Just how will the revised Basel Capital Accord impact on the UK mortgage industry?

RACHEL BLACKMORE is external affairs manager at the Building Societies Association

The proposals for changes to the Basel Capital Accord have created quite a stir in the financial services world. Of course, if you mentioned Capital Adequacy or Basel II to ordinary folk they would look at you with a mystified expression. So why is Basel causing such a stir?

The Basel proposals have the potential to allow institutions such as banks and building societies to hold lower levels of capital than they do currently, on the condition that they can prove good internal auditing; risk assessment and governance. This could have a knock-on effect on the pricing of products, as the released capital is used to create price competition. Alternatively PLCs may decide to release the capital to shareholders in order to increase their dividend.

The proposals would introduce one significant change for all institutions right away, as the capital weighting would fall from 50% to 40%. To gain further reductions on the capital an institution is required to hold against its risk, which will need a range of complex calculations. While this proposal is being touted as being advantageous for larger institutions, there are also a number of distinct advantages for smaller institutions like building societies. Operational risk is significantly lower for small institutions that provide a simple product range, therefore, capital requirements should be less. One only has to look at how the service levels of one large lender have hit the press in the last couple of months after it failed to be able to match customer service with the growth in the volume and product set of its business.

Small institutions know their markets extremely well, therefore, they face less risks than those of the larger, more remote institutions who come up with one-size-fits-all product propositions, which may not work for sections of the market. Applying the new rules within a large, multi-faceted business is going to be a complex and time-consuming task and it could well be that larger lenders spend more time about how to squeeze every last drop of capital out of their business rather than thinking about how best to deliver to their customers.

Two dangers often touted for small institutions are that they will not be able to take advantage of the new rules due to lack of critical mass of data, or that they will be in danger of take-over by larger institutions who wish to release their capital. On the first point, the BSA is exploring ways of enabling building societies to pool data, should they so wish. On the latter point, it is unlikely that large institutions would gain any synergies from a merger with a smaller building society and such predatory behaviour would only serve to decrease choice in financial services, something which the consumer, the government and the Competition Commission are keen to avoid.

As to the future, building societies are following this debate closely and are poised, as much as the larger institutions, to take advantage of Basel II. In addition, as mutual organisations, building societies will be able to pass the benefits Basel II may bring straight onto consumers, rather than coming under pressure from the City to pass those benefits onto shareholders.

JOHN GILL is director of finance at Standard Life Bank

The impact of the revised Basel Accord (Basel II) on the mortgage industry in the UK centres on how the Accord deals with the amount of regulatory capital that banks will be required to hold to cover credit, market and operational risks.

The consequence of Basel II will be that the total amount of regulatory capital supporting banks worldwide will remain unaltered, but that its distribution will change. Take mortgages, for example. For every mortgage on their books, lenders currently have to set aside capital on that mortgage. Whether this mortgage is low-risk or high-risk, the current rules stipulate that the same amount of capital is set aside in both instances. Following Basel, this will change dramatically and a high-risk loan will have a higher capital requirement than a low risk loan. Basel II is therefore all about managing risk. The Accord will reward those with good credit quality whilst penalising those with less impressive credit books.

The impact on mortgage lenders will in future depend on the quality of their mortgage lending. Those with a high quality mortgage book (low in arrears, less exposure to 100% LTV loans, for example) will gain, while lenders with a high exposure to arrears, and higher risk – for example those operating in the sub-prime market – could lose out.

To exploit the benefits of Basel will require substantial investment in good risk management, but the larger lenders will have the capability to jump to this. After all, the best modelling tools are of no use if the data is lacking. Where long-term data on credit risk and modelling capability is available, the risk management process should be better and Basel II will reward this with lower capital requirements. Those lenders who are exposed to high credit risk have two options. They either move out of low quality into high quality lending, or they use wider, differential pricing to charge customers more when the risk is greater. Big banks with a large presence in the mortgage market, such as HBOS, should be well placed. After all it has the historic data on credit worthiness plus the credibility and scale with regulators to allow benefits to come through quickly. Banks whose concentration on mortgages as a slice of their overall business is low will be attracted by the capital requirement rewards gained by low risk lending. Watch out for major banks with relatively limited mortgage books, for example HSBC, expanding rapidly into mortgages.

The little guys can look at Basel II in two ways. It could work to their disadvantage since they will have difficulty competing in price and by virtue of their size may face hurdles when trying to provide long-term data on quality of risk. However, Basel also presents the small mortgage lender with a challenge. Those who are able to release further capital because of the quality of their business will remain around to compete for longer. The Accord may even defer consolidation in the industry.

How quickly the benefits will come about is less obvious because the FSA is not going to want to see an overnight revolution in the capital requirements of every bank. The international issues also mean that final rules could still be changed.