Response by The Building Societies Association to the HM Treasury Consultation Document
1. This paper sets out the brief comments of The Building Societies Association on the HM Treasury consultation document The new Capital Adequacy Directive, CAD 3: The transposition of the new Basel Accord into EU legislation. The Treasury document lays out key questions and issues as currently seen by the Treasury and seeks comments thereon, together with comments on any other matters relating to the new Directive.
2. The Building Societies Association represents all 63 building societies in the UK. Those societies have total assets in excess of £215bn, about 15 million adult savers and over two and a half million borrowers. Building societies account for over 18% of both outstanding residential mortgage balances and retail deposit balances in the UK. Almost all building societies have their head office outside London, providing much needed regional diversity, and their 2,100 branch network covers all areas of the UK. Building societies are mutual institutions (with no equity shareholders), constituted under the Building Societies Act 1986 and (like other UK financial institutions) are regulated by the Financial Services Authority under the Financial Services and Markets Act 2000. Building societies are within the definition of "credit institution" for the purpose of EU Directives.
3. At the end of 2002 the aggregate capital held by building societies amounted to 6.60% of liabilities on shares, deposits and debt securities (of which 14% was in the form of issued capital - subordinated debt and permanent interest bearing shares (PIBS) - the remainder consisting of reserves). The aggregate building society sector solvency ratio (capital as a percentage of risk weighted assets and off balance sheet items) was 12.37%.
4. Unlike banks and other lenders in the UK mortgage market, building societies are required by legislation to have a significant majority of their assets in the form of residential mortgage loans. (Section 6 of the Building Societies Act 1986 requires each society to ensure that at least 75% of its "business assets" must be loans fully secured on residential property. "Business assets" are total assets plus provisions for bad and doubtful debts, less fixed assets, liquid assets and any long-term insurance funds.) Accordingly, building societies are uniquely committed to providing finance in the UK residential mortgage market, and have limited opportunity to diversify into other asset-related business (not that there is any great demand currently from societies to do so beyond the current limit).
5. The Association has the following comments in respect of some of the specific questions asked in the consultation document.
Q1 - What is your assessment of the behavioural impacts of the proposed Accord?
6. The Association agrees with the Treasury's expectation that lending behaviour by banks and building societies will be most influenced in those areas where the change in regulatory capital requirements will be greatest. As the Treasury notes, a significant area where reduced credit risk weights will result in lower regulatory capital requirements is residential mortgage lending. While the risk weight for well-secured such loans in the standardised approach is proposed to be reduced from the current 50% to 35%, the general expectation is that risk weights in the internal ratings based (IRB) approach to credit risk will generally be significantly lower than 35%.
7. Accordingly, the potential reduction in capital requirements for the larger UK banks and building societies able to adopt the IRB approach (particularly those with a significant focus on residential mortgage lending) will be very much greater than the equivalent reduction in capital requirements achievable by those (generally the majority of UK retail focused credit institutions, including the majority of UK building societies) that will remain on the standardised approach to credit risk. Many commentators see this as a potentially significant threat to the latter category of firms, both because of the possible impact of more competitive mortgage pricing by the IRB firms (which could not be matched by firms that are unable to meet the extensive eligibility criteria for adopting the IRB approach), and the possibility of smaller firms being subject to takeover approaches by IRB firms that would be able to free up capital by applying the IRB approach to the acquired loans. Either of these outcomes would not be in the best interests of competition.
8. For similar reasons, the prospect of there being any future new entrants to the UK residential mortgage market that are deposit-takers (either based in the UK or elsewhere) would seem very much reduced (since any such firm would be unlikely to have the necessary historical statistical data to qualify for the IRB approach).
Q5 - Do you agree with us that the Basel Accord strikes the correct balance between giving the right incentives for improving risk management practices while minimising competitive distortions?
9. As described above, there are clearly competitive implications potentially arising from the differential credit risk weights for residential mortgage loans that are likely under the IRB approach to credit risk compared with the standardised approach. It is particularly unfortunate that there is to be no foundation IRB approach, nor some other "middle way" between the standardised approach and the advanced IRB approach, for retail exposures. This was perhaps understandable in relation to large internationally active banks in the Basel context, but less so in the EU where the UK is not alone of the member states in having a significant number of smaller deposit-taking firms.
10. Even if smaller lenders were able to obtain access to pooled loss data, the cost of such access, together with the cost and complexity of implementing and complying with the other eligibility criteria for the IRB approach, would make this prohibitive in practice for most building societies. Such societies may nevertheless be well run and risk averse, and currently provide an important local or regional service.
11. As identified by the Treasury (para 3.31), a potential further source of competitive distortion could arise from uneven application of Pillar 2 (supervisory review process) across countries. Capital requirements for banks and building societies in the UK have featured a supervisory review process for some time. It is welcome that all countries implementing the New Basel Accord or CAD 3 will be implementing Pillar 2, but there is concern that the requirements of some countries may be significantly lower than those to be included in the FSA's rules. There is also the possibility, depending on the structure of the Pillar 2 framework that the FSA intends to implement in the UK through its rules, that Pillar 2 might lead to competitive distortion between UK firms.
Q6 - Do you agree with our understanding on each of these detailed issues [in Chapter 4] raised during discussions on Basel II and CAD 3?
12. Paragraphs 4.9 to 4.11 describe the potential competition impacts, in particular in relation to residential mortgage lending. It is, of course, conceivable that the impact of the changes in regulatory capital requirements on this market may be limited. However, it seems much more likely that the larger deposit-takers will use a significant part of the reduced level of capital that is expected to arise, in more competitively priced mortgage products.
13. In paragraph 4.23 the Treasury has correctly identified a potential problem in relation to loans to housing associations under the foundation IRB approach. This issue, together with a number of other detailed mortgage related issues, is covered in the response to the Treasury by the Council of Mortgage Lenders (of which almost all building societies are also members).
Q7 - Are there other issues that we have not documented that are equally matters of concern?
(a) Risk Weighting of Exposures to Financial Institutions
14. UK building societies are concerned about the potential consequences of the likely adoption by the FSA of the option for weighting claims on other financial institutions in the standardised approach to credit risk, where the risk weight would be based on the credit rating (if any) of the borrowing institution. Most of the larger building societies have external credit ratings (mainly from Moody's). However, only one building society currently has a rating that would likely result in it being assigned to the highest credit quality step (risk weight of 20%). Smaller building societies generally do not raise funds in markets for which credit ratings are required, and so have had no reason to obtain one, but do borrow significant funds from other financial institutions. In any event, the credit ratings held by most of the larger building societies would result in them being assigned a risk weight of 50% - the same as that assigned to a claim on an unrated society - for such claims with an original maturity of over three months. Such a risk weight is two and a half times the current weight and is inappropriately high.
15. The potential effect of the above could be an inappropriate increase in the cost of wholesale funds raised by building societies from banks and other building societies, and a likely reduction in the sources of such funds. This matter has gained potentially increased significance as a result of the proposals by the Commission Services to allow permanent use of the standardised approach for claims on institutions and sovereigns, by an institution that is applying the IRB approach for other asset classes. This otherwise potentially very helpful provision may mean that many of the larger institutions from which building societies raise funding will be applying the standardised approach risk weights to their claims on societies, rather than the IRB approach. Accordingly, this issue remains of significant concern to UK building societies.
16. In our October 2003 response to the European Commission Services CP3 we asked that serious consideration be given in finalising the Directive proposal, to the definition of short-term exposures, which would attract a risk weight of 20% under the option likely to be chosen by the FSA, being lengthened from three months to one year, and/or that residual (remaining) maturity, rather than original maturity, be used. The Association can see no logic in relating capital requirements to original maturity.
(b) Treatment of Certain Wholly-Owned Subsidiaries ("Solo Consolidation")
17. One aspect of the proposed CAD 3 that may be of critical importance to some building societies (and banks) concerns those that have mortgage lending (or other) subsidiaries that are currently "solo consolidated" when calculating the "society-only" capital requirements. It is not clear that such a basis of calculation may be continued under CAD 3. Many building societies have acquired mortgage books from other lenders through the use of wholly-owned subsidiaries. Until relatively recently this was the only way in which a building society was permitted to acquire such assets. Although no longer required by law, there are a number of operational reasons why it is attractive to continue with such a practice. In any event, it would be costly, and inappropriate, to change the existing arrangements. The Association has provided detailed information to the FSA (which we understand has been discussed with the Treasury) on the potential impact of loss of the solo consolidation arrangements. It would be appreciated if the Treasury and the FSA could pursue this matter within the relevant European Commission Working Group.
(c) Cross-Border Competitive Impacts
18. In order to avoid inappropriate cross-border competitive impacts, the Association suggests that CAD 3 should -
state that the part of a residential mortgage loan not meeting the requirements for the favourable 35% risk weighting in the standardised approach to credit risk be weighted at a figure no higher than 75% (and not at 100%), and
require that where the competent authority of a member state applies a risk weight higher than 35% to high loan-to-value residential mortgage lending, the same higher risk weight, and the same loan-to-value threshold, be applied to such lending in that member state by lenders (using the standardised approach) from other member states.
19. It can be seen from the above comments that the introduction of CAD 3 has the potential for a number of issues -
more competitive mortgage pricing by IRB firms
higher cost of funds for building societies
increasing cost and complexity of regulatory requirements
to combine to make it more difficult in future for many building societies (not just the smallest) to be able to continue to provide a competitive service to their members, and therefore to the local, regional and wider communities that they have served so well for so long.
20. In this context we note with interest, and are re-assured by, the comments of the Financial Secretary to the Treasury, Ruth Kelly MP, during a debate on Standard Life and FSA Regulation (on 4 February 2004 in Westminster Hall), reproduced below for ease of reference -
"Let us consider the mutual sector and the Government's view of mutuality. The Government believe that financial mutuals have specific, distinct advantages since they do not have shareholders to whom they have to pay dividends. They can therefore deliver greater value to their members, either through higher returns to investors or lower interest rates to borrowers or both. The additional competitive pressures that diversity of ownership creates in the marketplace can deliver benefits to investors in mutuals and non-mutuals. We also value the strong links between many mutuals and their local communities, some of which have their roots in the co-operative self-organisation of working communities in the 19th century. Today, credit unions play a key role in promoting financial inclusion in local communities and the Government are keen to encourage that valuable work.
"The Government and the mutual movement have a shared interest in an inclusive society in which all have equal access to the means to participate to the best of their ability. We also have an interest in markets as social institutions that confer rights and obligations in equal measure on the participants, and the exercise of individual liberty with the acknowledgement of individual responsibility. The Government are committed to ensuring that mutuals continue to serve the best interests of their members and wider society.
"As I said earlier, we have taken many steps to promote mutuality and encourage mutuals to develop in future. I hope that I can make more progress on the development of the mutual sector in the coming months and years. We are committed to the mutual sector and to proper and realistic financial accounting to ensure that firms recognise the true value of their liabilities and that they treat customers fairly. I hope that I have also shown Hon Members that the FSA has no indirect or covert agenda to disadvantage the mutual sector. The Government and the FSA value diversity in promoting competition and ensuring that consumer needs are fully met."
The Association hopes that in negotiating CAD 3 the Government bears in mind this statement.