FSA: Building society sector vulnerable to further shocks

The Financial Services Authority has warned societies that they need to ensure their business models together with their supporting risk management systems and controls are sustainable.

In its Financial Risk Outlook for 2009 the regulator says societies have been weakened by adverse economic and financial market conditions, however the extent of that weakening has generally been less than that experienced by the large banks, mainly because of their lower exposure to wholesale funding.

The FSA says they continue to be at risk from the effects of a low interest environment, falling house prices and increasing levels of arrears.

Its report says: “Building societies, like banks, perform a maturity transformation role, taking in short-term deposits and extending longer-term loans.

“As such, their experiences in the crisis bear some similarity to those experienced by the banking sector. However, the differing business models mean that market pressures have not been identical.

“A few societies have, in recent years, responded to the statutory constraints
on their business model by pursuing higher-risk stategies, in particular,
diversifying heavily into commercial, self-certification and non-prime lending.

“The adverse market conditions have proved particularly difficult for these
societies and led to several mergers in 2008.”

The Building Societies Act 1986 requires societies to ensure that at least 75% of their lending is for residential mortgages.

Therefore, they inevitably face a concentration of risk within residential mortgage lending, and this risk is exacerbated if their lending book is concentrated in a restricted geographic area.

As with banks, societies already face an increase in loan-to-value ratios on their existing mortgage books and further deterioration is to be expected as house prices fall, leading to rising arrears on impairment charges will increase.

The FSA says margins will be squeezed for societies, which together with
the higher impairment charges – and FSCS levies arising from bank failures
– can be expected to cut profitability in the short term.

Its report adds: “Indeed, a number of societies are expected to record losses for 2008 as a result of these factors.

“However, societies have relatively strong capital positions and are not profit
maximisers; most are likely to respond to market conditions by curtailing
growth and therefore may be in a better position to cope with reduced profits
than banks.”