CML: Learning the lessons of the past

In a wide-ranging speech to yesterday’s mortgage sector conference hosted by the Financial Services Authority (FSA), we put the case for regulation focusing on key areas of potential consumer detriment, better supervision of firms by the regulator and the restoration of a sustainable mortgage market.

The speech reflected initial feedback from lenders on the key regulatory issues we need to address.

It reinforced our view that the recently published Turner Review presented a thoughtful description of the global banking crisis and the breadth of issues to be addressed in the UK and internationally. The mortgage market is a small but crucial part of the jigsaw.

In making adjustments to the regulatory system, it will be important to unbundle broader, systemic banking issues relating to capital, accounting, liquidity and other matters from the review focusing specifically on mortgage lending.

We know from talking to lenders that the industry recognises a need for change. But we also believe that the mortgage conduct of business (MCOB) rules overseen by the FSA have largely fulfilled their purpose and do not need substantive amendment. We need to avoid change for the sake of it. But looking again at how the rules and principles are applied and supervised by the FSA might achieve a better overall result for consumers.

Some key questions

As the Turner review suggests, it is important that there is a proper analysis of areas of real consumer detriment – and what caused them. What we need is careful scrutiny of real problems in the mortgage market, not knee-jerk reaction to ill-informed perceptions. Our speech sought to identify a series of key questions for the debate about the shape of regulation, including:

Will the existing regulatory structure ensure that, in future, mortgages balance risk and price appropriately for the lender, and are suitable and affordable for consumers? If not, what do we need to change, and why?

Has the growth of remortgaging been a good thing (that is, a healthy indication of consumers switching effectively between providers) or has it been driven by a combination of churning by intermediaries, matched by serial re-financing by some borrowers?

Does the increase in mortgage arrears and possessions in the last 18 months show that lenders have lent irresponsibly in the past, that customers have over-extended themselves by borrowing irresponsibly, that lenders are taking possession too quickly and not treating their customers fairly now, or that higher unemployment is creating more payment problems, as might be expected in any economic cycle?

Have consumers taken sufficient responsibility for their own actions or relied too much on poor quality advice?

Has the government been right to promote a culture of home-ownership in its desire to create an asset-owning democracy in the UK, or has this simply led to more marginal borrowers taking out loans that proved unaffordable when those customers were confronted with a financial shock?

What sources of funding will be available to meet consumer demand for mortgages in the future, and what can the FSA do to help, rather than hinder, market activity? Will mortgage rationing continue? And should the FSA be seeking to re-open the market to improve economic prospects, and not close the door to interested lenders by its prudential attitude?

A starting point

We endorse the FSA’s view – set out in its business plan – that it should review the value chain, extending from lenders through intermediaries to consumers. There needs to be an acceptance of responsibility across the board, including by:

lenders, some of whom have mispriced some mortgage products, relaxed credit standards or relied too heavily on the securitisation market;

intermediaries, whose behaviour may have worsened the outcome for some consumers and who may need to accept changes to their future obligations and in the structure of their sector; and

borrowers, some of whom may have borrowed irresponsibly and may need other forms of protection, if they are not adequately protected by lenders’ affordability models or by the quality of advice they receive from intermediaries. “But,” the speech asked, “how do we introduce protection for the few without reducing the choice of the many?” And how can we do this without undermining the potential innovation and other benefits of competition that most consumers want to maintain?

Running in tandem with the debate now under way about the future shape of regulation in the UK is another one about regulation in Europe. “It is therefore absolutely vital that what the FSA does in this UK review runs with the grain on international issues, both in banking supervision more generally as well as mortgage regulation specifically,” today’s speech said.

Better regulatory supervision

We have already begun a process of consulting widely with members and, so far, four main themes have emerged. But we are only at the start of the process, and consultation with lenders will continue. So, the views expressed in our speech today are not our final word, but a first contribution. The first theme already clearly identified by lenders, however – and one which the FSA acknowledges – is a failure of regulatory supervision.

“The quality of supervisors needs to be improved,” the speech said. “The types of dialogue which supervisors and firms have are mixed, and we are some way from a relationship of mutual trust and understanding.

“A regulator seeking to instil fear will fail again. What we need to have, but we do not yet consistently have in place, is proper informed debates between firms and supervisors, and appropriate prudential requirements to match business models and risks.”

The role of intermediaries

The second theme emerging from our consultation revolves around mortgage distribution and the role of intermediaries. We have seen some of the problems created by customer churn, product and commission bias, the misrepresentation of borrowers’ income and poor quality advice.

We believe that larger intermediary firms are less likely to exhibit this kind of behaviour, and there is a need to look at a combination of enhanced intermediary authorisation, higher capital and professional insurance requirements for firms, more rigorous training and qualification standards for advisers, and a review of remuneration in the sector. “Market expectations suggest that the majority of future business will continue to come from mortgage intermediaries, so this is something we cannot leave to chance.”

The lending industry must, of course, accept its share of responsibility for what has gone wrong. Some lenders have priced products in ways that have encouraged consumer churn, or enhanced their commission for particular types of products, relaxed credit standards in products, for example, without income verification, or not priced properly for risk. With mortgage funds now scarce, however, this laxity is not likely to return in the foreseeable future.

Risky products?

Does this mean that we need to ban “toxic” products or even to put limits on loan-to-value ratios or loan-to-income multiples? We are asking members for their views, and will feed them into the debate. And the Turner review has said it will look at the evidence and experience in the UK and internationally.

We know that some countries already have loan-to-value limits. Some also have enhanced government-backed insurance. “We also know that the UK has developed better, more focused mortgage products to meet consumers’ needs at different times in their lives than in any other country in the world.”

So there has to be a balance between reducing risk and volatility, and reducing the availability of products that have benefited customers. These include higher loan-to-value loans that have allowed people to become home-owners, flexible mortgages which help financial planning, offset products that encourage both saving and borrowing together, equity release that helps people enhance their income in old age, products that comply with Islamic principles and so on.

There are ways of offsetting risk other than simply by banning products. Compulsory mortgage payment protection insurance, for example, might be preferable to simply stopping customers from taking out mortgages. Feedback from lenders has already highlighted the need for the FSA to look more closely at prudential risk and higher capital requirements for more risky business models. We believe that a product ban is too blunt an instrument and would not achieve its objective.

Reassuringly, the FSA accepts that the emphasis must be on getting it right, and not rushing to implement knee-jerk reaction in the way we warned against in our speech.

In his own address to the conference, Lord Turner made it clear that he had not made up his mind about banning products and made “no apology for that lack of certainty.”

He continued: “What I have tried to do today is to indicate that the issue is a complex one, which requires careful consideration and further empirical analysis, running up to the FSA September discussion paper, and indeed subsequently, in a wide-ranging debate.

“We do not need to rush to decision. We do not face today, nor are we likely to face any time soon, the danger of irrationally exuberant behaviour by either borrowers or lenders. We have time to get it right. And getting it right is very important, given the huge importance of the mortgage and housing markets to individual households, to banks, building societies and other credit intermediaries, and to the macro economy.”

The scope of regulation

We have consulted on whether lenders believe that regulatory scope should be widened. We first suggested that the FSA should regulate secured second charge lending in 1999. If that were to happen, however, it would be important for the FSA to manage any additional responsibilities without taking its eye off the ball of delivering the enhanced supervision we all want to see in place first.

Regulating buy-to-let lending is more problematic. There is support in principle for it among lenders, but should it be regulated by mortgage or investment conduct of business rules? And clearly an amateur landlord has a different regulatory need than a professional, perhaps running a sizeable business. A blanket approach would therefore be inappropriate.

Conclusion

So, what lessons can we learn from the past?

“First, the FSA spent too much time on the minutiae of consumer protection issues, and the treating customers fairly agenda, and insufficient time and rigour on prudential issues and systemic banking risks.” Regulatory activity therefore needs to be re-balanced. Recent feedback, however, suggests that FSA staff in their various silos are still pursuing too many small issues, rather than focusing on the “big ticket” risks.

Second, better supervision needs to be embedded within the FSA. Until that happens, there are risks in extending the FSA’s scope. But a view is emerging from the industry is that there may be a case for widening the regulator’s role to protect consumers taking out secured and buy-to-let loans.

Third, in a market influenced substantially by intermediaries, a culture of compliance must be enshrined in small firms to ensure that a better outcome is routinely delivered for customers in future. Otherwise, the structure of the intermediary sector will need to change.

Finally, there is a case to be explored for banning particular types of high-risk products. Our initial perception, however, is that risk can be addressed in more appropriate and better targeted ways.