Is UK's housing-finance system broken?
- 5 February 2014
- From the section Business
It is probably true that it was impossible for the UK to enjoy much of an economic recovery without a revival in housebuilding and the housing market.
Which is why the Treasury's and Bank of England's schemes to wake up these markets from their long, deep slumber, Funding for Lending and Help to Buy, are seen by many as having been useful.
But there is a question about whether what began as a revival is turning into a bubble, especially in the south of England (which I've bored on about here quite enough).
There is however a longer-term question about the best, most prudent way to provide finance for house purchases.
This has become a little more urgent, given the work that the Bank of England is doing on the appropriate leverage ratio for banks.
Let me explain.
As you will recall, under the international Basel rules, the main constraints on banks' ability to lend more than they can afford to lose are the risk-weighted capital adequacy rules.
Vulnerable to gaming
In practice these have been deeply flawed, and - most would say - contributed to the chronic weakness of banks at the time of the great crash of 2008.
They have now been reformed. But they remain, in their highly complex form, vulnerable to gaming and abuse by banks.
At their heart are calculations by regulators of the riskiness of certain categories of loan, and they include the stipulation that banks have to hold varying amounts of loss-absorbing capital, calibrated according to this perceived riskiness of each category of loan held by them (many congratulations if you are still reading, at this juncture).
To elucidate in the simplest terms (did I really write that?), it means that a bank which concentrates on providing mortgages rather than business loans is forced to hold less capital than a bank which provides proportionately more business loans - because providing residential mortgages is viewed by regulators as a less risky activity than financing businesses.
Now there are all sorts of economic reasons why you may believe that is bonkers. To cite just one, because capital is expensive, these Basel rules provided a big incentive for banks to supply housing finance, as opposed to business finance.
And that incentive is still built into the reformed Basel rules.
But there is another point. The lesson of the banking crises in Spain, Ireland and - to a comparatively negligible extent - the UK is that there are prudential (as well as economic) reasons for wanting to make sure that banks aren't encouraged by the Basel rules to go lending-crazy in the housing market.
Now one way of putting a corset around mortgage lending, and indeed all lending, is by imposing a second much simpler constraint on how much each bank can lend relative to their capital resources, a so-called leverage ratio, which includes no calibration of the riskiness of different types of loan, but simply says that each bank has to hold capital equal to a fixed proportion of their total loans.
And, as it happens, the reformed Basel Rules do indeed contain this new requirement, which will become binding in 2019, for banks to hold a minimum amount of capital equivalent to 3% of their total assets or loans.
Think of it as a backstop, or safety net, to capture the danger that banks will abuse the weightings of the Basel rules to hide the excessive risks they are taking - which is what they did in the boom years before the Crash.
Now this is where it gets tediously complicated (if it hasn't done so already).
First of all, regulators in assorted parts of the world have implemented or are trying to implement different leverage ratios based around the Basel minimum.
So the leverage requirements in the US, Canada, Switzerland, the UK and the EU (minus the UK) are all a bit different.
And right now, I would argue that the leverage requirements in the US are more demanding than the European requirements.
Then there is the question of whether 3% is high enough.
Or to put it another way, what is the probability that a bank will incur losses equivalent to 3% of the value of all their loans and investments?
Well based on what happened to HBOS, RBS, UBS. Citigroup, Lehman, Merrill Lynch, assorted Irish and Spanish banks and plenty of others in 2008, the probability is not de minimis.
This is why there are plenty of regulators and others - including the Independent Commission on Banking set up by the chancellor - who argue that a 4% minimum would be more appropriate (and that even 4% may be too low).
Anyway, right now the Bank of England is doing some work on how high to set the minimum for UK banks, with a view to lifting it to around 4%.
Which is the cause, I am told, of some friction between the Treasury and the Bank of England, because the west end of town is concerned that an uplift in the leverage ratio would choke off the supply of credit so vital to the UK's economic prospects.
This is a perennial concern whenever there's talk of boosting capital requirements, because if banks don't want to raise expensive additional capital, they can improve their capital and leverage ratios simply by lending less.
As it happens, one of the banks that has been lobbying against a significant rise in the leverage ratio - but which wishes to remain anonymous - has done some work on the impact of lifting the ratio to 4%.
It calculates that if big UK banks and building societies were to meet a 4% leverage ratio by reining in their lending, rather than asking investors for more capital, they would shrink their lending by just under £800bn - which is a non-trivial sum.
And at a leverage ratio of 4.5%, the contraction of credit would be not far short of the UK's national income, at £1.3tn.
Now the bulk of impact would fall on two categories of bank - those like Barclays with a big presence in investment banking and asset-based short-term lending to financial institutions (through the so-called repo market), and mortgage banks such as Nationwide, Lloyds and Santander.
As it happens, Barclays is braced for running its investment bank on a more capital intensive basis. It is not complaining (or at least not to me) about the imposition of greater leverage constraints, so long as these are imposed over a few years.
But the mortgage banks are less happy.
They are concerned that a higher leverage ratio would push up the cost and shrink the supply of mortgage finance.
And, as I understand it, the chancellor feels their pain - but, I am told, the governor, Mark Carney, takes a principled view that in the long term the UK would benefit from imposing higher leverage ratios.
Where will it end?
Well we won't have a sense of this till nearer the end of the year.
But one way of minimising any tightening of the mortgage market caused by a higher leverage ratio would be to resuscitate the provision of home-loans by investors, rather than banks, through the process of packaging mortgages into bonds.
It is true that what is known as the securitisation of mortgages became discredited in the banking crisis. But that was because of poor lending standards, excessive complexity in the creation of the bonds, and the lunacy of banks keeping the bonds on their own balance sheets to an excessive amount.
But the idea that insurers, pension funds and even ordinary savers should be investing in mortgages is a sound one - in that mortgages can provide long term, reliable income to them.
Or to put it another way, one important way of making the banking system more stable and secure is to shrink its role in the provision of finance, to make respectable again the notion that savers should bypass the banks and directly provide the finance so badly needed for economic growth.