure to households is highest in Europe, which is worrying in times of stress – Anastasia Girshina, Assistant Professor
“With interest rates rising during this past year, questions about sustainability of household balance sheets and their capacity to service mortgages have naturally arisen. According to the ESRB latest report (November 2022), Swedish banks’ exposure to the household sector is among the highest in Europe. What perhaps is even more worrisome are the levels of debt compared to the levels of household income. In Sweden, the overall household debt is almost twice as large as their gross income, with only Denmark, Netherlands, and Luxembourg being around similar levels.
At the same time however, Sweden has been on the forefront of implementing borrower-based measures aimed to ensure adequate capacity of households to service their debt. For example, since 2010, loan-to-value (LTV) ratio of new mortgages in Sweden should not be more than 85%. In comparison, in Denmark, home buyers are generally required to make a 5% down payment when purchasing a home; whereas in Netherlands or Luxembourg the LTV limit is set to 100% - that is, no cash is required as an initial payment for the house.
It is also important to note that rising levels of debt in Sweden have been accompanied by both low lending margins and a strong property market, with house prices growing steadily since the early 1990s. And although some models would indicate that Swedish housing market is overvalued, it may be a hard exercise to make this call given that our rental market is heavily regulated, and thus we do not have reliable data on rental yields.
When it comes to Sweden, the main unknown is the overall level of financial well-being of the Swedish households. And what I mean by this is the basic understanding of the level of financial and real estate assets as well as leverage together, at the level of individual household or at least within socio-demographic groups. And it is here that Sweden finds itself at a disadvantaged position compared to other countries lacking both comprehensive administrative data on all balance sheet items and survey data, such as the EU HFCS, available in other European countries. It is of importance that Sweden takes steps in the direction of detailed data collection and documentation to allow both researchers and policy makers to build a better understanding of how resilient our economy is, and which households are potentially the most affected by the current economic conditions.”
Financial mistakes may widen wealth gap - Paolo Sodini, Professor of Finance
“In our paper called ‘Fight or Flight: Portfolio Rebalancing by Individual Investors’, we found that households, on average, rebalance their portfolio in times of stress. Rebalancing means precisely buying in when the market goes down and we show people on average rebalance 50% of the drops.
On average, we see that for people who have higher education, are wealthier and save in private pension, tend to rebalance more. In this way they take more advantage of the risk premium that can be earned in risky financial markets, as they tend to buy when stocks are cheap, and sell when stocks are expensive.
We have also found in our paper “Down or Out: Assessing the Welfare Costs of Household Investment Mistakes,” that more sophisticated households have on average better diversified portfolios and thus earn the same expected return of less sophisticated households by taking lower risk.
Both channels tend to fuel wealth inequality in the long run, with poorer and less sophisticated households lagging behind due to their mistakes.
All these statements are true on average. When we take a look at the very rich, those at the top of the wealth distribution, the picture is dramatically different. Extremely wealthy households have the vast majority of their wealth invested in risky assets, so they have only a limited capacity to rebalance. Additionally, they are also not well diversified, in many cases because they still have most of their wealth tied up in the enterprises that made them rich. This means that their large finances are vulnerable to idiosyncratic shocks, which tend to rise during bad times and facilitate social mobility.
The big difference is that the richest households can rebalance less and hold concentrated portfolios mostly by necessity. Poor households, instead, are lagging behind because of their financial mistakes. The question is: are retail financial markets helping unsophisticated and poor households to take the right decisions?”