N&P: Country folk lead Europe to IRB status

Following N&P’s lead

HQ at the N&P: it won’t grow for the sake of growing, it’s choosy about the assets it acquires

Despite its humble attire, N&P has managed to gatecrash what many people thought would be a snooty and exclusive big banks’ club. Matthew Bullock, the mortgage provider’s chief executive, sees it as one of the most important achievements of his eight-year tenure but he also says that N&P had no choice but to succeed: "It’s nice to be first but it’s really a sine qua non – without it, you’re going to be substantially disadvantaged. Some organizations who don’t have it will fail because they don’t have it."

Using the internal ratings-based approach, or IRB, banks are allowed to work out how much regulatory capital they need to protect themselves and their stakeholders from severe credit losses – as long as they can satisfy regulators that they know what they’re doing. The general idea is that lenders use historical data to work out how likely a loan is to default, how likely that a write-off will follow any default, and how much money they stand to lose if that happens. Once a lender has a clear idea of the risk it faces, it can work out how much capital to hold by stressing the figures – predicting what would happen to default rates and loss severity if the economy were to go into recession, for example. It might sound nerdy and dull but it’s a revolutionary change from the old prescriptive regime, and banks that get the regulatory green light expect to gain a decisive competitive advantage over everyone else.

For mortgage lenders such as N&P, it’s a particularly big deal. IRB banks with high-quality home loan portfolios will see their regulatory capital requirements slashed – Bullock is coy about the numbers but says that the capital required to support N&P’s £2.8 billion ($5.64 billion) mortgage book has been cut "appreciably". The spare capital can now be used to support further growth of the mortgage book – or expansion in other areas. Lenders with IRB status will also be in a better position to compete for fresh loans because they will have a clearer understanding of the risk in new business and can cut or raise rates accordingly. In short, says Bullock: "It means we offer tight prices for good risk. Of course, we also offer lousy prices for bad risk. And if you look at what’s happening in the markets right now, that might not be such a bad thing."

But it’s one thing to recognize the importance of the IRB and quite another to convince regulators that you can calculate your own solvency requirements. As the Basle II project ground into life in 2001, there was some debate among regulators about whether it was worthwhile opening the door to small institutions, which were assumed to lack the data and the skills needed to model credit risk. "There was a presumption that small firms couldn’t do it," says Jeff Pritchard, N&P’s director of risk and compliance "But I always knew that we could."

Scratch N&P’s surface and it becomes easier to understand Pritchard’s confidence. The little building society buzzes with smart ideas – a lot of them imported from leading financial institutions – and is full of people who know how to make those ideas work. Pritchard himself joined N&P in 2000 from risk software vendor Lombard Risk. He had previously been in charge of risk management at Svenska Handelsbanken in London. Earlier, he’d run the Swedish bank’s derivatives business in the city. Bullock spent most of his earlier career at Barclays, running its regional operations in Yorkshire before being called back to London in the aftermath of the last UK housing market downturn to help modernize the bank’s approach to credit risk. He went on to lead relationship teams dealing with large corporate clients at Barclays’ short-lived investment banking and trading arm, BZW. N&P’s board risk committee, meanwhile, is chaired by Alan Brown, the former head of group credit risk at Barclays, with whom Bullock revamped the bank’s lending controls in the early 1990s. Other execs and board members come variously from Prudential, Rothschild, NatWest, PricewaterhouseCoopers, and software firm SAS.

"When I arrived here, I knew that we needed the same capabilities that I’d helped build at Barclays," says Bullock. His new colleagues were initially baffled, he admits: "It’s not often that you get someone who is both a risk management expert and a corporate financier taking over a retail bank, so when I started asking things like ‘what’s the cost of capital?’ I got a lot of blank looks," he says.

That’s no surprise. Since building societies are mutual companies, their capital comes from their members rather than the markets, so cost of capital is an alien concept. Because capital isn’t seen as a scarce, costly resource, building societies tend not to measure returns relative to capital – nor do they think about returns relative to risk. Instead, one-dimensional metrics such as growth and margins are the traditional yardsticks of success.

Bullock was undeterred. The opportunity to "bring sophistication to the High Street" is one of the things that sold him the job at N&P, he says – and he also saw it as a strategic imperative. As a result of his exposure to rapidly evolving credit markets at BZW, he believed that banks were entering a period in which liquidity would become increasingly cheap and plentiful, driving down the returns on offer to lenders while – initially at least – also masking the risk. "If we were going to survive and thrive in a difficult environment, we needed to set ourselves minimum acceptable targets for return on capital and hit those targets without taking too much risk," he says.