The risk of unintended consequences

This month, Paul Broadhead, BSA's Head of Mortgage & Housing Policy, focuses on the PRA's consultation on Basel 3.1 and how some of the proposed changes can have a number of unintended consequences. 

This month, the BSA's Paul Broadhead turns his attention to the PRA's consultation on Basel 3.1 and highlights how some of the proposed changes can have a number of unintended consequences.

Paul is Head of Mortgage & Housing policy at the BSA. This article was first published in Mortgage Finance Gazette.

For the last three months, I along with some of my colleagues, have been reviewing the Prudential Regulation Authority’s (PRA) Consultation on Basel 3.1.  At 1,400 pages, it’s not a quick read!

In simple terms the Basel capital standards are intended to strengthen the risk management of banks, by setting out the amount of capital they need to hold against the risks they take. Changes in how Basel rules are implemented, from legislation to the PRA’s Rulebook, has provided the regulator with an opportunity to consult on the standards and how they are applied.

Overall, we welcome this review and support the direction of travel the PRA is taking, not least its intention to introduce more proportionality, which is critical for smaller firms, such as many building societies.

But as with all complex frameworks, some of the proposed changes can have a number of unintended consequences, and it’s important that we highlight these early to avoid distortion in the market, unnecessarily higher costs and/or detrimental impact on consumers.

It’s important to note that the Basel standards only apply to PRA-regulated banks and not the non-bank lenders. Therefore, some changes could very well have a distorting effect on competition, and potentially push some consumers to alternative lenders, and we need to ensure the PRA remains alert to this.

Within the new proposals, three areas that have particularly caught our attention as requiring further thought and consideration are:

  1. Property re-valuations

The proposals suggest that properties should be re-valued when a borrower requires a re-mortgage product switch, which we completely agree with. However, there is a lack of clarity given on the methodologies that will be acceptable. We need certainty that current market practices, which include a combination of physical valuations, desk top assessment, automated valuation tools and HPI indexation, which are applied depending on the risk, can remain.  

We believe that lenders adopt a level of conservatism when applying automated valuation techniques compared to physical valuations, meaning the likelihood of properties that have been assessed using these methods being over-valued and under-capitalised are extremely low.

  1. Self-build mortgages

In the Consultation, the PRA has proposed a significantly higher risk weighting (3.5x higher) for self-build mortgages compared to other properties. Our data shows that these mortgages typically experience lower arrears and loss rates than we see on standard residential properties – despite what Kevin McCloud might tell us on Grand Designs!

Self-build borrowers generally build a home that is far more energy efficient than other properties and so to apply penal capital treatment on this type of lending would be counter to the government’s climate change and net zero ambitions. Also, with the self-build sector accounting for approx. 15,000 new homes a year, which would rank it as a top five housing developer in the UK, deterring lenders from being active in this market could also have a significant impact on the government’s new homes targets too.

  1. Buy-to-let properties

Within the new proposals, lending to buy-to-let landlords with (up to three) properties can be carried out using the risk-weightings that apply to standard residential mortgages, as these landlords are not considered to be materially dependent on the income from their properties. Higher capital requirements, and therefore higher mortgage costs, are proposed for those with more properties. The challenge will be for lenders to find out how many other properties a borrower has at any given time.

There have been a number of recent changes negatively impacting buy-to-let landlords, most notably a reduction in the tax relief on mortgage finance. Other changes that are likely to hit many landlords financially are also coming down the line, such as the requirement to bring the energy efficiency of properties to EPC Rating A-C. These changes are already starting to show signs of impacting the housing market, as some landlords exit the market or offload less energy efficient properties. We want the PRA to exercise caution, and base any changes to the capital treatment for lending on these properties on facts, in this particularly sensitive area of the market.

It's not too late for changes to be made, the deadline for consultation responses is 31 March. We’re putting our thoughts together, which will quite simply be around the message that to grow the economy, the housing and mortgage markets need to be competitive and operate smoothly, and that requires a proportionate approach to the regulatory rules.