As insurers and investment firms eye the mainstream mortgage market, can non-typical funding streams really challenge the UK’s big lenders?
It can be argued that the UK mortgage market has gone from boom to bust over the past decade. Annual lending peaked in 2007 at more than £350bn, before plummeting to £133bn just three years later. Following the financial crisis a bustling non-bank scene also disappeared.
However, slowly but surely the non-banks are returning and new, hungry challenger banks have emerged.
Nevertheless, the big banks retain their stranglehold on the market, lending £7 of every £10 advanced to borrowers.
Why is this? And do our cousins on the Continent offer a glimpse of a new type of mortgage funding that could inject even more competition into the market?
At the peak in 2007, there were no fewer than 27 specialist lenders, many of which were reliant on the wholesale market to fund new lending. But following the financial crisis so-called securitisation became a dirty word after it emerged that lenders – primarily in the US – had been flogging bonds filled with poor-quality loans and badging them as AAA rated. As the funding dried up, the non-bank lenders – and even banks such as Northern Rock – went to the wall.
Since then, however, the wholesale markets have thawed and a host of new specialist lenders have sprung up, such as Fleet Mortgages, Foundation Home Loans and Precise Mortgages. New challenger banks have emerged, including TSB, which was carved out of Lloyds Banking Group, and Virgin Money.
This influx of new entrants has led to the ‘Big Six’ (Barclays, HSBC, Lloyds Banking Group, Nationwide, RBS and Santander) losing market share, yet they continue to dominate the market.
In 2009 the six biggest players accounted for 86 per cent of all mortgage lending in the UK. This figure has since fallen to around 70 per cent as challenger banks and specialist players have come to market.
Nevertheless, no other lender has proved capable of challenging the hegemony of the big boys. Virgin Money, for example, the largest bank outside the top six, had a market share of just 3.4 per cent at the end of 2016. Even former challenger lender Northern Rock at its peak accounted for more than 5 per cent of the market.
Non-bank lenders too have struggled to make a significant dent in the market share of the biggest players, many struggling to grab more than 0.5 per cent.
Experts believe any new lender would take decades to build a big enough operation with which to challenge the UK’s largest mortgage lenders.
Association of Mortgage Intermediaries chief executive Robert Sinclair says: “It would take 50 years for a new lender to reach the size of someone like Lloyds by growing organically. The only way you can achieve it quicker is by acquiring other marginal players.
“It’s hard to scale up from scratch without being carved out from one of the bigger banks, like TSB. You need start-up capital and that will come from someone who wants a return on their investment.
“Plus, when you look at the major banks, many of them are well over 100 years old. That means they have more than a century of retained capital to deploy.”
Why, then, is it so difficult for new lenders in the current market to build scale?
A key reason is that they have to hold more capital than the big banks. This is because of the way smaller banks are forced to calculate how much capital they must set aside.
Newer lenders must use a standardised calculation, which obliges them to hold more capital. Established banks, however, use a more bespoke calculation based on their own loan books.
In short, this means the big banks can lend 10 times the amount lent by smaller banks, but for the same capital.
Fleet Mortgages chief executive Bob Young, who set up the lender in 2014, says: “We’ve seen a few new lenders do well. However, there are capital constraints that mean new lenders have to build more slowly.
“Established lenders won’t sit around watching their market share erode; they will fight primarily on price, which means newer entrants need deep pockets.”
However, last month the Prudential Regulation Authority threw smaller lenders a lifeline by promising to consult on a new framework that would not disadvantage small lenders. It said it would look at the disparities between those lenders using the standardised approach and those using their own loan books to work out their capital requirements.
PRA deputy governor for prudential regulation Sam Woods said at the time: “This consultation is a major step forward for the PRA in facilitating effective competition, reducing capital requirements for eligible small firms. This will be good for competition and for safety and soundness.”
The announcement has been welcomed by the challenger banks, but large obstacles remain for smaller lenders. Buy-to-let specialists, for example, have had to contend with a widespread clampdown on the sector. Faced with increased stamp duty rates, a cut to mortgage interest rate relief and tougher lending rules, lending to landlords has fallen dramatically.
Figures from the Council of Mortgage Lenders show the number of loans advanced in January to have fallen by 15 per cent annually, to 20,000. This is significant because many start-up lenders target the buy-to-let market to quickly achieve decent lending levels, as there is less red tape.
OneSavings Bank sales director John Eastgate says: “It is difficult to envisage [a new lender being able to achieve significant scale if it launched now].
“Our own journey has seen us take five years to get to £2.3bn a year of new lending. During that time, regulation has tightened and become more costly to comply with.
“And with regulation and political intervention in buy-to-let stepping up further this year, we are already seeing the market polarise towards some dominant specialists that have an established market presence.”
In a market with such high running costs, only investment and pension firms have deep enough pockets to compete effectively with the major banks.
Investment firms such as BlackRock, which provides a funding line to Fleet Mortgages, have dabbled in the specialist mortgage market. Insurers Legal & General and Aviva, meanwhile, have found equity release a fruitful sector.
However, there are few signs that such firms are ready to launch into mainstream mortgage lending.
In 2013, L&G toyed with re-entering the mortgage market for the first time in 11 years, but eventually it shelved its plans.
However, could the answer to smaller UK lend-ers’ problems lie overseas? In countries such as Ireland and the Netherlands, a potential new means of funding mortgages is emerging.
In the Netherlands, non-bank lenders backed by insurance companies and pension firms are providing a stern challenge to the country’s three main mortgage lenders – ABN Amro, ING and Rabobank. Within five years, non-bank lenders’ share of the market has grown from only nominal to around 20 per cent. They act almost as middlemen, funnelling money from pension funds to borrowers through third-party services, which carry out the underwriting.
The closest example of this in the UK is BlackRock’s relationship with Fleet.
In Ireland, meanwhile, a non-bank pension fund is challenging the market by using its funds to lend mortgages.
Clayton Euro Risk director Simon Collingridge, who knows the Dutch mortgage market well, says there are several reasons for the emergence of this type of lending in the Netherlands.
First, the major banks have retreated from lending in the past few years as they looked to dump non-core assets from their balance sheets. This has left a vacuum that the non-banks have been keen to exploit.
Second, as in the UK, intermediaries account for nearly 70 per cent of Dutch mortgage lending, giving new entrants key distribution.
Finally, pension funds and insurers in the Netherlands have fewer investment opportunities than their UK counterparts because the country has a much smaller savings industry.
So could the Dutch model be replicated on these shores?
Collingridge says: “[The Netherlands is] a stable country with strong personal credit performance. The returns are reasonable and, with the introducer network and third-party servicing, there is an infrastructure that enables relatively straightforward entry for new plat-forms and funders. On top of that there is a real political will to increase mortgage lending.”
He adds: “The difference in the UK is that there hasn’t been the retreat from lending among the big banks as there has been in the Netherlands, which is why non-bank lenders are more visible there.”
Young believes the returns on offer in the UK make an entry into the mortgage market unattractive.
He says: “Insurers and pension firms are looking at the UK mortgage market and, although they may not need the returns that private equity or investment firms require, the total return is probably below their requirements.”
With an increase in interest rates unlikely for at least a year, margins look set to remain low.
Eastgate says: “If you look at the return on equity for a high-street bank and compare that to what a specialist lender achieves – single digits versus 30 per cent or so – you can see one reason why mass-market, mainstream lending isn’t really an area where they play.
“It is the returns in specialist lending that make it attractive to private equity.”