The cost of regulation could be going up

The building societies lending and savings figures released by the Building Societies Association on Monday show that gross mortgage lending jumped 15% in December, compared with November.

But in terms of hard cash that translates into just £497m and may have been a blip in the system – some home buyers probably brought forward their decision to buy to take advantage of the Stamp Duty holiday before it lapsed at the end of the year.

And if you take an annual perspective, the picture looks even bleaker – gross lending in 2009 totalled a miserly £18.6bn compared with £37.5bn in 2008.

Still things must look a lot brighter on the savings side because just a few weeks ago the Office for National Statistics announced that the savings ratio had leapt to an 11-year high in the third quarter, to 8.6% of income, but the building societies’ savings data gives the lie to that.

Excluding interest credited to accounts, they experienced net withdrawals of £0.4bn in December and total balances at building societies fell by £1bn in 2009 compared with an increase of £19bn in 2008.

The societies are of course suffering from a triple whammy. Their business model doesn’t work well when interest rates are so low, and they are facing fierce competition for savings from the massive state-backed banking sector while the public’s propensity to save, despite the ONS figures, has actually diminished dramatically.

David Smith explained this paradox in last weekend’s Sunday Times. Paraphrasing a new study from ING, he noted that borrowing fell even more dramatically than savings and netting those out produced the rise in the savings ratio. It was, he stated, “driven by the fall in borrowing, and some repayment of debt, rather than by an urge to save.”

Worse, the ING paper saw no sign of a convincing increase in savings and if income growth slows sharply this year, as it is expected to do, it predicted that savings were likely to fall further.

This situation clearly shows how impossible it will for building societies and other lenders to fund mortgage from retail deposits – a problem which is exacerbated by their need to refinance existing mortgages which were wholesale funded before that market collapsed in 2007.

The Council of Mortgage Lenders has summed up the problem succinctly in a submission to the FSA that it published last week: “The loss of investor confidence in wholesale debt markets since 2007 has left a £300bn gap in deposit takers’ funding that has had to be filled temporarily by government funds through the special liquidity scheme (SLS) and credit guarantee scheme (CGS). These schemes expire in 2011 – 2012 and 2012 – 2014 respectively, leaving a major uncertainty overhanging the mortgage market as to how lenders will be able to refinance this £300bn.”

Even if the wholesale markets were to function again, the CML thinks that lenders will be unable to repay the government in full on the current timetable of the SLS and CGS, suggesting that an extension of the period of state support will be required.

But that isn’t the only ugly issue lurking beneath the regulators’ radar. As the CML points out, UK policy measures have focused on bank capital and liquidity, and on tightening mortgage market regulation, while if there was one outstanding cause of the crisis in UK banking, it was not insufficient capital or poor quality mortgage lending but the vulnerability of our banks’ funding structure.

Because the authorities still insist on seeing securitisation and wholesale funding as problematic, the CML argues that they have yet to develop a sustainable mortgage funding model and that, I suggest, could be the next big thing to trip us up.

I’d like to say that this has come about because the government and its regulators are haunted by the prospect of failure – they are too busy looking over their shoulder at what went wrong last time to see what may be waiting ahead but as the CML’s paper indicates, that’s not the case. They never identified the real problem in the first place which suggests that the cost of regulation could be a lot higher than we originally thought.