The sketchy recovery has lowered the pressure for immediate hikes but in an ideal world, interest rates will rise modestly in the medium term, allowing retail-funded lenders to rebuild savings balances

Savings market opportunities and threats

4 April 2011

GARY STYLES, STRATEGY, RISK AND ECONOMICS DIRECTOR, HOMETRACK

The economic recovery remains patchy and this has lessened some of the immediate pressure for higher interest rates. The mortgage market is trading sideways at best, as total volumes stay at around 100,000 a month and unemployment has ticked up as the impact of public sector job cuts and weaker demand hit the labour market.

In addition to weak demand for mortgages and credit, lenders must also cope with a competitive and depressed liquid savings market.
Many lenders are almost entirely dependent on the retail savings market for funding while others have started to tap into the wholesale and covered bond markets again, albeit at a much lower level.

The shifting nature of the savings market poses both opportunities and threats to many lenders. The graph below shows mortgage lending stock growth compared with household savings growth over the past 30 years. Two periods of rapid growth in mortgage lending and wholesale funding are clear. Since the start of the credit crunch at the end of 2007, mortgage growth has moved more in line with savings growth and this is likely to continue to be a feature of the market in the medium term.

The flow of savings in 2010 shows a mixed picture across the sectors. Assuming each sector aims to hold its current market share of the stock of savings, the mutual sector has significantly underperformed. This sector currently represents around 21% of the stock of retail savings but only achieved a flow market share of 18.5% in 2010.

Many new lenders plan to fund themselves largely from retail deposits which will limit their impact

But the banking sector outperformed against both the mutual sector and National Savings. This squeeze in funding for the mutual sector has had a major impact on the availability of mortgage funding in many regional housing and mortgage markets. Although the overall funding position is improving as wholesale markets open and UK savings growth exceeds the growth in the depressed mortgage market, the sectoral divide remains stark. The retail savings gap has narrowed in recent years and based on current forecasts this should show considerable further adjustment in the medium term. We expect the savings gap to reduce from £350bn in 2008 to around £150bn by 2020.

I thought it would be interesting to see what would happen to the funding gap under different interest rate scenarios. The graph below shows the path of the gap under three scenarios - the base case, flat interest rates at current levels and higher interest rates. Under the base forecast the savings gap eases to around £150bn by 2020. Under the higher interest rate scenario this adjustment is far quicker and the gap reaches around £180bn by 2015 and falls to under £50bn by 2020.

The flat interest rate scenario is largely shown to illustrate why interest rates will need to rise in 2011 and beyond. Until 2012 the funding gaps are broadly similar but once the economic recovery is in place and confidence and mortgage demand starts to rise, the savings gap widens.
If this unrealistic scenario is extended into the medium term the savings gap quickly returns to 2008 levels and beyond, assuming the wholesale markets are able to fund the difference.

The ideal path for the funding market is for interest rates to rise modestly over the medium term allowing retail-funded lenders the opportunity to rebuild savings balances. Lenders need to achieve a sustainable long-term balance in funding between wholesale and retail but many will remain dependent on competitive retail savings.

Many new and prospective lenders plan on funding themselves largely from retail deposits and this decision looks set to limit their impact on the overall mortgage market. If experienced building societies with established retail franchises are struggling to attract sufficient retail savings it seems unlikely new players will make much of an impact in the next few years - unless of course Sir John Vickers makes it easier for new competitors in his September 2011 recommendations.