I would like to thank the CML for inviting me to speak today and for the constructive way both it as a trade association and you, as its members, have worked with us so far.
You will hear later today about the CML’s recent member survey. They were kind enough to share the results with us, and while I don’t want to steal the thunder from the session later today, there is something I would like to highlight. The survey shows that the majority of CML members support changes to regulation of the mortgage market. I assume this doesn’t mean you want a change of regulator … but instead indicates – as other stakeholders have told us – that you believe changes to FSA regulation could benefit all in the mortgage market in the long run.
This is certainly what we aim for. I will shortly give you some background on our review of the mortgage market and why we are doing it, before covering some of the key issues we have already identified. And after that I’d be glad to take some questions from you.
But first I should put the review in context, in particular in terms of the current market conditions.
Although our review began in its initial guise before the financial crisis began, we have widened it beyond its original conduct of business focus to look at the whole range of options available to use – and it now complements our continuing programme to strengthen regulation.
This is important because, in response to the crisis, people are – quite rightly – questioning the role of regulators. We have been up front about the need to do that ourselves. We acknowledge that regulation needs to step up a gear in order to allow innovation and competition, but also to prevent systemic and firm risks from threatening our financial health and disrupting the economy.
And we have been working hard to do that. Much of our early effort was focussed on restoring confidence in the financial system, hit by what in retrospect were mistakes by financial institutions, governments, central banks and regulators, including the FSA. We have worked to minimise the impact of problems at individual firms and to lay the foundations for a more effective and better regime for the future.
We hope we have begun the process of rebuilding confidence by demonstrating we are an organisation that is willing to learn and that we have the ability to change for the better.
A key element of this change has been putting in place our Supervisory Enhancement Programme.
One example of our new approach is the recent consultation on a new code of practice for building societies, making our expectations of building societies’ business and operations more explicit, and helping to support and sustain a vibrant mutual sector going forward.
We are probing higher-impact firms more intensively than ever. An essential element of these interventions has been a far more comprehensive stress testing regime of the firms we regulate, to test the capital adequacy under extreme scenarios. Ongoing and in-depth stress testing is at the heart of our regulatory approach. This is a clear example of the radical change in our approach to a more intrusive style of supervision.
And this approach is supported by a more credible deterrence regime, where we are taking stronger enforcement action against both firms and individuals for unacceptable conduct.
But good regulation also requires good people so we have dramatically increased the number and quality of our supervisory staff and significantly upped the intensity of our supervision. We have expanded our specialist prudential risk expertise, as well as setting up a specialist conduct risk division of 80 people to focus attention at the ‘coal face’ and literally test whether what senior management say is happening on the front line is true, so-called outcomes testing. We have also introduced a new comprehensive training and competence regime for new and existing staff which involves more testing and a robust assessment of our front line supervisors. This will be extended to our small firm supervisors in 2010. And last week we announced we are bringing supervisors of all firms together under your former chairman Jon Pain.
We will continue to pursue this approach as part of our commitment to restore confidence in financial markets, to protect consumers and reduce financial crime. So firms should expect and indeed welcome a more intrusive style of regulation.
We believe it is important to get this approach firmly in place and learn lessons now before things get better and memories fade.
And that is the same approach we are taking with our mortgage market review. We realise that market conditions have diminished, for now, many of the issues that caused problems. But these issues still concern us as regulators, and we know that unless we seize the opportunity now, these same issues will re-emerge. So we need to address them now, to prevent this.
We must acknowledge the role that developments in housing and mortgage markets played in the origins of what has been the worst post-war global financial crisis. They are not the whole story, but they are enough of one to matter.
Rapid growth of mortgage credit drove a house price boom that turned to bust. New sources of funding were created that rapidly dried up when confidence disappeared. And confidence was undermined by lending to uncreditworthy customers, with a build up of risky practices – subprime lending, self-certified mortgages, and high loan-to-values – and new categories of mortgage, such as buy-to-let.
So it is not surprising that the agenda for regulatory reform includes looking at the mortgage market. Our comprehensive Mortgage Market Review will look at the whole market from lenders through to consumers.
We will take the time to fully understand what went wrong and explore all of the available options for putting things right, setting out our views and proposals in a discussion paper we will publish in September.
We hope that our discussion paper will provide a realistic, coherent and challenging set of options for the future of mortgage regulation that will help take the debate on a stage further. And of course we will want to hear your views then as much as we do now.
But I would like to stress that the review isn’t a knee-jerk reaction to the financial crisis. We are not going to have an FSA version of the Dangerous Dogs Act – rushing in changes and over-reacting to please those who shout the loudest. But equally we are not willing to carry on with the status quo. We believe there is a strong mandate for change, but we won’t try to fix what isn’t broken.
What we are embarking on is a considered review, that will analyse what went wrong and why. And we have set two clear future objectives:
first, a market that is sustainable for all participants – and that includes lenders, consumers, intermediaries and investors; and
second, a flexible market that works for consumers.
They are both very broad aims, so I will give you a bit of detail about what we believe they mean:
We believe that a sustainable market for all must be one that has the following characteristics:
Firstly, lenders have sustainable business models and are adequately capitalised, while at the same time competitive, innovative and competent at what they do.
Secondly, a regulatory regime that is predictable, clear and transparent – where regulation is not a source of volatility and minimises the pro-cyclical impacts on house prices, while helping to minimise mortgage fraud and other forms of financial crime. But, firms that don’t meet our standards should be under no illusions, we will use the full range of our powers to make interventions to underpin these standards, while those that embrace treating customers fairly and achieve good outcomes for consumers will benefit.
Thirdly, where the costs and risks of lending and borrowing are kept within the market and are not borne by the taxpayer.
And we believe that a flexible market that works for consumers must have these characteristics:
First, it should offer a range of products that meet all consumer types to allow individuals who can afford it, the opportunity to buy their own home.
Secondly, it should be one where consumers clearly understand the costs and risks of mortgage borrowing.
Thirdly, where consumers understand the implications and risks of looking at house purchase as an investment option rather than primarily as a home.
And last, where distribution helps to achieve good outcomes for consumers, and provide a professional service, with the number and complexity of products reflecting the needs of consumers, rather than brokers, and where incentives in the distribution chain work for the consumer.
In doing this we are looking at several areas of our recent mortgage market:
Responsible lending
The clear lesson this crisis has taught us, is that we need to review why – despite our responsible lending rules – irresponsible lending has happened and what changes are needed to promote more responsible lending in future.
During the boom years we saw some lenders prepared to take on unsustainable volumes of higher-risk lending and make lending decisions without always undertaking a proper assessment of the consumer’s ability to repay. In the sustained period of low inflation, low unemployment and consistent growth, market confidence was high and consumers were willing to take on ever increasing amounts of debt. And lenders were happy to oblige, with many relaxing credit standards.
But we must be careful to not solely focus on the idea of lenders fuelling an unsustainable borrowing binge. The story must include consumers and intermediaries taking their share of responsibility. We also recognise that in certain parts of the market risky behaviour was much more prevalent than in others. But, nonetheless, a key part of our analysis will include the role played by lenders and what we need to do as a result.
We saw mortgage credit extended to those who would not have previously qualified, with high-risk loans accounting for a significant share of the market. This was enabled by a rise in wholesale funding, including securitisation, as the traditional model of a bank originating a loan to a borrower and retaining the credit risk on its books wasn’t enough to fuel the demand for credit. It gave way to some adopting the ‘originate to distribute’ model, transferring credit risk to investors.
Many have questioned whether – with lenders not retaining the risk – this accounted for less care being taken in the quality of the lending.
This period saw the emergence of specialist, ‘non-bank’ lenders, many of whom relied on securitisation as a source of funding. Their market share increased from 4% in 2000 to a high of 20% in 2008. We also saw the emergence of business models built specifically around targeting highly indebted consumers, often with poor credit histories but with equity in their properties.
In the face of sustained house price growth, there was less risk of a loss on sale and as a result, the consumer’s propensity to default became less important. But as we have found out it all had to end eventually.
Arrears and repossessions and overall losses are forecast to reach by the end of this year the level of the mid-1990s. The pricing of the innovative mortgage products that have often led to these arrears, in turn, did not reflect the default risk that eventually materialised and, once funding lines dried up, contributed to the failure of several UK lenders – banks, building societies and non-deposit-taking lenders alike.
The very significant risks and costs of the underlying product innovation were ultimately borne, not by the product innovators or borrowers, but by the taxpayer.
So how should we bring about more sustainability and prevent irresponsible lending?
There are a number of options available to us – both from a conduct of business and prudential standpoint – and we need to weigh up and decide what will be best to help us achieve the outcomes we want.
One option is product regulation.
The Turner review has challenged the idea that we should avoid regulating products and asked whether we should take the view that there are some products that could never be suitable for a consumer and/or are too risky for a lender and should simply be banned.
That, of course, caused a good deal of debate in the industry. But product regulation isn’t just about banning products:
we could, for example, set parameters or constraints around certain design features; and
we could make our selling processes or underwriting standards around those products much more prescriptive.
And of course, there are other options available to us – such as making more aggressive use of capital requirements as a check on certain riskier practices, and I will mention this more in a moment.
Another important consideration is to look at ways of making sure the borrower’s ability to repay is properly considered.
One particular feature of the recent years has been the rise of mortgages where income isn’t verified, such as self-certification and fast-track products. Both of these grew beyond the consumer groups they were originally intended for. And the line between fast-tracked and self-certification loans became blurred, with some fast-tracked mortgages even marketed with a guarantee that incomes would not be checked. At the peak of the market in 2007, 45% of mortgages were without incomes checks, a large part of which was self-certified.
And our analysis shows that self-certification borrowers take out larger loans in absolute terms than those using standard products – and fall into arrears much more frequently.
So, given that so many self certification mortgages have been sold … and so many of them are now in arrears, should there be more constraints on this type of lending?
And/or should we change our rules to require income verification for all mortgages – with lenders required to verify the plausibility and authenticity of the documentation provided by the customer before an offer is made?
And given that many in the industry seem unsure about what an affordability check is – and we hold our hands up here, because perhaps our rules weren’t as clear as they might have been – should we make this more explicit? Could we go beyond merely a superficial income multiple and really test affordability by looking more at income versus expenditure?
Should we say that we expect lenders to carry this out? We would not want to leave intermediaries’ responsibilities out of this, but – whatever we decide – many would say the ultimate responsibility should lie with the lender.
And we could encourage lenders to lend responsibly through other ways, such as our capital requirements – with holders of higher-risk loans having to hold more capital against these than they would for lower-risk loans.
So there is much for us to consider here and questions on which we welcome your views. A more controversial question, and one that has generated considerable debate already, is whether we should cap loan-to-value or loan-to-income ratios.
This is the FSA potentially going down a new route through a form of ‘product regulation’. And understandably sets some hearts racing in the industry. But as I have said product regulation can mean many different things – from a full-blown ban or pre-approval of products prior to their launch – to more generic restrictions placed on product design.
We are looking at all of these – and lending thresholds are something we need to look at further, because we know that high loan-to-value mortgages and high loan-to-income mortgages have been a feature of the recent house price boom. As house price increases outstripped salary increases, some lenders adapted their mortgage offerings (such as the 100%-plus products and loans made at five-times joint incomes).
So our paper, naturally has to assess the strength of the arguments for and against introducing lending thresholds.
We will look at how customer defaults and bank losses are correlated to either high initial loan-to-value or loan-to-income or a combination of the two. And we will draw lessons from what other countries have experienced. We know that many countries have taken a different, more prudent approach to us and some of them have been much less severely affected by the financial crisis.
But we also know that the ideas we are thinking of on responsible lending could potentially help us achieve the same outcomes.
And we need to ask whether prohibiting high-LTV or high-LTI products is likely to protect consumers from arrears and repossessions. Many people that borrow at high LTVs or high LTIs can afford to repay and there are other more important explanatory factors behind arrears.
Heavy adverse sub-prime borrowers and credit hungry borrowers – with significant overall debt – are the types of borrowers more likely to take out unaffordable loans.
Similarly, it is the build up of consumer debt – through equity withdrawal – that, alongside buy-to-let, has been one of the most significant growth areas in the mortgage market in recent years. In 2007 39% of the total mortgage market was for equity withdrawal with only 35% for house purchase.
This suggests we should ask whether product regulation which limits loans to heavy sub-prime individuals, to individuals with large debt commitments and which constrains excessive equity withdrawal would help achieve our objectives.
But we recognise that product regulation could be too blunt a tool to achieve the outcomes we desire, and it could be one which people find ways around. It could also lead to two of the outcomes we don’t want to see – a reduction in innovation or reduction in access to credit.
Indeed, our analysis points towards underlying issues in the mortgage market owing more to the unsustainable volume of high-risk lending and wholesale funding innovations than the simple availability of high-risk products. So it could be that key to a sustainable future market is reducing the underlying incentives and ability of lenders to supply risky credit.
As I have already mentioned we are also looking at whether prudential requirements could be part of our future proposals.
The current prudential standards for banks and building societies impose risk-based capital requirements designed to take account of the credit risk firms take on through mortgage lending. These are intended to protect depositors, the depositor protection scheme and ultimately taxpayers from bearing losses due to financially weakened or insolvent lenders.
At the same time capital requirements may influence lender behaviour, and that gives us an interesting option when looking at how to achieve our review’s objectives.
If our analysis were to indicate that the existing capital requirements for high-risk loans are insufficient, then perhaps we should consider changes to the prudential standards. For example, increasing the capital requirements for high-LTV or high-LTI lending may reduce the need for lending thresholds.
We are also reviewing the prudential standards applying to non-deposit-taking lenders, which are currently subject to fundamentally different prudential standards to mainstream lenders – and are in fact currently subject to capital requirements of only 1% of balance sheet assets or £100,000, irrespective of the level of risk.
We will also take into account developments in Europe. And changes to securitisation and the funding of mortgage lending as this will impact on the amount of mortgage credit available and the future growth of the market. An example of this is in the proposals we have published on liquidity that will significantly constrain the ability of banks to grow rapidly on the basis of wholesale market funding.
Distribution
We have also been considering whether there is a need to change our current approach to regulating mortgage intermediaries.
And there are several other questions we have to answer first when looking at the role of intermediaries.
We are looking at what the role of advice actually is – especially given that we have found the market is characterised by consumers looking for access to mortgage products rather than seeming to need advice on them. Should we focus on ensuring that intermediaries deliver high quality advice? Or do we need to look at what consumers really want and how services with and without advice respond to that need, and how meaningful regulatory intervention may be best delivered.
We also have to look at market complexity. We have to ask ourselves what are the benefits, if any, of the complex distribution landscape we saw at the height of the market, with many thousands of different products and multiple forms of intermediary services on offer. We need to look at what lies behind this complexity and what steps, if any, could the FSA and the industry take to improve the situation to get better consumer outcomes.
And we need to look at issues around regulatory compliance. What more can we do to ensure that – as I have already mentioned – intermediaries and lenders consistently assess affordability and suitability properly; intermediaries consistently and reliably act in the interest of the consumer; and that intermediaries do not commit or facilitate mortgage fraud.
One possible route for us to take is extending our approved persons regime to mortgage intermediaries. This could be a way of improving standards of fitness and propriety among individual mortgage advisers, prohibiting rogue individuals from the industry, and limiting the movement of problematic individuals through the industry.
We have been fairly opaque up till now on carrying over our requirements from the Retail Distribution Review to the mortgage market. Given the number of firms that operate across both the investment and mortgage markets, some think this is inevitable. Our analysis suggests there are different underlying reasons for the problems in the mortgage market and our key priority is to address these effectively rather than just carrying over a solution that was developed with a different market in mind. But there are issues we need to explore further.
And although we have seen issues throughout the intermediary market – many of them are more concentrated in the sub-prime parts of the market. It is possible that we could resolve problems in these areas simply by looking at some of the ideas I mentioned earlier, but there is clearly a lot for us to look at here.
Disclosure and changing consumer behaviour
Another area we are looking at is disclosure which is closely related to consumer behaviour. Disclosure of key pieces of information about the service a consumer should expect and about the mortgage product being offered to them has been an important part of our mortgage regime.
This was intended to enable consumers to shop around and compare the services and products on offer from different firms, and to help them make better informed choices. However, the evidence suggests that few consumers are using the prescribed documentation in the way we intended.
Our approach was underpinned by an expectation of fully rational consumers making intelligent choices when they have the necessary information. This was probably overly simplistic. In reality, consumers make decisions for a number of reasons and do not always make choices in their long-term interests.
In the light of all of this, we are considering whether our regulatory strategy needs to change to one that relies less on traditional written disclosure at the point of sale as a regulatory tool and looks to influence consumer behaviour in other ways.
As I said earlier, we believe irresponsible borrowing and credit-hungry consumers are as big a part of the story as the behaviour of firms. Clearly, borrowers must also bear some responsibility for taking on big mortgages and unaffordable loans when markets were booming and we are looking at ways that our financial capability work can fit in with our wider goals in the mortgage market.
The review is also looking at two possible areas for scope extensions.
Buy-to-let
When the government introduced mortgage regulation in 2004 the decision not to include buy-to-let lending was based on the distinction drawn between owner-occupiers who face losing their home if things go wrong, and landlords, whose properties are investments and who do not face the same risks.
Since then, the buy-to-let mortgage market has grown very rapidly and unsustainably for some firms, with evidence of poor quality lending and inadequate risk management. There is also growing concern about rising arrears and repossessions and at the extent to which the market has been subject to financial crime, through collusion between new-build developers, valuers and brokers.
This has led people to question why buy-to-let mortgages remain outside of FSA regulation.
Second-charge lending
And some have suggested extending the scope of regulation to cover second charge lending as well. The Turner Review recently renewed the debate while looking at lending thresholds and the concern that limits applied solely to the first charge market would be circumvented by access to second charge lending.
Our analysis on the impact and implications of these scope changes is continuing and we await the government’s imminent discussion paper on Financial Services, where we expect them to announce their position on the on both the case for transferring responsibility for second charge loans to the FSA and buy-to-let.
Arrears and repossessions
I will end this run through of some of the issues we are looking at in our market review by covering arrears and repossessions, a very topical subject for us at the moment – because in current market conditions, with more people struggling to meet their mortgage payments, it is vital that firms treat customers who get into arrears fairly.
We have recently published the results of the latest look at arrears-management practices which focused on specialist lenders and third party administrators – and we announced that we are beginning enforcement investigations against four specialist lenders.
What we found unacceptable was that some firms were applying fees unfairly and pushing customers towards repossession without considering alternatives.
In many cases we found a high incidence of mortgages moving straight into arrears and potential breaches of responsible lending rules, highlighting again that this is an area we need to take action on.
Proper handling of arrears will remain a high priority for us and will continue to be so until the necessary progress has been made. While we looked at specialist lenders in this work, all firms can expect continued intensive scrutiny of their arrears-handling processes.
We will factor in what we found from this and earlier work into the Mortgage Market Review to establish whether changes to our current requirements – which are relatively high-level – are needed. It could be we need to set out in greater detail what we expect of firms.
One area that we may decide to review is the level of charges that lenders apply to customers in arrears. Under our existing rules, we require that arrears charges to be a fair reflection of the costs faced by lenders. We do not expect them to be used simply as another way for lenders to increase their profits – but our project work has consistently found evidence of instances of these being unfair to consumers, particularly in the way they are applied.
We have provided practical examples of how firms can meet our requirements in our feedback on the work and sent out strong messages about following this up as part of our supervisory focus on customer outcomes. You can expect us to be much more proactive in this area in future.
So it is clear that we have a lot to think about between now and the end of September. We want to continue to work with you to help us develop our ideas and to ensure that what we propose will be both workable and likely to achieve the outcomes we want – a sustainable market that is flexible and works for consumers.
Thank you
