The FRO provides details of the risks the economy poses to the FSA’s statutory objectives. The business plan sets out how it intends to respond to those risks.
Our view is that, in the current market, the FSA should minimise any major new projects that risk creating further uncertainty in the market and potentially destabilising the industry or individual lenders. It has enough to do to manage the effects of the credit crunch and instability in the banking system.
Of course, we recognise that the FSA will want to step up its scrutiny of firms and consult on changes that are of immediate importance. But sweeping changes to how the FSA regulates the mortgage market, as discussed in the business plan, are unlikely to deliver significant benefits to borrowers or lenders at this time of market uncertainty and dysfunction. We believe the focus at this stage should be firmly on measures to reinforce financial stability.
The Financial Risk Outlook
The FRO identifies two key risks for firms:
the ability to cope with uncertainty in the current market by developing a robust, but flexible, business model properly tested against worst-case scenarios; and
the role of lenders in minimising the length and depth of the recession.
In its foreword, the FSA explains the contradictory forces that are currently at the heart of the problems facing lenders: "The future health of the financial system will be critically influenced by the pattern of economic growth or contraction, and therefore the severity of credit losses arising in the real economy. But, to a far greater extent than in any other recent economic downturns, real economic developments are in turn likely to be affected by the ability of the banking system to maintain lending."
The fact that this pressure to maintain lending is falling on a decreasing number of firms only exacerbates the problem. Capacity has been reduced by the paralysis of funding markets, the large-scale withdrawal of lending by many foreign-owned banks (such as Bristol & West) and the nationalisation of Bradford & Bingley and Northern Rock (although yesterday it announced a change in lending policy).
That has placed the burden on large banks and building societies, many of them on the government’s lending panel. But they are collectively unable to supply sufficient funds to match demand for borrowing from consumers – a consistent feature of the market in 2008.
The FRO recognises this when it says that: “There is a danger that the reductions in lending capacity could result in an excessive reduction in corporate and household debt.” It argues that “a crucial policy issue is therefore whether the lending panel banks have the capital and funding resources to at least maintain their lending levels and ideally to expand to fill some of the gap left by the disappearance of other sources of lending capacity."
A balancing act
In discussing the specific risks to banks, the FRO accepts that it makes sense for individual banks to de-leverage and reduce their exposure to risk. The problem is that on a macroeconomic level it will only worsen the current problems if they all do this at the same time.
The FSA’s message for lenders is that they need to follow a “careful balancing act between continuing to lend to economically viable, credit-worthy borrowers; treating all customers fairly; and reducing exposure to the minority of least credit-worthy borrowers, who would be economically unviable even in benign economic conditions.” No mention is made, however, of lenders needing to avoid mortgages at 100% loan-to-value ratios.
At the same time, low interest rates – and the pressures to pass on rate cuts to borrowers – are threatening the availability of savings deposits as a source of funding for lenders and affecting the underlying profitability of many firms. Building societies are likely to feel the effects disproportionately, and the FRO recognises that “this has resulted in a squeeze on margins for societies, which together with the higher impairment charges – and FSCS (Financial Services Compensations Scheme) levies arising from bank failures – can be expected to cut profitability in the short term.”
But the FSA says that building societies “have relatively strong capital positions and are not profit maximisers; most are likely to respond to market conditions by curtailing growth and therefore may be in a better position to cope with reduced profits than banks.”
The FSA anticipates that low interest rates will mean that the building society sector may now enter a period of very limited growth. With specialist lenders – which did not get a mention in the FRO – remaining largely dormant, the burden to lend increasingly rests with the seven firms that make up the government’s lending panel.
Treating customers fairly
The FRO states that conduct of business issues remain a concern for the FSA and that economic conditions may result in some consumers being treated unfairly. How customers in arrears are treated comes under the spotlight, not surprisingly, with the document exploring the impact of falling house prices on the behaviour of both borrowers and lenders.
The FSA says that “if house prices were to fall by 30% from the end of 2007, it is estimated that over two million residential mortgage holders and 500,000 buy-to-let mortgage holders would be in negative equity.” It acknowledges that some borrowers may be more prone to handing back their keys to their lender voluntarily, believing they will minimise their debts (which is not, in fact, the case – as we reported last Friday).
However, borrowers are protected by the FSA’s mortgage conduct of business rules, covering how lenders deal with arrears and possessions. These are supported by our good practice guide to lenders.
The FRO lists three other specific risks for consumers in the current year:
that the advice they receive is appropriate and that suitable products are recommended to them;
that the risk of introducing unfair contracts terms is avoided; and
that firms strike the right balance between their need to retain capital and treating customers fairly. This may be an issue, for example, for firms that may try to reduce their resources for complaints-handling.
The business plan
We believe that at a time of heightened market turbulence and uncertainty, the FSA should try to be as consistent as possible in its approach, and should not look to introduce fundamental change. Inevitably, however, it will want to increase its scrutiny of lenders, both from a prudential and conduct of business perspective.
In his foreword to the business plan, FSA chief executive Hector Sants appears to endorse this overall approach. He says:
“Our focus this year is to ensure that we respond effectively to the financial crisis and recessionary climate, whilst retaining the necessary emphasis on our other priorities. In doing, so we will seek to minimise new initiatives.
“We also believe that events have demonstrated the importance of an integrated approach to the supervision of individual firms. To analyse fully the risk inherent in a given firm, the supervisor must have oversight of both the full range of the firm’s business and its prudential and conduct issues.”
Future regulation
Worryingly from a lender’s perspective is that, having stated a desire to minimise new projects, the business plan includes proposals for a paper on the future shape of regulation in the mortgage market. The business plan says that the paper will cover the following issues:
all aspects of regulation, including prudential, conduct of business, and financial crime;
the future shape of regulation and how the FSA’s approach should evolve to reflect this;
the complete “value chain” in the market (ie, lenders, intermediaries and consumers); and
whether there is any “read across” to the mortgage market, from the proposals made in the retail distribution review of the investment market.
On the face of it, therefore, there is potentially a conflict between this broad plan and the FSA’s acknowledgement of the need not to launch any major new initiatives – but that depends on the scope and timing of the planned paper.
Our concern is that it could mean a comprehensive review of regulation and the roles of the key players in the mortgage market, at a time of rapid change. In current uncertain market conditions, this may be more disruptive than far-sighted.
As the publication of this mortgage review paper is not listed in the FSA’s key milestones for 2009/10, we assume that this will be a “slow burn” issue this year.
