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Could PRA change the UK mortgages’ market?

Overview

Recently the PRA (Prudential Regulation Authority) has published a consultation paper (September 2020: CP14/20) proposing changes in capital requirements related to the UK mortgages’ portfolios. Infotonomy has reviewed this proposal and by utilising our consultants’ experience and exposure in the UK and European Union firms has come up with a number of topics that must be considered prior to its implementation by the affected UK mortgage lenders.

Background

Recently the PRA (Prudential Regulation Authority) has published a consultation paper (September 2020: CP14/20) proposing changes in capital requirements related to the UK mortgages’ portfolios. PRA believes that in some cases (i.e. low LTV’s mortgages) the UK firms, which report capital based on IRB approach, underestimate RWs (inappropriate low Risk Weights) for mortgages’ portfolios. This issue creates an uncertainty around firms’ capitalisation and by extension, an uncertainty to UK’s economy that could be vital in current challenging conditions (i.e. Pandemic, Brexit).

The PRA prefers a more conservative and less sensitive approach compared to changes in house prices that could lead to more robust estimations of RWs. Thus, it proposes two types of RWs’ minimum:

  1. Exposure minimum: A minimum of 7% RW is proposed to be applied at an individual residential mortgage exposure level;
  2. Portfolio minimum: A minimum exposure-weighted average risk weight of 10% for all UK residential mortgage exposures to which a firm applies the IRB approach.

This proposal in combination with the recent IRB reforms (e.g. loses for cured case, maximum workout period, etc.) and the wider regulatory changes, including the leverage ratio, is believed that it will contribute to a better capitalised financial sector in the UK and finally, to a more stable UK economy. Furthermore, this change will reduce the gap between the IRB and the standardised approach (SA[1]) RWs for UK Mortgage loans. Thus, a greater competition between the UK mortgage lenders who report capital based on an IRB approach and these who are based on a standardised approach (SA) could be encouraged.

Topics for consideration

Minimum thresholds applied at capital level: Most of the European prudential authorities (e.g. DNB, the Netherlands) propose minimums at an LGD level. These proposals are directly related to the house price changes across time and regions and they could be confirmed by assessing the LGD estimating errors coming from portfolios segments with low LTV. It is interesting that PRA’s preference is to propose a capital related threshold (the thresholds apply at an RW level). The implementation of these two thresholds could be a challenging exercise that could lead to an inappropriate credit risk allocation[2].

IRB Models’ complications: Mortgage lenders should potentially need to review their IRB models, along with appropriate methods to apply the new RWs’ thresholds. It will be easier for lenders that calculate RWs at a pool level to deal with the requirements compared to these based on a continuous (exposure level) approach. A more advanced segmentation approach could lead to pools that confirm all regulatory requirements (e.g. minimum thresholds, homogeneity, appropriate credit risk allocation, lack of concentration, etc.) before a minimum limit (threshold) applies at the stage of implementation. On the contrary, a potential model recalibration cannot confirm the new regulatory requirements and at the same time maintain a fully compliant approach. Additional work is required in order the lenders to maintain an appropriate and compliant credit risk allocation.

Sensitivity vs house prices: The capital calculations will become less sensitive against a potential increase in house prices. The RWs’ calculations will be less depended on the LTV values and therefore, potential extreme increase in house prices will not lead to an extreme reduction in RWs. This leads to less cyclical IRB solutions, but more work is required for identifying the overall impact and its implications. The outcome of this assessment could influence the firms’ future strategies around their products, portfolios and target clients.

UK mortgages’ cost could be increased: The minimum thresholds at exposure and average level will increase the capital requirements for most of the big mortgage lenders. The recent and future challenging economic environment and the very narrow BOE base rates could force mortgage lenders to transfer the additional cost to the borrowers. This could put extra pressure to the low LTV borrowers (e.g. these who are close to re-mortgaging or need to borrow a small amount compared to their property value).

Potential change in mortgage lenders’ business strategies: This is a material change for big mortgage lenders who attract most of the low credit risk borrowers. Applying minimum RWs to low credit risk mortgage borrowers could change the business strategies of the mortgage lenders. It could encourage them to be focused more on riskier facilities in order to retain their market share and finally their marginal profits. This could increase the competition between big (IRB approach) and small or niche (most of them follow SA approach) mortgage lenders, but at the end ,this could be in advance of the big market players (in contrary with what is anticipated by the regulators). As the capital requirements’ range becomes more restricted, more lenders could offer mortgage products with similar interest rates. This change could have an impact on acquisition strategies of the big lenders and finally increase their market share to areas where smaller lenders used to dominate. Furthermore, small or niche lenders could not have the appropriate funds in order to gain more share of low risk borrowers[3]. Therefore, mortgage lenders that use more sophisticated acquisition processes and tools could finally benefit from a change in capital requirements and gain more share from market’s segments that previously did not look attractive (profitable) to them.

Conclusions

The PRA’s proposal (consultation paper) is expected to change the market standards and extra consideration is required by the mortgage lenders, prior to proposal’s implementation. Additional work is required by the mortgage lenders in order to assess the appropriateness and impact of the new regulatory requirements. Finally, this assessment should be done with extra care in order appropriate (accurate) capital requirements’ calculations for covering UK mortgage lenders’ credit risks to be achieved, and finally optimum business strategies, during this challenging economic environment, to be accomplished.


[1] By comparison, the lowest SA UK mortgage risk weight is 35%, while the IRB lowest RWs could be 4%.

[2] More than appropriate capital will be kept for exposures with low PDs and low LTVs in order to compensate for these with low PDs and high LTVs.

[3] Most of the small and niche mortgage lenders are focused on mortgages with higher risk and lower exposures.

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