If implemented, the proposals could lead to a significant increase in the amount of capital held against some residential property lending, including to most first-time buyers, buy-to-let lending and the commercial funding of housing associations.
According to the CML, mortgages in the markets affected would become scarcer and more expensive if the proposals are implemented, as the costs imposed could lead some firms to withdraw from these markets altogether, reducing choice and further disadvantaging consumers.
Under the current system, some larger lenders are able to use a more advanced, internal ratings based approach. Under this more complicated model, firms calculate their own risk weightings. The IRB approach takes into account a broader range of measures, including the probability of default on different types of lending and potential losses, given default, and uses the lender’s historic data when calculating risk weightings.
In the aftermath of the financial crisis, some commentators and regulators have suggested that the system had been open to exploitation by banks, and that this was a major contributory factor to the financial crisis.
The new proposals seek to strengthen the existing regulatory capital standards in several ways. The measures would mean less reliance, for example, on credit ratings to determine risk weightings, and make it more comparable with the IRB approach.
Built into the Basel proposals is an explicit re-evaluation of the risk weightings for residential mortgages, and an implicit re-weighting of buy-to-let lending and the funding of housing associations.
For residential lending, the proposals are extremely radical. Instead of applying an across-the-board 35% risk weighting to lower LTV mortgages, risk weightings would be based on two aspects of the loan: the amount advanced relative to the value of the property (LTV) and the borrower’s debt service coverage ratio.
Lending to individuals with low LTV and DSC ratios would attract a low risk weighting, potentially as low as 25% (if the LTV was lower than 40% and the DSC ratio was no higher than 35%).
But mortgages at higher LTVs (of up to 100%) and higher DSC ratios (in excess of 35%) would attract a much higher risk weighting, in this case a weighting of 100%. Moreover, weightings would be determined at the time the loan is advanced, and not updated thereafter.
The CML said:
"We have considerable reservations about the proposals. While we agree that LTV can be a relatively good predictor of default, we also know that what happens to a loan over time has an important bearing on the outcome.
"As house prices rise over time (and the LTV ratio therefore falls), the potential for default declines. A static, historic LTV calculation therefore provides little insight into the potential for default five, 10 or 20 years down the line.
"Our submission to the Basel authorities will therefore suggest that lenders should have flexibility to adjust the value of the property – and hence the risk weighting – over the lifetime of the loan. If this is not permitted, lenders will have an incentive to encourage re-mortgaging or the “churning” of loans to take advantage of a lower risk weighting as house prices rise and LTV falls.
"The proposals are also likely to raise capital requirements for all lenders, which will raise the cost and limit the supply of mortgages. This will have consequences for lending in specific areas of the market, with first time buyer loans in particular becoming scarcer and more expensive – at a time when it is already difficult for people to get into the housing market.
"In the UK, lenders already apply a stressed affordability test at the time the mortgage is advanced as part of the MMR requirements. We believe that this provides sufficient insight for lenders to assess the risk of lending."
