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‘Lower of Price or Value Principle’ in Switzerland:  Regulatory changes through 'Basel III Final' and the implications for private credit in real estate

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Summary

  • 'Lower of Price or Value Principle': Mortgages may only be based on the lower value between the purchase price and the market value of a property, ensuring more conservative lending.

  • Basel III and New Equity Capital Ordinance: Starting January 1, 2025, Article 72b (ECO) will come into force in Switzerland, impacting the ‘Lower of Price or Value Principle’. Specifically, the duration of this principle will extend from the current 2 years to 5 years, significantly prolonging the period before a property can be re-evaluated:

    • Impact on borrowers: Reduced flexibility for mortgage increases to fund investments or liquidity unless the funds are reinvested directly into the property.

    • Implications for banks: Reduced interest income and potentially higher competition from alternative capital providers like crowdfunding platforms or private credit funds.

    • Alternative capital providers: Increasing importance as they are often less strictly regulated and can offer higher loan-to-value ratios, making them more attractive to borrowers.



1. Introduction

In just a few days, Basel III will come into effect in Switzerland on January 1, 2025, along with the new Equity Capital Ordinance (ECO / ERV / OFR / OFoP).1 This regulation introduces significant changes to the so-called ‘Lower of Price or Value Principle’.2 But what exactly is this principle, and what are its implications for borrowers, banks, and alternative capital providers such as private credit funds?

This article will provide answers to these questions and delve into the fundamentals and upcoming adjustments.

2. What is the ‘Lower of Price or Value Principle’?

The Lower of Price or Value Principle was introduced in 2014 by the Swiss Bankers Association (SBVg) and will be incorporated into national law in 2025 in the form of the Equity Capital Ordinance (ECO) for banks. It plays a central role in the granting of mortgages by banks and essentially means that a property may only be financed based on the lower value between the market value and the purchase price. The market value (also referred to as fair value) corresponds to an appraisal conducted by the bank or a property valuer. The consequence is that banks issue a lower mortgage based on the lower value of the property. It is important to note that the Lower of Price or Value Principle previously applied for 2 years from the date of transfer of ownership. This means that after 2 years, the bank could commission a new valuation of the property and, in the event of an increase in the property value, raise the mortgage while maintaining the same loan-to-value (LTV) ratio. The goal of the Lower of Price or Value Principle is to reduce the risk of a real estate bubble – particularly during the recent low interest rate environment – as borrowers must provide more equity to cover the difference between the market value and the actual purchase price (SBVg, Basel III Final (2022)).

The following example illustrates the concept of the Lower of Price or Value Principle for two scenarios, assuming that the purchase price is identical in both cases, but the market value differs from the purchase price:

Scenario A): Purchase price > Market value

A property buyer can acquire a property for CHF 10 million (purchase price). However, the bank values the property at only CHF 8 million (market value). The purchase price is therefore higher than the market value, and according to the Lower of Price or Value Principle, the mortgage must be based on the market value of CHF 8 million (see Figure 1 below, Scenario A). At an LTV of 75%, the mortgage is therefore 'only' CHF 6 million, and the property buyer must provide the difference between the purchase price and the mortgage, i.e., CHF 4 million, in the form of equity capital (see Figure 2 below, Scenario A).

Scenario B): Purchase price < Market value

The same property buyer can now acquire another property at the same price of CHF 10 million (purchase price). However, the bank values this property at CHF 12 million (market value). The purchase price is therefore below the market value, and the buyer seemingly makes a good deal. Nevertheless, even though the bank appraises the property at a higher value, the Lower of Price or Value Principle stipulates that the mortgage can only be based on the lower of the two values – namely the purchase price of CHF 10 million (see Figure 1 below, Scenario B). At an LTV of 75%, the mortgage here amounts to CHF 7.5 million, with the required equity in this case being only CHF 2.5 million (see Figure 2 below, Scenario B).

Figure 1: Lower of price or value (CHF million)

lower val Scenario A

Figure 2: Mortgage and equity (CHF million)

lower val scenario B

As can be seen from the two scenarios, the Lower of Price or Value Principle tends to require more equity capital – especially when the purchase price is significantly higher than the bank’s market value assessment (see Scenario A).

3. Upcoming regulatory changes

As previously mentioned, on January 1, 2025, the new Equity Capital Ordinance (ECO) will come into force in Switzerland as part of the implementation of Basel III. With it, the Swiss mortgage market is facing significant changes that also affect the Lower of Price or Value Principle.3 Specifically, this concerns Article 72b (ECO), which will have direct implications for the Lower of Price or Value Principle as of January 1, 2025, and reads as follows:

Direct and indirect mortgage-backed positions: Lending value

“The original lending value of the mortgage collateral must be determined during credit granting for new transactions and credit increases and maintained for a period of five years. If the funds generated by a credit increase are not reinvested into the mortgage collateral, a reassessment of the lending value is not permitted, and the five-year period continues to run. If mortgage collateral is included in portfolios during the credit term, the original lending value is the value at the time of inclusion in the portfolio.” ECO (effective January 1, 2025), Art. 72b, Para. 1

“The internal guidelines must provide for a Lower of Price or Value Principle, according to which, in the event of a change of ownership, the original lending value is based on the lower value between the market value and the purchase price.” ECO (effective January 1, 2025), Art. 72b, Para. 7

Our attention here is on the mentioned period of 5 years, during which the original lending value must be maintained. In combination with the legally enshrined Lower of Price or Value Principle in Art. 72b, Para. 7, this results in a significant extension of the period from 2 to 5 years.

Validity period of the Lower of Price or Value Principle

Previously: 2 years Now: 5 years

But why is this extension even relevant, and who does it affect? In the following section, we will take a closer look at these questions.

4. Possible implications for borrowers, banks, and alternative capital providers

The basic consideration for all parties involved is an increase in the property’s value over time, which would in turn allow for a mortgage increase. Specifically, this means:

  1. Borrowers

    For borrowers, such as entrepreneurs who want to make short- to medium-term investments in their business or real estate investors who wish to react to market opportunities, an increase in the mortgage can be very helpful in securing important liquidity for various projects. However, with the extended 5-year period, it now takes significantly longer to conduct a revaluation of the property. The consequence could be reduced investment activity for businesses, or important liquidity buffers may not be available (or not available in time) during uncertain periods.

  2. Banks

    For banks, the longer validity period of the Lower of Price or Value Principle essentially means lower risk exposure and higher security buffers as property prices rise. At the same time, however, it also means lower interest income, as mortgages will remain at a lower level for a longer period. Banks might therefore be inclined to promote direct investments in properties to increase their lending value and thus allow for a mortgage increase, as this is the only exception during the 5-year period (see Art. 72b, Para. 1 and 2 (ECO)). Alternatively, they might simply increase the interest margin to compensate for the lower income, but this is likely to be of only short-term relevance due to increasing competition (see Section c below).

    Another consequence for banks and their competitiveness, as already pointed out early on by the SBVg (Swiss Bankers Association, Basel III Final (2022)), could be the allocation of new mortgage business to alternative capital providers who are not subject to the ECO or Basel III and therefore not bound by the Lower of Price or Value Principle or its 5-year validity period. These could include, for example, crowd-lending platforms, private credit funds, or pension funds.4 Possible cooperation between banks and alternative capital providers is therefore conceivable to combine both approaches in mortgage lending.

    Another factor that could impact the competitiveness of Swiss banks is the fact that the 5-year validity period of the Lower of Price or Value Principle is part of the so-called 'Swiss Finish' of Basel III. This means that while foreign banks are subject to their national implementations of Basel III, these do not include a quantitative design of the Lower of Price or Value Principle. Although there are other regulations that make mortgage lending for residential properties by foreign banks in Switzerland more difficult, it is not impossible. How the dynamics in the Swiss mortgage market will develop remains to be seen – overall, however, an increase in the number of players is to be expected.

  3. Alternative capital providers

    As already suggested in section b), it is likely that alternative capital providers (i.e., particularly crowdfunding platforms, private credit funds, and pension funds) will face increasing demand, as they can offer higher loan-to-value ratios than banks, allowing borrowers to provide less equity capital. This does not necessarily have to replace the bank's first-lien mortgage but can also complement it in a subordinated position. Specifically, with crowdfunding platforms and private credit funds, regulators would likely encourage the transfer of the higher risk in subordinated positions to alternative capital providers or investors, rather than placing the risk with banks and their depositors.

    Another consequence of the extended validity period will likely be longer terms for subordinated mortgages from alternative capital providers. Generally, these have a duration of about 2-3 years, similar to the previous 2-year validity period, as borrowers could bridge the time until a mortgage increase with subordinated loans. With the extended validity period, alternative capital providers will also be forced either to adjust existing products or launch new products that, among other things, provide for longer terms.

5. Conclusion

We can summarize that the Lower of Price or Value Principle aims at conservative mortgage lending. In the wake of the upcoming regulatory changes through Basel III Final and the new Equity Capital Ordinance, the validity period of the Lower of Price or Value Principle is now extended from 2 to 5 years. This leads to even more conservative mortgage lending and suggests that, on the one hand, banks will seek alternative ways to compensate for lower interest income (due to lower mortgages for an extended period of time), and on the other hand, the type and number of players in the Swiss mortgage market will increase to offer borrowers financing solutions.


Footnotes

1 https://www.fedlex.admin.ch/eli/oc/2024/13/de

2 The 'Niederstwertprinzip' is often translated as 'Lower of Cost or Market Principle.' However, we have deliberately chosen the translation 'Lower of Price or Value Principle,' as this more clearly conveys the meaning of the concept and does not equate it with a cost perspective, such as replacement costs.

3 There are further adjustments due to Basel III, which have direct consequences on the mortgage market. However, including these adjustments would go beyond the scope of this article.

4 We deliberately exclude insurers as alternative credit providers here, as insurers must hold equity capital for mortgages, and FINMA explicitly refers to Article 72 (ECO) within the Swiss Solvency Test (SST) (see Section 2.4, FINMA (2024)).

Sources:

ECO (2024): Verordnung über die Eigenmittel und Risikoverteilung der Banken und Wertpapierhäuser (Eigenmittelverordnung, ERV); Änderung vom 29. November 2023: https://www.fedlex.admin.ch/eli/oc/2024/13/de

FINMA (2024): https://www.finma.ch/de/~/media/finma/dokumente/dokumentencenter/myfinma/2ueberwachung/sst/technische-beschreibung-standardmodell-kreditrisiko.pdf?la=de

Swiss Bankers Association, Basel III Final (2022): https://www.swissbanking.ch/_Resources/Persistent/4/e/7/6/4e7629d71e7bea24070c52d6933ee3afa4b19ca7/PP%20Basel%20III%20Final_Hypotheken_DE.pdf


Disclaimer
This commentary is provided for informational purposes only and does not constitute an offer or solicitation to buy or sell any securities or financial instruments. The information contained herein is not intended to provide investment, legal, or tax advice, and should not be relied upon in making any investment decisions. Investing in securities involves risks, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, investors should carefully consider their own investment objectives, risk tolerance, and financial situation. The views and opinions expressed in this document are those of the author(s) and do not necessarily reflect the views of Artemon Capital Partners. Artemon Capital Partners does not guarantee the accuracy or completeness of the information provided herein, and disclaims any liability for any errors or omissions. Investors are advised to consult with their financial advisor or other qualified professionals before making any investment decisions.