It is against this backdrop that lenders have to increase capital adequacy. Most economists agree banks should hold substantially more capital and deleverage to help limit the chances of future bank failure.
Monetary Policy Committee member David Miles has argued that if we want greater confidence in the banking system, substantially higher levels of capital will be needed. Capital requirements may need to double in some cases to reduce the risk of bank failure.
The Basel Committee has announced that capital requirements will rise over the next seven years, with the largest banks holding around 10.5% of risk weighted assets in capital by 2019 compared to 8% at present.
In addition, there are substantially higher requirements for Core Tier 1 capital, with more liquid capital now required as these are planned to increase from 3.5% to 4.5% in 2015 and on to 7% by 2019.
However, some lenders will struggle to compete while holding far more capital than normal. Many building societies already hold two to three times their standardised Pillar 1 Basel requirements and as a result, will need to charge far more for mortgages in the medium term.
Aside from the economic changes stemming from additional capital, the current changes have markedly affected the retail lending markets. A wide range of risk weights is applied to mortgages across the industry.
You would expect the risk weights attached to higher risk lending to be much higher than those for low risk, low LTV lending, but it is far more complex than that.
The Basel Committee has already announced that capital requirements will rise over next seven years
There are two key approaches to Basel II/III. First is the standardised approach often adopted by small and medium-sized players.
This is less sophisticated, with mortgage lenders usually achieving an average risk weight of around 40% for mortgage assets.
This approach has far less onerous requirements for data collection, modelling and risk governance and is closer to the Basel I approach of applying 50% risk weights to all mortgages, regardless of risk characteristics.
Second, there is the internal ratings basis approach. IRB tends to be used by the biggest lenders but some medium-sized players have achieved it by investing in better systems, data, models and governance.
For this approach, the risk weights average around 15% for mortgage assets for the top five lenders and several have achieved lower risk weights.
On the surface, this sounds appropriate. A lender invests in sophisticated risk systems and models and achieves a potential reduction in capital of around 60%. But most of the biggest lenders also have exposure to higher risk segments and the risk weights on these loans will not, on average, approach the 40%+ paid by those on the standardised approach.
As the minimum capital requirements under Basel III and possibly Basel III+ start to increase in the next few years, the competitive advantage accruing to the biggest lenders will increase even further.
The table below shows what happens to the UK total mortgage stock and minimum capital requirements under a variety of assumptions.
Under scenario one, the whole of the UK mortgage stock is subject to the standardised approach and, as a result, the minimum capital requirements under Basel III would be around £52bn.
If the whole market could move to the more advanced IRB basis – scenario two – this would fall to just under £20bn.
The more realistic assumption is around 25% of assets stay on standardised and the rest on advanced IRB. The total capital requirement would be nearer £28bn – scenario three.
Under all three scenarios, capital requirements rise by over 30% under Basel III and perhaps by as much as 50% if further requirements are added by the local regulator under the so-called Basel III+.
The growing divide between lenders achieving the more advanced IRB status and those on standardised has meant larger lenders have been able to substantially enhance their profitability in a weak market.
Higher mortgage rates and SVRs have enabled the biggest lenders to increase their capital holdings and reduce their total leverage.
Several smaller lenders have also reduced new lending and widened the margin on existing lower risk loans.
This deleveraging has had a major impact on the level of overall lending and the speed of recovery in the UK housing market. Competition has largely been stifled and this will need to be revisited by policymakers.