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, economics editor Article written by Robert Peston Robert Peston Economics editor

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  • rate this

    Comment number 94.

    the banks have had 4+ years to revise the 'creative' accounting used in auditing subprime mortgages.
    They have had the time but not the will.
    are they the laziest bunch of spongers ever.....

    how many mortgages are buy-to-let as opposed to single ownership?

    Until the govt gives a taxbreak to owner-occupiers and starts to tax buy-to-let after deduction of mortgage interest housing bubble remains.

  • rate this

    Comment number 93.

    RP "In gripping & slightly alarming research M/Stanley cites £143bn of high quality mortgages on the books - and it calculates that Lloyds holds just £314m of capital against the specific risk of these mortgages going bad."
    ~ ~ ~
    Think clue may be in words & MS are getting excited over nothing.

  • rate this

    Comment number 92.

    You couldn't make it up.

  • rate this

    Comment number 91.

    Robert, is the process you describe in the Casino or the safer Amusement Arcade part of traditional high street banking? If it is the latter aren't we are lucky to have the financial acumen of the UK government pulling the levers?

  • rate this

    Comment number 90.

    Capitalism feeds the Greedy Ego or Id. The financial system or money has had its time and because MP's dont understand the system unlike say computer programmers who build complex systems not to mention the software that runs the financial system, MP's fall victim to what Milgram & Asch noted with obedience and conformity. Watch Dan Pink: The puzzle of motivation to see how screwed up things are!

  • rate this

    Comment number 89.

    87. Blacksheep.
    The oldies with garden forks were the Home Guard and they mobilised to defend these shores from invaders. No need for that today, nothing left here worth having.

  • rate this

    Comment number 88.

    lack of construction is a symptom not the cause. The cause is banks have unrealistic fractional reserve ratios. The BoE has printed money and handed it to the banks who sit on it (rather than lending to business) to reduce the ratios

    better to take the interest rate medicine in one hit than a long slow death. How do you kick start the economy when the banks are broke and QE = inflation

  • rate this

    Comment number 87.

    Who cares about banks?

    World War 3 started yesterday! Come on people, pack your kiddies off to the countryside. Join up at your local recruitment office. Paint your windows white. Old fellas - grab your garden forks and broom handles and get down to the church hall - Captain Mainwaring is waiting for you.

    The writing is on the wall sheeples!

  • rate this

    Comment number 86.

    FauxGeordie, Botannic88, Average Joe & Comrade Ogilvy - not all mortgages go bad at once, and they generally take time to go bad, and the average loan to value mortgage in the UK is only 60% of property value, so a truly spectacular collapse would be needed to really dent banks capital. Hude demand for housing - not enough construction - that is the real problem!

  • rate this

    Comment number 85.

    What do you really expect if you let bankers run (and regulate) the banking industry?

    For sure, there is an argument of setting up the 'poacher as the gamekeeper', but that's clearly not a way to bring new blood into the industry.

    In fact, some would say it's more realistically like turning the mad-house over to the in-mates.

  • rate this

    Comment number 84.

    JfH is living in the self constructed fantasy world again thinking that a 5% interest rate or even one of 2 (BoE) would not have the most dire effects on the finances of millions of people and lurch the economy into depression and junking the value of banks. Not so much cold turkey but more cold bread and dripping. The economy needs to be kicked back into life and the debt problem starts to ease.

  • rate this

    Comment number 83.

    Weak UK housing market is contributing to economic doldrum, a further tightening of credit conditions would be regarded as highly UNWELCOME by the Treasury! So what?
    Govt neeeds to ask: who does it exist to govern - the huge investment banks or the taxpayers. Basel II (then III) is imperative, especially for banks too big to fail BECAUSE they are to big to fail.
    Fix it quickly…or fall.

  • rate this

    Comment number 82.

    @72 The balance of supply and demand has been fundamentally skewed by the BoE's rate setting, so normal rules don't apply I'm afraid.

    @72 There are 900,000 empty houses, so that's nearly 4 years of spare capacity for you.

    Wake up and smell the coffee. The housing market is behaving as a function of the BoE keeping banks on life support.

    Let them fail, or should we keep kicking the can a la EU?

  • rate this

    Comment number 81.

    Robert. No one seems to be mentioning the "Leverage Ratio" to be brought in under Basel III (too busy ranting about unrelated topics). A ratio of 3% will be introduced which will reduce balance sheet exposures to 33* capital. The whole purpose of this ratio is address the realisation that risk sensitive weighting of assets for capital allocation purposes failed to mitigate risk.

  • rate this

    Comment number 80.


    Yes, that noise from vested interests stipulating housing shortfall, is reaching crescendo now. Like a boomerang it seems to repeat itself every 20 years or so.

    That shortfall is all in the South East. It's for the Government to create conditions in other parts of the country to reduce overcrowding in SE. Some imaginative, bold, perhaps not very-PC initiatives are required...

  • rate this

    Comment number 79.

    I don't understand why people are calling for a housing market crash - US, Spain and Ireland mean anything?

    In the US and Spain, banks are purposely maintaining repossessed houses in order to limit supply and maintain prices.

    When you go to your Chinese creditor and say the value of the asset no longer covers the debt against that asset, what do you think that creditor will do? Bye bye.

  • rate this

    Comment number 78.

    As lots of people here have stated over the years, technically the banks are all bust.
    Can’t raise interest rates = can’t devalue assets = can’t get out of depression.
    It’s time to let the banks go or the entire country will be destroyed.

  • rate this

    Comment number 77.

    just reminds us again that it is the high st banks that are the major danger to the uk economy not the investment banks

  • rate this

    Comment number 76.

    This is a shocking abuse of the capitalist system. Why on earth should it be possible for banks to create all the money in the system. That is a very nasty monopoly. One where the normal citizen would go to jail. They forge money in existance and then have the audicity to try to get even more profit out of the process. It is time for full reserve banking. See

  • rate this

    Comment number 75.

    The risk of mortgage lending depends, among other things, on the proportion of value lent. Probably the article is right and overall provisioning is too low, but it would still be reasonable for some banks to give lower risk weightings than others, if they are demanding higher proportions of equity from their borrowers.


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