What does a 0.5% Bank rate for four years mean for lenders?
Published: 8 May 2013 | Author: Bernard Clarke
- Bank rate was last cut more than four years ago – to 0.5%. However, lenders' funding costs are determined by a complex series of factors, not just Bank rate.
- Nonetheless, the average new mortgage rate has declined significantly over the last four years. In February this year, it stood at 3.5% – more than 230 basis points lower than in 2008.
- Housing equity withdrawal has declined during the period of low rates, but not because households are consciously paying down debt. The fall is largely because there are fewer transactions.
- No-one expects an imminent increase in Bank rate. When the rate does rise, it is likely to do so only slowly.
- Borrowers have prioritised mortgage debt over the last four years, despite pressures on real incomes. The Bank has said that when it does raise rates, it will do so in a way that can be reversed if necessary.
The Bank of England last cut its official rate on 5 March 2009 to 0.5%, a rate unprecedented in its 319-year history. The truly extraordinary economic circumstances in which the UK has been operating has therefore now produced a four-year period of interest rate stability that is unparalleled since the 1950s. But low rates are a global phenomenon, with the European Central Bank cutting its base rate to 0.5% only last week.
Today, we look at what it means for lenders to operate in a market in which the Bank rate has persisted at 0.5% for more than four years. What we have seen during that period underlines that the relationship between such a low Bank rate and lenders’ funding costs is far from straightforward, but the persistence of Bank rate at an unprecedented low level has a series of implications for lenders and borrowers.
Bank rate and funding costs
The decision to reduce Bank rate to 0.5% initially led to calls for lenders to "pass on" this cut to borrowers. To some extent, this was understandable, given that historically there had usually been a clear link between the official rate and borrowing and savings rates.
And in the four years since the Bank rate was cut, borrowing rates have indeed declined significantly, as Chart One shows. At 3.5%, the average new mortgage advanced in February this year was more than 230 basis points lower than the equivalent rate of 5.83% in 2008.
However, the decline in borrowing rates over the last four years has been driven by unprecedented monetary easing and measures to improve the availability of mortgage funding, and not just a low Bank rate. Calls for lenders to "pass on" the 0.5% rate were based on an erroneous understanding of the complex range of factors affecting the cost of funding to lenders, as we sought to explain at the time.
Chart One: Average initial interest rate on new mortgages advanced
However, the decline in rates has been against a backdrop of changing conditions in funding and mortgage markets and a prolonged period of unprecedented monetary easing, including a variety of asset purchase and liquidity schemes, £375 billion worth of quantitative easing, and the launch last year of the funding for lending scheme (FLS), which was extended again by the Bank last month.
Different types of lender have been affected by the events of the last four years in different ways, often depending on their size, funding model, and access to funding markets and to help under various official schemes. The diverse range of factors affecting funding costs and mortgage pricing for individual firms has included:
- increased instability in wholesale and retail funding markets, with depositors moving their savings around in search of higher rates;
- the balance between the cost of funding new loans, their price to the borrower, and the returns from mortgages already originated by firms and held on their books;
- changes in anticipated credit losses and provisioning;
- lower returns for lenders from their own capital and reserves as a result of the low interest rate environment; and
- the cost of strengthening liquidity and fulfilling new requirements to hold more capital against loans advanced by firms.
The response of consumers
The low rate environment affects the behaviour of borrowers, as well as lenders. The confidence of consumers has been dented by economic developments since 2008, and their ability to borrow has also been affected by the cost and availability of mortgages and by evolving lending criteria over the intervening period.
Against this backdrop, however, the low Bank rate, and the decline in borrowing rates, have delivered benefits for borrowers in lower and more stable debt-servicing costs. But debts are eroded more slowly than in a high rate, high inflation environment.
Low rates also create opportunities for borrowers to reduce their debts more quickly by overpaying their mortgages, although the effect on real incomes of inflation and low wage growth mitigates their capacity to do this.
Although lower rates enable borrowers with spare cash to pay down their mortgage debt more quickly, the Bank of England says this is not happening to any significant extent. In its report on housing equity withdrawal in the third quarter of 2012, the Bank states categorically that:
"The decline in housing equity withdrawal – and move to injections of housing equity – since the start of the financial crisis has not been associated with an increase in repayments of secured debt."
The Bank’s data shows a clear and pronounced switch from the withdrawal to the injection of housing equity by households. As Chart Two shows, this occurred between 2007 and 2009 – at the height of the financial crisis. What drove this, however, was not a conscious effort to pay down debt but a pronounced decline in lending activity, and the continuing steady repayment of capital through a combination of regular and one-off capital payments.
Chart Two: Housing Equity Withdrawal
In an article on housing equity withdrawal since the financial crisis, Bank of England economist Kate Reinold suggested a number of reasons for the marked switch from households withdrawing to injecting equity as a result of the financial crisis, including:
- falling house prices and tightening credit conditions, which reduced the amount of equity held by home-owners and their capacity to withdraw it;
- less desire to withdraw equity as borrowers began to view their housing wealth as a buffer against economic uncertainty; and
- a decline in the number of housing transaction and purchases by first-time buyers.
Her analysis concluded that fewer transactions made it harder to create housing chains, which typically lead to large withdrawals of equity. First-time buyers are needed to start chains, but their numbers declined dramatically during this period. Moreover, because first-time borrowers typically take out loans at higher loan-to-value ratios, they often account for a significant part of the withdrawal of equity in a housing chain.
An ancillary factor that limited the withdrawal of equity was the decline in remortgaging as a result the financial crisis. The number of borrowers re-mortgaging declined from almost 1.4 million at its peak in 2003 to fewer than 340,000 in 2010 – close to the lowest level for 15 years.
The onset of an era of exceptionally low interest rates was therefore associated with a significant decline in equity withdrawal – but not as a result of households, in aggregate, conspicuously paying down debt, as we concluded in an article in CML News & Views last year. The significant changes are lower levels of house purchase activity, less remortgaging and, as a result, less capital withdrawal.
This trend has been reinforced in recent years by the decline in the number of new interest-only mortgages. The fact that most lending is now advanced on a repayment basis reinforces the steady repayment of capital through monthly mortgage payments.
What will happen when the Bank rate rises?
Most commentators agree that any rise in the Bank rate is not imminent. Chart Three shows how expectations about future increases have declined with the persistence of the 0.5% Bank rate. When rates do eventually begin to rise again, the consensus among commentators is that the rate of increase will be slow.
Chart Three: Financial market expectations of Bank rate, current quarter and three years ahead
A higher Bank rate – associated with higher lender funding costs – will affect the ability of borrowers to service debt. But the speed and circumstances in which the Bank rate rises will be crucial in determining the outcome.
Policymakers are aware that many households will only be able to manage slow and modest increases in borrowing costs. In his evidence to the Treasury select committee earlier this year, the incoming governor of the Bank of England, Mark Carney, said:
"To ensure the monetary policy committee retains adequate room to respond to the developments in economic conditions, it will be sensible for any tightening in monetary conditions to come about first through an increase in Bank rate that could, if necessary, be reversed easily."
Most commentators agree that we are unlikely to see any tightening of policy until economic recovery is well established and some growth in incomes has been restored. What we have seen in the aftermath of the financial crisis is that that borrowers in aggregate tend to prioritise mortgage debt even when their real incomes fall. We would expect this to continue once the Bank rate begins to edge slowly upwards again in the coming years.
Bank rate has now been at an historic low level for more than four years, and this is a feature of the truly extraordinary circumstances in which the UK economy has been operating since 2008.
The decision to cut the rate to 0.5% initially led to a clamour for lenders to "pass it on" to borrowers. Over time, however, there has been a clearer understanding that lenders’ funding costs are determined by a range of factors and are not directly linked to Bank rate. Nonetheless, against a backdrop of unprecedented monetary easing, the average new mortgage rate has declined by more than 200 basis points over the last four years.
In theory, lower rates create the potential for borrowers to pay down their debts more quickly, but there is little evidence that this has happened to any significant extent. There has been a marked decline in housing equity withdrawal but this is largely because of a fall in the numbers of housing transactions and borrowers remortgaging. Falling house prices have also eroded the potential to withdraw equity, and households are more likely than they were four years ago to view their housing wealth as a buffer against economic hardship rather than as a means of funding spending.
The current picture is likely to change only slowly. We expect to see a steady increase in the number of transactions to more normal levels but this, like any increase in remortgaging, will only occur over an extended period. When the Bank eventually raises the official rate, it is also likely to do so slowly. Policymakers are alert to the potential impact of higher rates on household finances, and the Bank has said that it will approach this in steps that can easily be reversed if necessary.