The top priorities for most, if not all, mortgage providers and financial services companies across the UK this year will be maintaining margins, improving cost-efficiency, and adapting to Basel II. As the 2006 results season draws to a close, the first two have had plenty of air time, but the implementation of Basel II could have massive implications for the market.
Capital requirements
Given the risk that some borrowers will be unable to repay their loans, lenders need capital of their own to protect their depositors – the savers – from the risk of losing money. This capital acts as a cushion to absorb unexpected losses. The question is, how much capital should a mortgage lender hold?
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About 20 years ago a group of international bankers met in Basel, Switzerland, and agreed that banks should weight their assets according to their risk. They drew up some simple rules for risk weighting based on security, ranging from zero for loans to governments – no risk of loss, so no need to hold any capital – through to unsecured consumer lending at 100 per cent, because it is potentially more problematic. The internationally agreed framework they came up with was called ‘Basel I’. Now ‘Basel II’ is introducing changes to those rules for calculating how much capital to hold, which UK lenders must comply with by 1 January 2008.
Under both the old and the new regulations, lenders must hold total capital equal to at least 8 per cent of risk-weighted assets and tier one capital – the purest form of capital, including shareholders’ funds – of at least 4 per cent of risk-weighted assets. What is changing under Basel II is the way the risk weighting of assets works.
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Mortgages, being secured on property, were weighted at 50 per cent under Basel I, and loans to banks, being a pretty good risk, at 20 per cent. So a £100,000 loan to a bank would need £1,600 of capital – 100,000 x 20 per cent x 8 per cent – which is less than a mortgage for the same amount – £4,000 – or unsecured consumer loan – £8,000. So to generate the same percentage return on capital, the expected profits on a consumer loan would need to be double that on a mortgage.
Basel II takes risk weighting a stage further from the original ‘Basel I’ rules, and provides two potential approaches. In the ‘standardised’ approach, mortgages are weighted at 35 per cent, but lenders have to increase the risk weighting for accounts more than 3 months in arrears, and for LTVs over 80 per cent, to reflect the higher level of risk. Alternatively, under the ‘Internal Ratings Based’ (IRB) approach, mortgage lenders model more precisely, on a loan-by-loan basis, the probability that the borrower will default, and how much – if anything – would be lost by the lender if they did.
Quality and risks
So, focusing on mortgage lenders in particular, the minimum amount of capital they will need will depend on the quality of their assets, their operational risk and other risk factors, such as risk caused by interest rate mismatches between assets and liabilities.
As residential mortgage lenders traditionally have one of the lowest rates of credit losses, lenders are already likely to hold less capital relative to their asset size than most other lenders under Basel I, because of the 50 per cent risk weight for mortgages compared with 100 per cent for corporate and unsecured personal loans.
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Basel II further recognises the safety of residential mortgages by reducing their weight under the standardised approach from 50 per cent to 35 per cent for loans with a loan-to-value ratio (LTV) of up to 80 per cent. And if a firm moves to an IRB approach, a low-risk mortgage book could require even lower levels of capital. As a result, mortgage lenders could in fact be the largest beneficiaries of Basel II.
Lenders therefore, particularly those using IRB, will be able to reflect risk in application scorecards, and recognise the higher capital requirements by charging more for higher risks. That may sound like bad news, but in fact it’s great news for borrowers and brokers, because then there’s no such thing as an unacceptable risk – just a matter of quantifying the risk and deciding the price.
At the other end of the scale there should be the opportunity for lower rates for good payers on low salary multiples and low LTVs.
Financial institutions should be more secure too. They will be able to manage their capital efficiently and understand what margins they need to maintain financial stability and generate a return on capital, especially if they use IRB.
As building societies prepare for this change in regulation they should see benefits from lower capital requirements because of their relatively low-risk lending portfolios. They are also becoming more sophisticated in their risk management, and as a result, even safer for savers.
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