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 234.

    Re: 230. robbieAA - I don’t think you’ll find many (if any) of those 100%+ mortgages from any of the front-line lenders in at least the last 5 years. If anyone managed to get one at high-street interest rates then they're lucky.

    232.harbourmaster also makes a good point – the difference between bank borrowing and lending rates quickly builds up a buffer against an overall loss on a loan.

  • rate this

    Comment number 233.

    We need to define a "Dangerous Risk".
    If Joe Public keeps on bailing out duff Bankers how can any Bank

    Everything to gain.Nothing to lose.

  • rate this

    Comment number 232.

    Banks taking the risk on providing loans?

    Isn't that why we pay them interest?

  • rate this

    Comment number 231.

    @ That_Ian 168.




    Policy - not controls / the boards being out of contol yes / lending made directly by board members / FSA useless or not doing job.

  • rate this

    Comment number 230.

    Not strictly true, AgeTheGod. Many house purchases were made in recent years with 100% or even 125% mortgages on an interest only basis. No attempt was made to pay off any of the capital. The banks and those who purchased were relying on ever increasing house prices to pay off the capital. It will be interesting to see how they cope when the bubble eventually bursts!

  • rate this

    Comment number 229.

    all bubbles burst.....

  • rate this

    Comment number 228.

    Too Bust To Save

  • rate this

    Comment number 227.

    The problem we have with unravelling these things can be traced back to deficient accounting standards, the lax behaviours they have helped foster and hide. Throw in ineffective auditing and its become a mess. You have to use the separate regulatory returns to even begin working out how badly fudged the numbers might be (guestimation). The framework for impairments and loan losses is a joke

  • rate this

    Comment number 226.

    Excellent piece Mr Peston. One thing that is probably worth mentioning is that although Lloyds have probably levered up significantly on this part of thelr mortgages book, the mortgages themselves are probably very de-leveraged (I.e low LTVs). In pure cash terms it actually is probably over-prudent to reserve too much against assets for which you have a signifcant charge over.

  • rate this

    Comment number 225.

    The banks are not passing on the record low interest rates to house buyers or business - that is result of Labour govts too big to fail rescue of banks in 2008.
    Banks are making more profit on low interest rates now thatn they were in 2007 when interest rates were at 6+% - hence the Libor scandal. Banks just serve their own interests not those of the public - ie partly why UK does not 'recover'.

  • rate this

    Comment number 224.

    Rather than enduring 20-30 years of decline in a zombie like existence (if we are lucky), wouldn't it be better to suffer carnage in the housing market for 2-3 years while we finally fix the economy ?

  • rate this

    Comment number 223.

    So, how many of these Lloyds mortgages have actually defaulted in, say the last 2 years; the answer appears to!

  • rate this

    Comment number 222.

    202.Sutara - "......If neither Gov't or Jo Public have the money - who's paying for the 'recovery'?"

    As the on of the two great economists of history (along with Adam Smith) John Maynard Keynes got it right - Govt borrows the money, invests it wisely, the economy grows & we're all richer.....Govt are borrowing the money anyway:

  • rate this

    Comment number 221.

    There's still room for 30% price falls
    Correct if eg EU crashes out with Ireland & Greece & Spain dragging UK taxpayer into major bank bail outs again with more pressure on UK ave incomes also dragging more into mortgage arrears. However, 30% increase more likely in next 4-6 years as UK population pushes demand for resi housing creating rent & price inflation - banks sit tight

  • rate this

    Comment number 220.

    Yet another dismal example of the failings of UK style QE. Is the Fed not buying housing debt in the US to free up working capital for industry?

    The UK economy will end up as an elitist group of rentiers and commodity speculators with no productive capacity at all if we allow Mervyn King Canute to carry on with his disastrous plan.

    Lets hope the Vickers axe is being properly sharpened!!

  • rate this

    Comment number 219.

    steve says.... he doesnt understand the basic principles of where money comes from. The banks do not just lend out depositors money, they invent it, which should be the job of 'government'. The problems we are now experiencing are due to the banks inventing so much money there is no chance of ever paying it back. Which is why they deserve to be 'bashed', because it is all their fault.

  • rate this

    Comment number 218.

    a weak housing market contributing to our malaise.... housing market to ever recover properly...

    you are assuming the housing correction has already taken place. I would say that the price corrction has NOT yet taken place and house prices are being artificially maintained by reductions in housebuilding in public sector and articifical low interest raes.
    There's still room for 30% price falls

  • rate this

    Comment number 217.

    Re: 130. That_Ian

    Not really – anyone 10+ years into a mortgage and still paying it will have repaid a significant chunk of capital so the risk becomes even lower for the bank – they only have to get the outstanding money back not the original loan amount.

    Then, of course, what %age of mortages are 10 to 15 years old mortgages and still on the original terms?

  • rate this

    Comment number 216.

    Permission from Basel ll - biggest banks to use own internal risk models to determine riskiness of categories of loans & amt of capital they need to hold as a protection against souring of those loans.
    Role of regulators was to APPROVE RISK MODELS. After that,, banks had discretion to decide the riskiness of different kinds of loans.
    So, was it not the REGULATORS that really failed?

  • rate this

    Comment number 215.

    @ 165/166 nautonier

    We have a national catastrophe as successive govts have lacked strategic planning - infrastructure v population growth & demand for public services - all the banks do here is restrict lending & at some point house prices & rentals will inflate due to expanding population & improve bank balance sheets - banks can see demand does not match supply = inflation


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