Are banks taking dangerous mortgage risks?

Lloyds bank sign

After we learned in 2007 and 2008 that banks in general had far too little capital as a protection against losses on their loans and investments, you would probably think that by now it would be difficult to find examples of banks continuing to lend several hundred times the sums they hold in reserves to protect depositors and taxpayers against the risk of picking up the bill when borrowers default.

You might think that, but according to the banking team at Morgan Stanley you would be wrong.

In gripping and slightly alarming research published this morning, Morgan Stanley cites £143bn of high quality mortgages on the books of Lloyds - and it calculates that Lloyds holds just £314m of capital against the specific risk of these mortgages going bad.

In other words, Lloyds seems to have lent 455 times the value of the capital earmarked in its balance sheet to absorb losses, just in case these mortgages go bad. To put this in another way, just 0.2% of these mortgages would have to go bad for this capital to be wiped out.

Now Lloyds may be right that these really are the most succulent and prime of loans, where the probability of them going bad really is more or less zero.

But history, especially recent history, would probably remind us that by the time a bank has lent £143bn to any sector, the idea that there is a negligible risk of default is naive (at best).

The important question, however, may be how it is that Lloyds and the other big banks are allowed to lend such large multiples of their protective capital in the form of mortgages?

It is all down to our old friend, the Basel Rules, which attach risk-weights to different categories of loans. And in this instance, the culprit (if that is the right word) is the permission that was given under so-called Basel ll to the biggest banks to use their own internal risk models to determine the riskiness of categories of loans and - by implication - the amount of capital they need to hold as a protection against the souring of those loans.

The role of regulators, in this system, was to approve the risk models. But once that had been done, banks had discretion to decide the riskiness of different kinds of loans. And what won't surprise you is that banks' model all came to the conclusion that their own mortgages were significantly less risky than the standard Basel rules implied.

Just to remind you (needless I am sure), the current convention is that banks need in general to hold equity capital equivalent to around 10% of their loans. But this is not 10% of their gross loans and investments, but 10% of their loans adjusted for the putative riskiness of said loans.

So, for example, if all loans were perceived to be equally risky, then Lloyds would have to hold equity capital equal to 10% of that £143bn portfolio of high quality mortgages, or £14.3bn. But Lloyds believes that the probability of these loans going bad is negligible, as I have already mentioned, so its own regulator-approved risk model attaches a risk weight to the loans of 2.2%.

In other words, Lloyds - with the support of the Financial Services Authority - says that the risk-weighted value of these loans is just £3.14bn, and therefore it holds capital equivalent to 10% of that low number as a buffer to absorb losses on the entire £143bn gross value.

If you were to think that is slightly bonkers, you might not be alone.

Now this freedom given to banks to decide their own risk ratings, or what is known as the Internal Ratings Based Approach to determining capital, yields the following consequence for our biggest banks: they all hold relatively modest amounts of capital against their large books of mortgages.

So Lloyds, for example, attaches a risk weight of 16% on average against its entire book of mortgages. And in case you think Lloyds is being singled out as somehow taking an unusually optimistic view of the risk of mortgages going bad, that would be wrong.

According to Morgan Stanley, HSBC, Barclays, Santander and Nationwide all take a rosier view than Lloyds of the likelihood of default by homeowners. They respectively attach risk weights to their mortgage books of 15%, 15%, 14% and 11%. Only RBS, for reasons that are unclear, uses a much higher risk weight of 27% on its mortgage book.

Just to repeat, what that would mean is that when Nationwide, for example, lends £100,000, it attaches a risk-weighted value to that loan of £11,000 - and then holds capital equivalent to 10% of that £11,000, or £1100, to cover the danger of that loan going bad. Which would imply that Nationwide is frequently lending not far off 100 times the value of its capital.

Now the reason Morgan Stanley has been taking a keen interest in all of this is because of the noises coming out of the Financial Policy Committee - the new macro regulatory arm of the Bank of England currently working in an informal capacity but soon to have statutory powers - that the capital banks hold against mortgages is too low.

Or to put it in the jargon, the Bank of England may well try to reduce the so-called leverage in the mortgage market.

It would want to do this for three reasons:

  • It is not beyond the realms of possibility that the UK housing market could at some stage lurch downwards, foisting bigger losses on banks than their dedicated capital could absorb
  • When a category of loans, such as mortgages, benefits from such low risk weights, it can distort the economy, by giving incentives to banks to provide mortgages rather than other (potentially more useful) types of loans
  • If the housing market were ever to recover properly, the low risk weights could fuel another dangerous bubble

But there is a non-trivial problem with moving fast to remedy this alleged flaw. If banks were told, for example, to very rapidly increase their risk-weight for mortgages to the Basel standard of 35%, as has been recommended in Switzerland, they would either have to raise many billions of new capital (£17bn says Morgan Stanley), which would neither be cheap or easy right now, or - which is far more likely - they would simply shrink the amount of credit they provide in the housing market.

And at a time when a weak UK housing market is contributing to our economic malaise, a further tightening of credit conditions would be regarded as highly unwelcome by the Treasury - and it would go against the grain of government and Bank-of-England policy, in the form of their Funding for Lending scheme to provide more and cheaper loans to households and businesses.

So, as ever with the imperative of fixing what went wrong during the boom before the great crash of 2007-8, it is pretty obvious what needs to be done to provide a more stable financial system. Unfortunately, in the short term, the cure can hurt us all.

Robert Peston Article written by Robert Peston Robert Peston Economics editor

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  • rate this

    Comment number 74.

    66/7 J_f_H

    I completely agree.

    Banks ARE bust. House prices will have to fall. Interest rates need raising. Not sure how many people are grasping the underlying problem that the BoE has opted to prop up the broken banking system rather than administer the medicine of higher interest rates.

    The problem is the medicine will be hard, but a much better long term solution than currently on offer

  • rate this

    Comment number 73.

    Do you propose the BoE increases interest rates - just like the Federal Reserve did - thus increasing the interest paid on mortgages for all those who have a variable-rate mortgage?

    In the US, that tilted people over the edge, causing huge numbers of defaults and a housing market crash - not price fall, but a price crash.

    House prices are falling - they haven't kept up with inflation!

  • rate this

    Comment number 72.

    JfH: the idea that house price will crash is simply wrong. What we have is a mismatch between supply and demand

    There are approx 18m households in UK, we need to build c 250,000 new homes every year, yet average about 100,000. That means every years we increase the supply shortfall by about 0.5% of total housing stock. For a couple of years that does not matter, for 20, it creates price rises

  • rate this

    Comment number 71.

    Repo risk?

    Actually even when rates rise substantially the volume of repossessions will be far lower than the housing market soothsayers (bubble fools!) would have us believe.

    Why? Because borrowers have seen what is happening & have been repaying debt as fast as possible - which is the market forced reaction caused by the idiots at the BoE.

    Don't worry about repossessions- just banks!

  • rate this

    Comment number 70.


    The massive demand for houses exists because the normal supply and demand rules have been suspended - through the BoE actions. BoE are protecting their chums in the City to the detriment of just about everybody else. If the house prices were allowed to drop, just as they have done in all previous recession, the demand would have followed too

    Yet BoE prefers to imitate Japan

  • rate this

    Comment number 69.

    High house prices = rich get richer as land values increase and poor see their labour devalued. Why else would Mervyn King have got a knighthood while ruining the economy?
    Households mired in mortgage debt and the next stage is the financial sector snatching the equity from people who bought while prices were cheaper. Pensions/savings trashed by QE so pensioners forced to do equity release debt.

  • rate this

    Comment number 68.

    "Oh dear Bob - you really don't understand mortgages do you! The reason why so little capital is required as the banks can reposess the properties if the loan defaults, so the chances of loss really are quite small"

    Hysterically funny. Dim greedy City boys really can't add up enough to work out what happens when the prices collapse.

    I'm sure they'll give us the bill so why would they care

  • rate this

    Comment number 67.


    It is all about a prudential price for money. Today bank rate should be 4% ish at least! (Mortgages at 8% with 40% deposits - 10% with 10% deposit.)

    The present ludicrously low price of money (1/5 of the previous 300 year low) will go on destroying any hope of recovery in jobs - the recovery will be jobless - if at all!

    Rates must rise - so the banks (&BSoc) will go bust - sans option!

  • rate this

    Comment number 66.

    All mortgage providers are taking huge risks - and they know it -that is why the best offers are fixed very short term.

    The housing market is way above any sustainable price level for the UK to be able run the economy.

    House prices WILL fall. The problem we have is that the fools at the BoE are desperately trying to stop it happening so are making it far worse.

    The Banks are BUST!

  • rate this

    Comment number 65.

    #48 No Trevor, it is you who doesn't really understand mortgages!
    The risk is small when a only a few borrowers default, because the houses can be repossessed. But the risk is great when large numbers of borrowers default. Then the supply of houses would increase, probably accompanied by a reduction in demand. The value of the repossessed houses would plummet and the banks could easily collapse!

  • rate this

    Comment number 64.

    Noises out of Financial Policy Committee - new macro regulatory arm of BoE currently working in an informal capacity but soon to have statutory powers - that capital banks hold against mortgages is too low. Makes sense to me since BoE and Federal Reserve have a rather - well, incestuous relationship.
    2 countries in major danger of falling to lack of capitilization - US and Britain.

  • rate this

    Comment number 63.

    There's a reason why house prices are artificially high, and why the current bubble refuses to burst. We should have seen a correction in prices now, but the BoE has opted to fund bankrupt banks rather than savers, pensioners etc.

    This is how a bubble works:

    The BoE has prevented it from bursting w/ low interest rates and £bns of QE.

  • rate this

    Comment number 62.

    "I notice the BBC completely refused to report that Northern Rock shareholders will not to be abe to gain justice through European Courts"

    Yah absolutely. The BBC should have kept its mouth SHUT so the gravy train could keep on rolling for all those City boys laughing up their sleeves at an atrociously run public company.

    It was in fact a RESPONSIBILITY to keep quiet coming up to bonus time

  • rate this

    Comment number 61.

    I notice the BBC completely refused to report that Northern Rock shareholders will not to be abe to gain justice through European Courts.

    Probably a guilty conscience.

  • rate this

    Comment number 60.

    As of Octobr 1st, I see US - 8 largest banks - is still talking about implementation Dodd-Frank Wall Street Reform & Consumer Protection Act of 2010s; US has not moved forward with Basel II or Basel III.
    Banks in Canada, I am proud to say, were among the first to comply with Basel II rules.
    Why can't US move. Talk to its 8 largest banks = lack of adequate capitilization.

  • rate this

    Comment number 59.

    Here are two examples of how it could all go wrong for the banks and the mortgagees. both properties within 4miles of Leeds in good class areas.sold under distress situations.
    (1) Five/Six bed detached in just under two acres in good condition marketed by the agents for 1.1 Million price realised after final and best offers £540,000
    (2) four bed detached valued at £400.000 realsed £245,000

  • rate this

    Comment number 58.

    The banks have access to our income tax via SMI etc. and FSA permission to hide problems under the carpet by switching repayment mortgages to interest only and past retirement dates. Everything is being done to try prove Mervyn King right that we didn't have a housing bubble. When Deputy in 2003 the MPC cut rates when inflation was over target and HPI at 24.9%. Saving and labour devalued.

  • rate this

    Comment number 57.

    But 'Trevor', you are assuming that the banks will get most of their money back when they sell those properties they have reposessed even in a market of falling house prices. And in Spain thats not working out too well.

  • rate this

    Comment number 56.

    2) A 100% risk rating requires a 10% capital buffer - RP are you suggesting that the entire mortgage book of UK lenders (some being loans probably less than 5% of current asset surity value require a 10% buffer or is it not sensible to adjust the level of buffer according to the potential risk?

  • rate this

    Comment number 55.

    Perhaps we should just tinker around the edges and prop up the failed system of banking we quite blatantly have then.

    The great and the good will surely behave themselves now. They were very naughty and cost us £800bn + but since then they've only rigged LIBOR, spanked us all with PPI, kept the bonus culture ...

    We need root and branch change, not a slap on the wrist.


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