Basel proposals risk making mortgages 'scarcer and more expensive'
Published: 19 March 2015 | Author: Bernard Clarke
We are currently finalising submissions to the Basel Committee on consultations that could significantly disrupt parts of the UK mortgage market.
- If implemented, the proposals could lead to a significant increase in the amount of capital held against some residential property lending, including to most first-time buyers, buy-to-let lending and the commercial funding of housing associations.
- Mortgages in the markets affected would become scarcer and more expensive if the proposals are implemented.
- We believe that the costs imposed on both buy-to-let lending and funding for housing associations could lead some firms to withdraw from these markets altogether, reducing choice and further disadvantaging consumers.
- For most lending, the proposed risk weightings are unnecessarily severe. Both buy-to-let and funding for housing associations, for example, have a good record, with low risk. In the housing association sector, in particular, there have been no defaults affecting a lender or investor in the last 40 years.
Our final submission will contain considerably more detail on the issues raised by the consultations.
Capital requirements – the background
In simple terms, all lenders have to hold capital against the mortgages they advance. Under a system originally devised before the financial crisis, firms have to follow one of two risk-based approaches, in which risk weightings are applied to a range of assets.
In the first, the standardised approach, universal risk weightings are applied; for example, a weighting of 35% applies to mortgages with a loan-to-value (LTV) ratio that is lower than 80%.
Under the current system, some larger lenders are able to use the second, more advanced, internal ratings based (IRB) approach. Under this more complicated model, firms calculate their own risk weightings. The IRB approach takes into account a broader range of measures, including the probability of default on different types of lending and potential losses, given default, and uses the lender’s historic data when calculating risk weightings.
In the aftermath of the financial crisis, this two-pronged risk-based approach has come in for considerable criticism. Some commentators and regulators have suggested that the system had been open to exploitation by banks, and that this was a major contributory factor to the financial crisis.
In response, national and global regulators have sought to reinforce the system to stop a build-up of excessive risks. Reforms have been implemented through a combination of new conduct regulation (introduced in the UK via the mortgage market review [MMR] and the forthcoming European mortgage credit directive), macro-prudential regulation and reinforced capital requirements (with the introduction of a leverage ratio and rules for holding capital buffers).
Now, in the consultations to which we are now finalising our response, the Basel authorities are reviewing the risk weightings of various asset classes, and the requirements to hold capital against them.
The Basel proposals
The new proposals seek to strengthen the existing regulatory capital standards in several ways. The measures would mean less reliance, for example, on credit ratings to determine risk weightings, and make it more comparable with the IRB approach. The consultations are on two highly technical documents: Revisions to the standardised approach for credit risk and Capital floors: the design of a framework based on standardised approaches. In this article, we give a high level overview of the proposals, and set out our key concerns.
Built into the Basel proposals is an explicit re-evaluation of the risk weightings for residential mortgages, and an implicit re-weighting of buy-to-let lending and the funding of housing associations.
For residential lending, the proposals are extremely radical. Instead of applying an across-the-board 35% risk weighting to lower LTV mortgages, risk weightings would be based on two aspects of the loan: the amount advanced relative to the value of the property (LTV) and the borrower’s debt service coverage (DSC) ratio.
Lending to individuals with low LTV and DSC ratios would attract a low risk weighting, potentially as low as 25% (if the LTV was lower than 40% and the DSC ratio was no higher than 35%).
But mortgages at higher LTVs (of up to 100%) and higher DSC ratios (in excess of 35%) would attract a much higher risk weighting, in this case a weighting of 100%. Moreover, weightings would be determined at the time the loan is advanced, and not updated thereafter.
The CML’s concerns
We have considerable reservations about the proposals. While we agree that LTV can be a relatively good predictor of default, we also know that what happens to a loan over time has an important bearing on the outcome.
As house prices rise over time (and the LTV ratio therefore falls), the potential for default declines. A static, historic LTV calculation therefore provides little insight into the potential for default five, 10 or 20 years down the line.
Our submission to the Basel authorities will therefore suggest that lenders should have flexibility to adjust the value of the property – and hence the risk weighting – over the lifetime of the loan. If this is not permitted, lenders will have an incentive to encourage re-mortgaging or the “churning” of loans to take advantage of a lower risk weighting as house prices rise and LTV falls.
The proposals are also likely to raise capital requirements for all lenders, which will raise the cost and limit the supply of mortgages. This will have consequences for lending in specific areas of the market, with first time buyer loans in particular becoming scarcer and more expensive – at a time when it is already difficult for people to get into the housing market.
We have similar concerns over the application of a DSC ratio, but with added problems. We believe that it would be extremely difficult to define the DSC ratio in a way that can be applied consistently and fairly across different countries, with different tax and benefit systems.
We also question whether a DSC ratio is a good predictor of default. Over time, it becomes out-of-date and therefore less relevant – but it is difficult for lenders to update. However, in the UK, lenders already apply a stressed affordability test at the time the mortgage is advanced as part of the MMR requirements. We believe that this provides sufficient insight for lenders to assess the risk of lending.
Buy-to-let – and social lending
In our view, assessing risk on the basis of both LTV and DSC ratios is inappropriate for buy-to-let lending. Lenders already set the LTV at which they are prepared to lend in the sector. And, instead of a DSC ratio, a more applicable test of affordability for buy-to-let lending is the rental coverage test, which lenders already use widely.
One of the main problems with the Basel proposals is that they do not acknowledge the special characteristics of buy-to-let lending. Buy-to-let loans are instead potentially captured under a broader heading of ‘specialist lending.’ That could mean that the risk weighting on buy-to-let lending rises from its current level of 35% to 120%.
The proposals are even more opaque on the classification of lending to social housing providers. This type of lending is not even listed as an asset class in the Basel proposals. As a result, it too could end up being classified as specialist lending – and hence attract a penal risk weighting of 120%.
For the funding of both buy-to-let and social housing, such an increase in risk weighting is unjustified, particularly when taking into account lenders’ experience of low levels of default with both types of lending.
For social housing in particular, a penal rating is entirely inappropriate, given that there has been no default in the sector resulting in loss for a lender or investor in the last 40 years. In the buy-to-let sector, CML data also shows that default rates are extremely low. As a result, we believe that no increase in risk weighting can be justified.
Imposing a higher risk weighting would have extremely serious consequences for both sectors. It would increase costs for borrowers – whether they are housing associations or buy-to-let investors – as firms are forced to cover higher capital costs. Some lenders may even choose to withdraw from these markets altogether, given the costs involved.
We have significant concerns with the Basel proposals. At a high level, we take issue with the methodology applied. The Basel authorities have presented no evidence to justify the higher risk weightings proposed. Indeed, our data suggests that lower risk weightings could be considered.
We would also point out that the UK regulatory framework has already undergone significant change in recent years and that reforms to both conduct and macro-prudential regulation have reinforced a system that is now robust enough to prevent the build-up of risk on lenders’ balance sheets.
Some of the recently introduced regulatory reforms have not yet even worked fully through the system, and some, particularly those introduced as a result of the MRR, should lower both the probability of default and loss given default. We therefore believe that the risk weighting of asset classes does not need to change in the way being proposed.
We are currently putting the finishing touches to an extensive submission on the Basel proposals, in consultation with members. We are also working alongside other UK trade associations, including the House Builders Federation, to ensure that there is a co-ordinated approach to highlight UK concerns, and with the European Mortgage Federation, so that these views are represented at a European level. And we have highlighted our concerns with the relevant government departments.
We would hope that the weight of opposition to the proposals will persuade the Basel authorities to re-consider them, and undertake further consultation with the industry. The authors of the Basel documents are due to publish responses later in the year and we hope that UK concerns will be reflected in modifications to the current proposals.