Boost savings to save mutuals

Lending Strategy March 2010

This is likely to be remembered as a turning point for the mortgage market. House prices have broadly stabilised and house purchase mortgage lending has finally picked up from the record lows seen in early 2009.

As I discussed last month the economic picture remains far from robust and the policy backdrop of tighter fiscal policy and likely higher interest rates is not supportive of a strong recovery.

But this month I’d like to turn my attention to retail funding and the likely limits this will place on competition and mortgage growth in the next few years.

This is one of the key structural issues shaping any recovery in the mortgage and personal finance markets and existing models are struggling to cope with shifts in this market and their likely policy effects.

The savings market has been hit by low interest rates and consumers who have run down savings to maintain consumption in the downturn.

Low inflation and low interest rates make funding for retail-funded lenders difficult, highlighted by the declining retail savings flows seen in the building society sector.

Societies traditionally offer attractive savings rates to ensure they can fund their targeted levels of mortgage lending. Last year saw the worst retail flows since the 1950s.

The business model of societies as well as regulation compels lenders to fund most of their mortgage activity from retail savings whereas banks can choose to fund from almost any source

Although the size of the society sector has been reduced by conversions to plc status and mergers, the core funding issue remains the same for all retail-funded lenders. The absence of a healthy flow of retail funds either from deposits or interest accrued to accounts is making lending difficult for many lenders.

The position is further highlighted by the graph on this page which compares household liquid savings with mortgage lending.

For long periods of history the two series tracked each other closely as lenders matched mortgage lending to retail funding, the exceptions being the mid-1980s and from about 2002 to 2007 when securitisation became the biggest source of new lending growth.

The business model of societies as well as regulation compels lenders to fund most of their mortgage activity from retail savings whereas banks can choose to fund from almost any source including commercial deposits, securitisation, covered bonds and wholesale borrowing.

In addition to the overall low growth in retail savings the composition of institutions tapping into retail funds has become dominated by banks and National Savings & Investments.

I expect the pressure from NS&I to increase as funding of the public finances become more acute in the coming years. And unless there is a big change in investor appetite for residential mortgage-backed securities or covered bonds banks will continue to drive retail savings flows.

Looking at the prospects for retail savings for the next two or three years it is hard to see where funding growth is going to come from for pure retail-funded lenders.

Although mortgage lending is expected to grow only modestly in the next few years the composition of retail funding and competition in the savings market will make a pure retail strategy highly challenging. So what can we expect to see? Well, if we carry on the way we are the pressure on societies to consolidate or hibernate will become greater.

Many of the retail banks that currently benefit from government support and funding are likely to find it increasingly difficult to justify paying 3% to 4% for new savings while charging existing borrowers 2.5% to 4% for mortgage lending.

We need a healthier outlook for retail savings and this will be helped in 2011/12 by higher market interest rates.

The government could do much more to encourage long-term savings in the household sector, and extending the support given to equity investments to liquid savings for a period is a particularly attractive option.

It is in all our interests to have a diverse group of lenders funded from a wide range of sources including household retail savings, wholesale markets and commercial deposits as well as RMBS and covered bonds.

The short-term priority should be to help the society sector by encouraging liquid savings.