New research by the Council of Mortgage Lenders (CML) has revealed that lenders adopting the Internal Ratings Based (IRB) approach under Basel II may gain competitive advantage and market share at the expense of non-IRB lenders. But why is this the case?
This article looks at the benefits of Basel II for lenders, and how the subsequent ability to deliver true risk-based pricing can be used.
The basics
Basel II is a new legislative framework – the Capital Requirements Directive – governing how much capital all banks and building societies must hold to protect their members, depositors and shareholders, was introduced by the European Union from January 2007. In the UK, this is being implemented by the Financial Services Authority (FSA).
Norwich and Peterborough Building Society (the parent company of Astra Mortgages), is the first in Europe to have received the FSA Basel II waiver to use its own risk models.
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Under Basel II legislation, most lenders will be using the standardised approach. This means that they will allocate the same percentage of capital relative to advance to each mortgage. The research from the CML found that over 40 per cent of lenders surveyed plan to stay with the standardised approach.
This approach does not take account of the real risk associated with the customer. Using the IRB approach, however, Basel II risk models allow the lender to calculate an individual’s likelihood to default and to individually risk grade customers. This means that for a lower risk customer, a lower amount of capital is reserved against the loan. The lender can then either:
- Reduce the mortgage interest rate accordingly to still meet its internal ‘return on capital’ target in the hope that the improved competitiveness drives a greater volume of sales and profitability increases.
- Maintain the existing mortgage interest rate which generates a higher return on capital per case as a lower level of capital need be held for the mortgage.
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But by lowering your interest rate you are reducing your overall margin. Therefore, you need to write a greater volume of business to prevent damaging the overall profitability of the business. The degree to which you can lower the mortgage rate will depend upon the individual customers’ level of risk and the type and term of mortgage they select.
Option two takes a higher return on capital from each loan to increase profit rather than going for growth, which is a more conservative approach.
In the same way, the Basel II risk models allow you to calculate precisely how much capital should be applied to the individual customer for lower quality business such as adverse credit. In some cases, if more capital is required to meet the individual’s risk, then the mortgage interest 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 you can also target higher risk, low quality customers – you can even make greater profits in this sector, as the increased risk requires a higher reward.
Issues to consider
The advantages of Basel II pricing for risk may be quite clear, but there are, however, a few issues worth raising.
It takes several years of internal customer data and external data to build the Basel II models and significant management time and training to ensure a good understanding is reached across the business. Any lender that hasn’t yet started this process may be at a pricing disadvantage for a considerable time. The CML research revealed that only 30 per cent of lenders have the necessary five years’ data history.
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Secondly, while lenders using Basel II risk models are steps ahead of the competition, one complication in being first to market is that the sourcing systems used by brokers to select a product for their client were not designed with Basel II risk-based pricing in mind. So to get around this obstacle, lenders using Basel II risk models must build more products. This method works well with the sourcing systems and allows lenders to utilise their Basel II risk models to build a wide range of products that are appropriate for all customers.
The important point is that the Basel II pricing model allows you to 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? Whether you are a plc or a mutual, risk-based pricing means a consistent and fair approach to pricing and managing risk.
