The mills of the regulators grind slowly, but exceedingly fine. At long last, the UK’s Prudential Regulation Authority (PRA) is embarking on a consultation into meaningful changes to internal ratings-based (IRB) assessments of UK mortgage risk weights, the models by which big banks are able to sidestep the harsher risk weights generated by the standardized approach (SA).
Why does it matter? For two reasons. First, as the regulator notes in its consultation paper (CP14/20, dated 30 September, 2020), the pattern of steadily falling IRB risk-weight outputs in the UK when it comes to mortgage lending raises obvious concerns about whether banks are provisioning cautiously enough.
Since 2014, according to the PRA, the average IRB mortgage risk weight in the UK has fallen from 13% to 10%. This compares to 35% under the SA. The regulator says that it is worried that “some IRB UK mortgage risk weights may not fully reflect the potential for losses in unlikely, but possible, tail scenarios.” That’s because some risk weights go as low as 4% for individual loans.
Its second reason is perhaps more interesting, though. It relates to the PRA’s secondary remit around competition. That remit doesn’t go as far as many small banks would probably like – the regulator does not commit itself to actively promoting competition, for example. But it does have a goal of ensuring that competition is not harmed.
This is what is in regulators’ minds when they write in the consultation paper that “there can also be large differences between SA and IRB mortgage risk weights. Where such differences are unwarranted, this can distort competition. Reducing unwarranted difference would advance the PRA’s secondary competition objective.”
Uneven playing field
Back in 2016, the debate around the uneven playing field for the UK’s challenger banks was intense. Paul Lynam, chief executive of Secure Trust Bank, was then and still is a standard-bearer for the sector. In his capacity as chairman of the challenger banks panel at the British Bankers’ Association (BBA), he would appear before parliamentary committees or meet with Bank of England officials.
While researching our story on the UK’s challenger banks in October 2016, I went to see Lynam at his bank’s headquarters in Solihull, where he was particularly exercised about the lack of a level playing field when it came to risk weights. “The real cause of the lack of effective competition in UK banking is the extreme capital discrimination against challenger banks and small building societies,” he told me at the time.
Has much changed since then? And does the PRA’s new consultation make Lynam more hopeful than before?
These days he is the challenger bank lead on the board of UK Finance, the trade body that was set up in 2017 to replace several associations, including the BBA. Covid-19 prevents a return trip to Solihull, but Lynam joins me via Microsoft Teams to shoot the virtual breeze.
“The situation for challenger banks hasn’t really moved on at all,” he says. “There’s been plenty of talk but not much in the way of action.”
That doesn’t sound great, but he notes that at least the PRA is finally looking like it might be about to remedy the situation a bit. In its consultation paper, the regulator agrees with him that things have got worse over the years, not better.
One impact of model-based risk-weight assessments is that they distort the market hugely in favour of the biggest banks. And the result is to make parts of the industry more risky, not less.
The capital advantage that big banks have creates a massive barrier for smaller firms
Paul Lynam, Secure Trust Bank
Even if one accepts that the data that models are using are meaningful and a risk-weight output of 4% for the highest quality mortgages can be justified on that basis, the fact that small banks still have to impose a risk weight of 35% for the same lending under the standardized approach creates a concentration of risk in small banks. Because the model-based advantage is more pronounced in higher quality credits, that’s where big banks put their focus.
“The capital advantage that big banks have creates a massive barrier for smaller firms,” says Lynam. “It means they are all herded into the upper end of the LTV [loan-to-value] spectrum, where the big banks are less active, which by definition makes smaller firms more risky.”
The competitive angle is an important one. You could make a reasonable argument that a 10% LTV mortgage on a prime property should be zero risk-weighted, on the basis that the asset could lose 90% of its value and the lender would still get its money back. But that doesn’t get around the problem of the standardized approach, which banks that don’t have access to sufficient data and modelling power have to use.
The bigger picture
Lynam welcomes the PRA’s new consultation, which looks likely to result in some kind of risk-weight floor that would take precedence over a bank’s IRB outputs. It is proposing a minimum risk weight of 7% for an individual mortgage, and an exposure-weighted average of 10% for a portfolio.
The PRA notes that the latest tweaks to Basel III will mitigate the situation a little, because individual SA risk weights for low LTV mortgages will fall to 20%. Basel is also targeting IRB models, with output floors of its own. But these changes will not be fully implemented until 2028 and they apply to entire balance sheets, meaning that individual segments of lending may still be using inappropriately low risk weights. The PRA is proposing to implement its changes from 2022.
Rob Smith, banking risk partner at KPMG, sums up the twin dynamics of the PRA’s proposals.
“It will increase banks’ capital requirements which, against a backdrop of low return on equity and other challenges created by the pandemic, could further depress profitability,” he says. “More positively from a challenger bank perspective, the changes could increase market competition as larger banks won’t be able to take as much advantage of their models.”
In the US banks go bust all the time, but here the tiniest bank is regulated on the basis that it is too big to fail
Paul Lynam
The bigger picture here is the overall approach to regulation of UK banks, which results in the sector being dominated by a handful of very large firms.
“Why should small firms be regulated in the same way as systemically important or very international banks?” asks Lynam. “In the US you have real diversity and banks go bust all the time, but here the tiniest bank is regulated on the basis that it is too big to fail.”
Here’s where the most interesting changes might be afoot. For a while now, the PRA and Bank of England governor Andrew Bailey have been making noises about proportionate regulation of smaller firms after Brexit. What looks likely to be considered, once the sector is not bound by the approach dictated by the European Banking Authority, is some degree of discretion over the application of Basel standards.
Discretion needs care, of course, as does handicapping the IRB method in favour of standardization for its own sake. Euromoney has previously pointed out the dangers in regulators drifting away from risk-sensitivity.
But while the PRA’s consultation isn’t going to satisfy every smaller bank, it certainly looks like a step towards creating a more dynamic approach. A more level playing field should reduce risk concentration, which will reduce the importance of individual firms to individual market segments. In banking, a safer sector is one where failure is truly an option.
