Capital is a costly and limited resource for all institutions – the more capital a lender has, the more mortgage business it can write.
The new legislative framework known as the Capital Requirements Directive – commonly referred to as Basel II – governs how much capital all banks and building societies must hold to protect their members, depositors and shareholders. It was introduced by the European Union in January 2007.
In the UK this is being implemented by the Financial Services Authority. The new Basel II regime is important for lenders because it enables them to be more efficient with their capital and therefore write more business.
Basel II in effect
From 1 January 2008, the new capital requirements directive comes into effect for all lenders. In simple terms this means that lenders who have not already received their approval for the Basel ll IRB waiver must adopt the ‘standardised approach’ to measuring credit risk.
Under Basel I, a mortgage attracted a risk weight of 50 per cent, which was applied to the firm’s own solvency ratio when calculating capital. This risk weight also covered operational risk alongside capital to cover unexpected losses during a market downturn, for example, a credit crunch.
Under Basel II, the standardised risk weight is reduced to 35 per cent, but this excludes operational risk and Pillar Two. Regulatory bodies may require extra capital to cover market downturns, liquidity or other risks under Pillar Two. It is therefore possible that the total capital requirement for some lenders may be higher in the new regime when Pillar Two and operational risk is included. Clearly, the implications of this could be wide-ranging, from changes to a lender’s pricing strategy, such as an increase in rates, to, potentially, changes in a company’s corporate strategy.
Creating models
Firms with an IRB waiver use their own internal default and loss experiences to create models used to assign capital under Pillar One which, for quality lending, should substantially reduce risk weights (capital requirements) below the 35 per cent standardised rate. In addition, the operational risk capital and Pillar Two requirements are calculated internally, while the regulator is at liberty to request additional capital if it believes it is necessary.
The benefit of an IRB waiver is that the risk weight is determined by the capital, which is in itself derived from a combination of the probability of default and the loss given that default. In simple terms, risk weight will directly reflect the individual quality of each loan. This means that a business with an IRB waiver has added flexibility because it can pick and choose the type of business it wants to write, based on an assessment of its risk and an understanding of the level of capital required and the projected returns. For high quality business the level of capital required will be significantly lower than the standardised rate of 35 per cent.
In short this is ‘true’ risk-based pricing, where the highest quality business will receive the best rate. This gives lenders with an IRB waiver an advantage in pricing mortgages for low-risk customers because they will use up less capital per customer and therefore be able to write more business.
Strategies
In this situation an IRB lender can adopt one of two basic strategies. Firstly, it could aim to drive sales by reducing rates to the point at which its internal return on capital target is still met. In this case the lender must be confident that the improved competitiveness will bring in a greater number of sales for the overall profitability to increase. Care needs to be taken, because if volumes do not increase to make up the reduction in income as a result of a lower margin, then the lender could damage the overall profitability of its business. Secondly, the lender could take a more conservative approach by maintaining existing interest rates. This will result in a higher return on capital per mortgage as a lower level of capital is applied to the mortgage, which should mean the lender’s overall profit increases.
For lower quality business, lenders with the IRB waiver can calculate precisely how much capital should be applied to the individual customer. In some cases, if more capital is required to meet the individual’s risk, then the mortgage rate may need to be increased to meet the internal return on capital target. Just as you can target high quality, low-risk customers with Basel II pricing models, lenders can also target higher risk, low quality customers – lenders can even make greater profits in this sector as the increased risk requires a higher reward. The important point is that with an IRB waiver, and Basel II pricing models, a lender can accurately allocate capital against the risk profile of the customer. This clearly highlights the illogical ‘equality’ of pricing under the standardised approach. Why should higher quality prime lending subsidise lower quality lending? Risk-based pricing means a consistent and fair approach.
Significant opportunity
Under Basel I, the market was over-capitalised and most loans will require a lower level of capital under Basel II. As a result of this, for lenders with a high quality book or customer base, the application of Basel II models will free up and release capital. Clearly, this is a significant opportunity for firms with quality loan books – the release of millions of pounds of capital which had previously been held in reserves to protect against bad debt is a good start for growth.
There are a number of ways in which Basel II will impact mortgage intermediaries and financial advisers. Firstly brokers should make themselves aware of those lenders that have the Basel II waiver because these lenders should be able to offer low-risk customers some competitive rates. In turn, this may help mortgage intermediaries targeting low-risk customers to grow their business faster. Finally, among lenders with the Basel II waiver, brokers may find the best rates from lenders outside the top 10 in terms of market share. This is because by lowering price on a mortgage, lenders are cutting their margin and need to write more business to make the same profit. Lenders with 5-15 per cent market share may end up cannibalising the margin on business they would have expected to receive anyway.
Consequently, these lenders may simply maintain their interest rates and improve return on capital. Smaller lending organisations are less likely to cannibalise their existing business and the potential rewards in increasing relative market share by lowering rates may be much greater.
In summary, Basel II risk models allow mortgage lenders to become more accurate in their assessment of customer risk and to deliver ‘true’ risk-based pricing. Low-risk, high value customers are likely to receive the most competitive rates and mortgage intermediaries and advisers may find this segment one of the most attractive to target.
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