Research on verðtrygging - price-indexation of loans and mortgages in Iceland - Conclusions

 

In the year 2012 I got a grant from the University of Iceland to do research on this problem. I promised to clarify the legality of this practice in EU/EEA law, to write an article and to disclose the conclusions to the whole Icelandic society.

The whole amount of the grant is destinated to finance the doctoral studies of Irina Domurath, Ph.D. candidate at the University of Iceland and University of Copenhagen during 2012. She does research on the need of a new paradigm of consumer protection in the area of credit in European law under my supervision.  Her doctoral research has been financed for the period 2012-2015 by the University of Iceland with another grant from Research Fund.

There is no other personal disclaimer to be done. I work independently on this problem following only my knowledge and convictions, I have received no financial compensation for this research from external associations/organisations and I do not have a vertryggt loan myself.

Conclusions of the research - academic article now being prepared for submission to an international journal in consumer law with peer-review procedure

 

Verðtrygging or the indexation of financial obligations to inflation is, in reality, real effective interest calculated a posteriori (instead of nominal interest predicted by financial institutions ex-ante).

 In my opinion that it is illegal in the light of European law and Directive 20089/48/EC to indexate the principal of the loan and payments of interests to reflect inflation a posteriori (ex-post).

 This is so because under Icelandic current framework and new legislative proposal on consumer credit this means in fact that the principal is left undeterminate and is unclear. The information and transparency paradigm on which the Directive is based fails completely. The information and plan of payments given to consumers is always wrong by definition as effective real inflation cannot be stated beforehand. The total cost of credit and  the amount of the principal are therefore by definition inaccurate.

The European Directive works with the hypothesis, definition, methods and formula supposing we have a clear principal of a loan determinate. Consumers must know the total cost of the loan so that they can commit responsibly to their future financial obligations.

A European Form is obligatory for all financial institutions offering credit in EU/EEA Member States. The cost of credit must be calculated within the rules of Annual Percentage Rate of Charge, not outside. The method of calculation is harmonised at European level so that consumers can compare between offers of different providers of financial services competing between them.

Icelandic current practice of verðtrygging goes against responsible borrowing and lending as it encourages overindebtness seducing consumers by initial low payments and by hiding the real cost of credit over the life-spam of the loan. Furthermore banks have incentives to promote inflation because they benefit both from the creation of money/debt and from real inflation which put damages and consequences  on the side of consumers.

See Directive and obligatory information which needs to be disclosed

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2008:133:0066:0066:EN:PDF

Furthermore in Iceland consumers pay for the cost of credit twice: with nominative interest calculated and agreed before hand and with effective real inflation indexation ex-post. But not only, in most cases, interest on interest on interest is regularly consolidated into the principal giving way to an extreme form of anatocism which - in some European countries- would be forbidden as usury.In the light of European consumer law, this would qualify as an abusive clause which must be null and void according to the case-law of the Court of Justice of the European Union and European legislation prohibiting  abusive clauses and abusive commercial practices.

To adjust to inflation, European  considers two main options: the payment of nominal interest charges agreed beforehand (fix rates of interest) or revisable regularly (variable rates). European law does not work on the hypothesis of real interest charged a posteriori. A price-indexation scheme such as it is practiced in Iceland is not incidental but is the main feature of the total cost of credit for debtors. For this reason it cannot escape the scope of the methodology foreseen by the Directive. 

Indexation of payments of interest (not the principal of the loan) could be in accordance with the Directive  if the method is properly disclosed ex ante (pre-contractual and contractual stages) and it is done through the required technique of Annual Percentage Rate of Charge.

See Guidelines of the European Commission on calculation of cost of credit and Annual Percentage Rate of Charge

http://ec.europa.eu/consumers/rights/docs/guidelines_consumer_credit_directive_swd2012_128_en.pdf

European legislation does not harmonise cost of credit itself as long as it respects the European framework on transparency, information and does not constitute abuse. Some countries such as Estonia have high interest rates fro credit while other such as Germany have low interest rates.  My criticism refers therefore to the methodology applied for the cost of credit in Iceland, not to the fact that the ISK króna requires high interest rates due the problems of economic governance, to its instability and size which increase risk for creditors.