The jury seems to be still out on what the recent relaxation of Basel III rules means for the mortage market, largely because the issues involved are so complex. Edmund Tirbutt goes back to basics and asks whether if the higher capital requirements for the banks, for example, may lead to some lenders struggling to compete and offer competitive loans
As with the Funding for Lending Scheme, it is rare to find negative comments from providers or intermediaries about the implications for the mortgage market of the relaxation of the Basel III rules announced on January 6 this year.
But, unlike with the Funding for Lending Scheme, positive comments or, indeed, any kind of comments are also hard to find. Out of 10 major lenders invited to provide input, only Lloyds Banking Group could muster anything resembling a response.
This situation seems to result from the fact that most spokespeople have yet to actually get their heads fully around the issues involved. Some even quip that Basel III sounds like it has something to do with Fawlty Towers.
So let’s start by going right back to basics. The introduction of the Basel Committee’s liquidity coverage ratio was agreed in 2010 after the financial crisis had exposed deficiencies in global liquidity risk management.
It required banks to maintain liquid assets to cover 30 days cash outflow, and these were defined as government bonds, cash and a highly restricted set of corporate bonds.
Banks were required to be 100 per cent compliant with the new liquidity coverage ratio rules by January 2015.
Nevertheless, it soon became evident that the timetable was rather tight and inflexible and that an excess of demand over supply for the permitted liquid assets was inflating their prices. So something had to give, and our own Bank of England governor Sir Mervyn King figured prominently amongst those to say so.
“The regulators realised that they had gone too far too quickly and there was a call to reign back the speed with which the new rules would be required,” says John Charcol senior technical manager Ray Boulger.
“Bearing in mind the perilous state of some European banks, imposing requirements that were too severe would result in the economy suffering and would therefore restrict growth.”
So this January the Basel Committee loosened the LCR rules.
Cash outflow assumptions in a stress scenario have become more relaxed and the implementation timetable has been extended.
Instead of having to introduce the 100% minimum LCR requirement by January 2015, the minimum will be set at 60% from January 2015 and raised by 10% a year until it reaches 100% in January 2019.
“In normal market circumstances banks will likely operate with an LCR comfortably above the minimum requirement to avoid the risk of inadvertent breaches and to meet market expectations,” says Richard Barnes, senior director, financial services ratings at Standard & Poor’s.
“The size of the cushion that banks choose to maintain will depend on the extent to which the LCR varies day to day, and only time will tell what investors believe are the appropriate ratios that banks should maintain.”
The definition of cash/near-cash assets that banks can hold has also been made significantly broader.
It now includes shares, AAA-rated residential mortgage-backed securities and other corporate bond instruments.
With regard to RMBS, the bank holding the asset cannot be the issuer and along with its affiliates cannot be the originator of the underlying loans – which must be full-recourse residential mortgages.
Additionally, the Basel Committee is now turning its attention to a review of standards for funding mismatches beyond the 30-day horizon: the net stable funding ratio.
The committee stresses that this is a crucial component in the new framework and that it is adopting it as a high priority over the next two years.
“The NSFR, which is the LCR’s stable mate, is probably the most impactful of all the Basel ‘more-capital-more-liquidity’ requirements,” says Simon Hills, executive director for prudential capital and risk at the British Bankers’ Association.
“It will mean that banks have to hold much more one-year-plus funding against their term loans and it cuts across the key function that banks undertake for society: namely, maturity transformation.
“The BBA looks forward to working with the Basel Committee to examine the impacts of this second liquidity metric. It is likely that such one-year plus funding will be more expensive for banks, and that extra cost can only be passed on to customers. Whilst this might not have a huge impact on residential mortgages, it probably will have for infrastructure finance.”
Overall, the package of changes have been greeted as broadly positive for banks in the round by most of the elite few who have developed any serious level of understanding of them, although the consensus view is undoubtedly that they remain less significant than the introduction of the Funding for Lending Scheme for the time being.
Council of Mortgage Lenders spokesman Julian Wadley says the relaxation of the criteria has reduced some of the asset price bubble issues that were forming in government securities and has enabled firms to generate a better return on their liquidity asset portfolio. “Likewise, the delay in implementing these rules until 2019 gives financial firms the opportunity to build up their liquidity buffer in an orderly way,” he says.
Barnes does, however, flag up a reservation.
Current bank ratings generally incorporate the expectation that institutions with weaker stand-alone funding and liquidity will steadily strengthen their positions and reduce dependence on central bank facilities.
“The changes to the LCR methodology could have negative rating implications if they cause a delay in this rebalancing,” he says.
“Conversely, there could be positive rating actions on banks that choose to manage their liquidity well above the minimum requirements.”
Lloyds Banking Group director of intermediaries Mike Jones also points out that the combined implications of Basel III requirements and the Banking Reform Bill mean that major UK banks will be required to hold more capital than foreign banks.
“For some banks this pressure may be greater than others, and the higher capital requirements may lead to some lenders struggling to compete and offer competitive mortgages,” he says.
“It is also likely that the increased level of capital will result in increased costs for banks, and so this may result in banks charging more for mortgages in the medium term, although this may be offset by falling liquidity costs as the market continues to recover.”
The fact that AAA-rated RMBS can now be included as liquid assets should, however, prove to be to the specific advantage of mortgage lenders. RMBS enable mortgage lenders to access long-term funding by refinancing mortgage loans in the Eurobond markets, so the lenders should benefit from experiencing greater demand for these products.
The BBA’s Simon Hills says the trade body is pleased by the change of stance towards RMBS as their inclusion had been implacably opposed by the authorities, and we had felt this wasn’t right.
“If banks buy more RMBS, which they will now do because they are higher yielding than bonds, there will be more liquidity in the RMBS market, so financial institutions will be happier to buy RMBS as they had previously been hampered by liquidity,” he says.
“The funding costs for banks should therefore go down and this is likely to get passed on to borrowers.”
The move also means that the aggregate return on banks’ liquidity portfolios will be a bit higher but, more importantly, it should reinvigorate the securitisation market which has been moribund since the beginning of the global financial crisis, as all RMBS were tarred with the same sub-prime mortgage brush.
“As a result, banks will be better able to manage their balance sheets, to make space for lending to businesses by securitising good quality mortgage assets and selling them to natural holders of longer-term investments, such as insurance companies and pension funds,” Hills adds.
But some experts point out that the fact that RMBSs have to be AAA-rated to qualify imposes a significant restriction because the liquidity of AAA-rated products is likely to diminish in a tough market.
The Intermediary Mortgage Lenders Association executive director Peter Williams says that in some other countries central institutions have been willing to buy RMBS, which has effectively created permanent liquidity, but I’m not aware of any suggestion of the Bank of England doing this.
“Including RMBS in liquidity calculations works if they are liquid and the key seems to be to get the Bank of England to act as a lender of the last resort like other central banks around the world have done, including the ECB,” he says.
However, Tony Ward, chief executive of consultancy Home Funding, doesn’t rule out this happening in the future, especially in view of the impending personnel changes at the Bank of England.
“It would have been better if the Bank of England had committed to providing a liquidity purchase facility to guarantee the liquidity of AAA-rated RMBSs in the event of a market disruption,” Ward says.
“I requested it to do this three years ago when I asked it to extend the permitted liquid assets to RBMSs and, although it gave this serious consideration at the time, it didn’t feel it was appropriate. I think there is a chance of it changing when the governor of the Bank of England changes but it’s something that the outgoing governor Mervyn King wasn’t in favour of three years ago.”