Legal baseline We have identified the early repayment legal regimes in the EU and gone through a verification phase of these regimes with local regulators. We feel comfortable with concluding that almost all EU Member States grant a universal prepayment option for FRM and the remainder can be explained by legacy effects of covered bond systems and lack of legal development in transition countries. In the case of ARMs, Europe practices a universal option de-facto everywhere. A broad majority of Member States also makes a reference in legislation to either general principles of fairness, objectivity, reasonability or specific costs incurred by lenders that can be interpreted in the way of a ‘fair and objectively justified compensation’ that the policy options refer to with regard to early repayment compensation or fee levels. However, in most legislation, we miss clear guidance towards nature and form of computation formulae. In terms of levels of compensations for FRM, more specifically lender reinvestment risk, that are legally permissible, Europe is divided into three models: uncapped ex-ante fees – with a tendency of permitting above fair value levels transition countries, fair value compensations in Denmark, Germany and a few other Central and Northern European countries, and tight ceilings imposed on compensation levels in Western and Southern Europe (with the notable exception of the UK and Ireland). Surprisingly, legally such ceilings often appear as fee ceilings, which implies above fair value compensations when interest rates have risen (France, Belgium). Spain is an exception with her recent reform move back to fair value compensation levels for FRM.

We discuss a broad set of microeconomic concepts available to analyze lender and consumer cost and benefits in the areas of early repayment right, compensation formulations, and transaction costs. We also use a detailed empirical review to derive an option cost pricing – compensation or fee level curve that is the basis for the cost-benefit analysis. We also micro-economically analyze the policy option removing the universal early repayment right and introducing an unconditional contractual option and define it as a case where arbitrary fees are charged for early repayment as the result of a negotiation between lenders and consumers. We limit the analysis to the microeconomic costs and benefits for stakeholders in the mortgage market, consumers, lenders, intermediaries and government. Our main tool is the option cost pricing compensation/fee level curve for reinvestment risk and foregone intermediation profit defined based on the empirical evidence. Consumer mobility is addressed by assuming changing levels of non-financial prepayments.