Building Societies Association Annual Conference 2004, Manchester
6 May 2004
Speech by John Tiner

1. Thank you for inviting me to your conference this year. It is a particularly good and timely opportunity for me to speak about a number of issues facing Building Societies, as we are just 178 days away from the start of mortgage regulation.

2. I note that the BSA, with its usual far sightedness, has lined up sessions and FSA speakers at this conference on financial crime prevention and financial capability, both key areas of focus for us in the next year. I see also that a whole seminar session is being devoted to Treating Customers Fairly, a central plank of the FSA's key strategic aim of helping retail customers to obtain a fair deal.

3. So, to avoid duplication. I will concentrate on four other main aspects of your business. First, the implications for both lenders and advisers of the new rules on "responsible lending" that are embedded in our Mortgage Conduct of Business Sourcebook. Secondly, consumer indebtedness, and particularly the risks to both consumers and to you as lenders arising from the continued upward trend in borrowing, house prices and interest rates. Thirdly, to look at the risk implications of building societies understandable strategy to develop alternative sources of income. And finally, some thoughts on mutuality, post-Penrose.

Responsible lending

4. The new regime for mortgages that comes into effect in October will obviously have some significant implications for building societies, given that this is your core business. Our overall aim is to improve protection for consumers through the entire life of their mortgage, from the day they start searching for it, to the day it is finally paid off subject, of course, to the caveat that all such improvements must be justified fully on cost benefit grounds. Our intention is therefore that borrowers will get clear, comparable information about both mortgages and mortgage services in a format they can understand and use to make comparisons of products and lenders. While giving advice about mortgages will not be mandatory, we expect to see high standards among firms who choose to give advice. They will need competent advisers that recommend mortgages that are suitable to a customer's particular circumstance.

5. One of the key elements of the new regime is the set of rules on "responsible lending" for all mortgage lenders , including those becoming subject to regulation for the first time. Of course, building societies are already subject to a regime that requires them to "have adequate systems … for assessing ... the ability and willingness of borrowers to repay their loans" . So I would not expect the new rules to present any particular difficulties for you from a compliance perspective. I do, however, want to unpick this very important aspect of the new regulatory system and to relate it to its mirror image – that of responsible borrowing.

6. I hope you would agree that assessing the ability of a customer to afford a particular mortgage does not mean that all the lender or the adviser has to do is be satisfied that the amount advanced plus interest, will be repaid by one means or another. There is a world of difference for the borrower between repayment from income and repayment through a forced sale of the property upon possession by the lender. I realise you will say that it is obvious that no lender would advance money in the expectation that repayment could only be achieved through sale of the security held. But if we dip back into not too distant history we find a picture which has reminded me to emphasise this point. In the late 1980s, the most profitable and fastest growing mortgage lenders were those that lent money to the most marginally creditworthy customers: their business model was predicated on the belief that property prices were a one way bet – at least in nominal terms – so the property held as security could be relied upon to increase in value at a rate that would cover not just the principal advanced and interest, but also all the fines for late or non-payment of monthly instalments, and all the legal costs of taking possession. In short, they found that lending to distressed borrowers was a highly remunerative activity – until house prices unexpectedly fell. By no stretch of the imagination could that be called responsible lending. Suffice to say that hardly any of those lenders – which included some building societies – outlasted the housing market downturn of the early 1990s. I think lessons have been learned from the experience of 12-15 years ago, although one occasionally comes across salary multiples and loan to value ratios which cause one to pause and ask questions. And so I think this is a cautionary tale for any of today's lenders who might take an over-bullish view of the prospects for residential property prices!

7. The application of the affordability issue in practice will, as in all other parts of the financial services industry, need to strike a balance between the responsibilities of the borrower and the lender. On the one hand it certainly is not the intention of our rules that the lender should be able to abdicate responsibility for making an assessment of affordability by simply asking the borrower or borrowers to certify that they can afford the mortgage.

8. On the other hand if you decide that a customer can afford a particular mortgage, that does not absolve them of the need to consider for themselves whether the financial commitment that they are taking on will be affordable and sustainable. So, for example, it is not the case that a mortgage going into arrears will automatically signal that the lender's affordability assessment was inadequate from a compliance viewpoint – we know that the root cause of most cases of arrears is a change in the borrower's circumstances brought about by divorce, unemployment, long term sickness and other such life-changing events that were not expected at the inception of the loan. But we will be looking for lead indicators to signal where the affordability test had not been considered properly by lenders, such as a lender where a significant number of new loans go almost immediately into arrears. In such cases we will be investigating further whether that lending truly met our responsible lending requirements.

9. So what are the main factors that a lender should consider in determining whether or not a borrower can afford a mortgage?

10. Well, I suggest that any responsible lender would need to be satisfied that a prospective borrower (unless for a lifetime mortgage) had sufficient income to meet the monthly instalment due. For many years there has been a tendency to think in terms of income multiples as an expedient short-cut to assessing affordability, and that brokers particularly welcome the near certainty that income multiple criteria give when dealing with prospective borrowers. But, as of course all of you are aware, gross income on its own is a very poor guide to affordability – whether or not that income has been verified with an employer or accountant. After all, two individuals with the same level of income could have very different lifestyles and other financial commitments, meaning that a mortgage affordable for one could be unaffordable for the other. Those of you with children living at home will know what I mean!

11. There are, perhaps, three aspects to assessing affordability. First, to look at net income; i.e. income after tax coming into the household and deducting costs such as other borrowing, maintenance, dependent relatives and similar regular calls on available income. Logically the lenders should not just collect information on outgoings (as many do at present) but should also use that information in their underwriting assessment.

12. You will need to consider what plausibility checks you need to conduct on the net income number. I imagine you will also be concerned about how to build-in affordability to your systems where you use credit scoring and other decision support systems to facilitate electronic underwriting. We fully accept that credit scoring systems can provide a good guide to a customer’s propensity to repay a loan, but propensity to repay is not necessarily the same as ability to repay. Thus, a scoring system based mainly on evidence that a borrower has in the past been able to meet his or her commitments will not necessarily show that a new mortgage is affordable, since an additional commitment might actually be the trigger for financial overload. The challenge here is to bring together systems that validate the information given by the borrower, calculate propensity to repay based on historic and current data, and then use all that information to assess future ability to repay. Maybe some of you have already achieved that, but if not you still have six months left to fine tune your systems!

13. The second consideration for a responsible lender would be assessing whether the borrower can afford the level of payments not just at the start of the mortgage but also when rates normalise. Numerous new loans now include starter interest rates that are well below the prevailing market rate, and these terms usually last for only a short period. So, we will expect all lenders and advisers to assess affordability against the rate and monthly instalment amount that will apply once any initial discount period ends. This could also apply for mortgages where the rate is fixed for a short period at levels below the standard variable rate – again there is a potential shock for the borrower once the initial rate period ends. We understand some lenders will also assess affordability on variable rate mortgages in the event of a higher interest rate environment.

14. Our new regime does, of course, give you some assistance here, since the Key Facts Illustration that you will have to give to all your prospective borrowers, includes a section highlighting the effect on the monthly instalment of a 1% increase in mortgage rates. And we have also recently produced a leaflet entitled "You can afford your mortgage now, but what if….?" that highlights the potential risks for borrowers arising from changes in rates or their own personal circumstances. So borrowers will also have the information to be able to judge for themselves whether they will be able to afford the mortgage should rates rise – and to take joint responsibility with the lender for that assessment.

15. The third aspect of affordability is that the assessment should cover not just the interest servicing cost of the mortgage, but also the ability of the borrower to repay the capital amount. Clearly, this should not be an issue with a repayment mortgage – unless, of course, the repayment term is set longer than the realistic period in which income will be available to service the debt (which would raise affordability doubts). However, it does mean that lenders should be concerned about the source of repayment for an interest only loan. That does not mean that it is irresponsible for a lender to accept a borrower's assertion that the loan will repaid from the sale of the property, but that it would need to be a credible prospect not reliant on house price inflation to support the proposition.

16. In my mind, these three aspects of affordability are captured in a single term – common sense. But the application of robust processes and common sense by the lender requires borrowers to properly exercise their personal responsibilities, and these perhaps also have three forms. First, does the borrower consider the type of mortgage proposed as being suitable to their own particular circumstances? Secondly, do they believe they will be able to afford the repayments and interest in all foreseeable circumstances and do they need to acquire protection against unforeseeable situations such as redundancy or long-term illness? And thirdly, have they provided accurate information to the lender on which the lending decisions will be based? This was at the heart of our recent investigation into self-certification mortgages, prompted by allegations of systematic abuse made by the BBC and others. As you are aware, we concluded that lenders' systems and controls over such lending were broadly adequate to counter the risk of financial crime, but there is no room for complacency. Whilst you, as lenders, have a right to expect your customers to be truthful and borrowers need to be aware that fraudulent misrepresentation – whether encouraged by an adviser or not – is a crime, we nonetheless expect all regulated firms to have in place systems to detect and report attempted frauds to the relevant criminal authorities. That implies a need for you to look critically at the information provided by borrowers to check that it is plausible and internally consistent, rather than just accepting it at face value. It also implies a need to have processes for testing samples of information to ensure that any assumptions made about accuracy are valid. You know your business far better than I do and may find all of this a double dose of "motherhood and apple pie". But I wonder if the principles of good lending tend to get forgotten sometimes in the excitement of pursuing new sources of business and reducing administration costs, so I trust you will forgive me for reminding you of them.

Consumer borrowing

17. I have deliberately focussed on responsible lending, because it is self-evidently very important in the context of the subject I want to tackle next: consumer indebtedness. Regulatory responsibility for debt is multi-faceted. The Bank of England is interested in the impact of indebtedness on the economy as a whole and, specifically, on monetary policy. The DTI and OFT have responsibilities for the Consumer Credit Act and the FSA's responsibilities are limited to the prudential risks inherent in banks, building societies and other deposit-takers; promoting public understanding of the financial system, and as from October, regulating first charge mortgages. Concerning the second of these: promoting public understanding of the financial system, we are leading a major initiative to improve the financial capability of consumers, and one of the seven priority projects we will be revealing in our next paper on financial capability due out later this month will be to improve consumer understanding of borrowing. Michael Coogan of the CML is chairing the Advisory Group which will help guide this project and I know Shaun Mundy spoke to some of you yesterday on our work in this area. So what I want to focus on now are the prudential risks arising from over indebtedness.

18. Regulators are, of course, fully paid up members of the "Jeremiah Society" of professional pessimists– it is, after all, part of our job to look at the potential downside risks inherent in any given situation. Some 15 months ago, the FSA said in its 2003 Financial Risk Outlook, that the rate of growth in consumer indebtedness was almost certainly unsustainable and at some point likely to slow. Since then, using the latest figures released yesterday we can see that consumer debt has risen a further £131 billion to nearly £1trillion [mortgage borrowing increased 15.2% in the year to March 2004], and the overall rate of growth, currently 14%, shows little sign of moderating. Most of the increase is mortgage related and inextricably linked to the extremely high rate of house price inflation - which we also described in January 2003 as "unsustainable". The UK economy experienced an earlier than expected recovery last year, fuelled partly by strong consumer spending funded to some extent by increasing flows of mortgage equity withdrawal. In considering prudential risks to the banking and building society sectors we are mindful of the vulnerabilities which could emerge should there be a rapid slowdown, possibly associated with a sharp fall in house price inflation. In this scenario (and it is just that – not a forecast) we would be concerned about consequent increases in credit risks.

19. Notwithstanding improvements in employment prospects and overall confidence credit risks for lenders may actually be increasing. The combination of record levels of consumer debt and rising interest rates comes at a time when our own research suggests that household budgets are already feeling the strain. Some examples of the credit warning indicators that you, as lenders, are no doubt monitoring

  • there were over 10,000 individual insolvencies in the final quarter of 2003 – the highest level since the early 1990's and a figure that may be accentuated by the recent coming into force of the Enterprise Act.
  • The amount of debt being chased by collection agents has increased by 70% in the past 2 years to a record total of £5Bn.
  • The National Association of Citizens Advice Bureaux has reported a 44% increase in new consumer debt enquiries in the last six years – they now deal with over one million new debt enquiries annually.
  • The Office of National Statistics Omnibus Survey found that 6.9m families with a debt said they were either struggling or falling behind with at least one of their financial commitments.

20. In the light of these figures and despite the capital strength that is typical among British banks and building societies, you will, I hope, understand why we expect you to be looking particularly carefully at your risk appetite, credit management processes and risk management, including stress testing your portfolios to the possible effects of the kind of scenarios I have just described. That implies both care in taking on new borrowers and contingency plans for dealing with problems, should the current benign climate turn.

21. Taking these together, we accept that building societies are not significant players in the unsecured loan or credit card markets, but do increasingly lend in the "non conforming" sector. It does seem to be the case that one significant escape route for over-committed borrowers has been to consolidate their debts by remortgaging their homes, often spreading short-term debt over a longer period in order to reduce monthly payments. No doubt you would point out that, if you have taken remortgage business of this sort, your arrears figures are evidence that the quality of your lending is good. Of course, borrowers in trouble will generally keep paying their mortgages for as long as possible in order to protect their equity stake and keep a roof over their head, and it is always possible that borrowers in trouble are simply borrowing elsewhere to cover their mortgage – thereby postponing rather than solving any problem of over-commitment. However, we agree that signs of incipient problems are currently hard to find in your arrears numbers - although a pick-up over the next few months would not come as any surprise.

22. Should that happen, you will need to activate the contingency plans you no doubt have for putting additional resources into your collections departments. A quick and sympathetic approach from you as lenders to such problems can be very helpful in getting borrowers back onto the straight and narrow – and there is a section in the new rules for mortgage business dealing with the handling of arrears cases along these lines . However, taking a sympathetic view is made immeasurably easier for you as lenders if you have a comfortable margin in the property held as security. Which brings me neatly to the issue of house price inflation.

23. The continued rapid rise in house prices has confounded even the optimists in your own industry, and is difficult to reconcile with the apparent dearth of first time buyers that would normally be expected to underpin a healthy market. As we said in the 2003 Financial Risk Outlook, "the longer house prices grow at rates in excess of homebuyers' earnings, the more pronounced the risk of a substantial fall becomes" – and that was in the context of an 18% increase in prices in 2002 . Since then, prices have risen at least a further 12% (and possibly much more, depending upon which index you follow) and the rate of increase shows little sign of slowing. But as we know from equity markets, there is a risk that, to borrow a well known phrase, "irrational exuberance" may cause prices to overshoot their equilibrium level. In the late 1980s virtually nobody warned of the possibility that house prices might fall at the same time as interest rates rose, and lenders then were caught out by the sudden change in direction. It is not the FSA's role to forecast the direction of house prices, but with our Jeremiah Society membership in mind, we could highlight the risks to you as lenders arising from the massive increase in residential property investment in both the buy to let and second home categories. For instance in 2002 alone Building Society only figures showed a 160% increase in buy-to-let lending on the previous year. This has since slowed but nevertheless, it certainly seems plausible that the further prices rise, the more private investment money is being attracted to the housing sector – despite falling rental yields and the relatively high costs of acquisition and disposal. Now that the newspapers have started to contain advertisements extolling the "investment opportunities" offered by plots of vacant green belt land with limited prospect of planning permission at some future date, and of buy-to-let opportunities in the EU accession countries, the Jeremiahs have plenty of material for their prophecies. No doubt you are bearing this in mind when you set your LTV criteria and when you read the valuation reports from your surveyors.

Strategic Risk

24. So what are the implications of the current housing market for building societies? The Financial Risk Outlook published this January contained a paragraph specifically highlighting strategic risks for building societies arising from your perfectly understandable response to competition in your core business, and particularly the compression of margins. It seems likely, in our view, that societies will continue to find margins under pressure from a combination of incentive costs for new mortgage lending and intense competition for retail funds. It is noticeable that, in 2003, societies raised over three times more wholesale funds than retail funds, so that wholesale funds at the end represented almost 30% of total industry funding by the year end. Given that societies have to be mainly retail funded, it seems likely that attracting the required inflows will present a further strong challenge in 2004.

25. So, how are societies responding to this twin assault on margins? Well, the common strategy appears to be diversification into higher margin lending – such as buy-to-let and commercial lending where year-end figures for 2003 showed a year-on-year increase of 30% to £11.8bn. Of this lending the vast majority is not for commercial development purposes, but for commercial property investment - £7.7bn in 2003.

26. We recognise, of course, that well judged and managed diversification can improve both stability of earnings and financial resilience. However it is far from clear to us that all societies operating in the commercial, buy to let, equity release, sub-prime and self certified markets have properly assessed the additional risks that inevitably go with the higher margins available. We have been told by more than one society that, because they "cherry pick" or are looking for only relatively small amounts of such business, such loans are no more risky than their traditional residential mortgages. This suggests to us a misunderstanding of the nature of the risks, and it calls into question how the products themselves have been specified and priced: we see some societies undercutting other lenders on rate in order to obtain business volume, but without a clear understanding of their own true risk-adjusted costs. And it is certainly not sensible to set the rate for a particular type of loan by reference only to the competition without an understanding of how your own costs compare with those of other players in the same market – especially if they have greater economies of scale or access to lower cost funds. Our job is not to in any way constrain innovation or competition – they are the life blood of productive economies, but as Societies consider moving to new areas of lending where they may not initially have the depth of experience or knowledge possessed by competitors, it is essential that Boards focus not only on the potential new sources of income, but also the costs, risks, capital requirements, technology needs, management support and so on. We have seen a number of cases where a full analysis of these issues was not evident. If the costs, risks and cost of capital are not identified and priced into the product, it is far from clear how a Board can be taking a fully informed decision.

27. We noted in the FRO that some societies are also attempting to diversify their income streams by selling increased volumes of insurance and regulated investment products, particularly as opportunities for multi-use structures are opened up by depolarisation. In 2003 we carried out a review of those societies giving investment advice - as opposed to simply introducing customers to a product provider – and highlighted a number of concerns in a subsequent letter to Chief Executives. In particular, we found there was a lack of personal and financial information on customer files to support the rationale for advice given, and that letters explaining any product recommendation were often full of jargon and hard to understand. We also noted some compliance and internal audit shortcomings in a few cases. Now, we recognise, of course, that only a minority of societies currently give investment advice, but if you are considering this as a strategic diversification, I recommend that you look carefully at our letter which is published on our website. And there are lessons too for the advice regime that goes with mortgage regulation. We will certainly be focussing hard on these issues, which go to the heart of our principle that firms should treat their customers fairly, and that responsibility for embedding this in the culture and controls of the firm rests squarely with senior management.

Mutuality

28. Which brings me quite neatly to the question of how well the principle of treating customers fairly fits within a mutual business such as a building society. The answer should be "very well indeed", since mutual organisations are, by definition, focussed on customers as owners of the business and could therefore be expected to embed customer needs within their overall operations. So this seems an ideal opportunity for me to dispel again the myth that there is an FSA conspiracy against the mutual sector: our formal position is one of neutrality about the merits of a mutual structure compared to a proprietary one, and we strive to be even-handed in our dealings with firms regardless of ownership arrangements. Of course, we recognise that mutuals such as building societies provide strong competition in the markets in which they operate, and that consumers benefit from the diversity of suppliers both in terms of service and prices. But we do recognise that some forms of business require more capital than this and that for a mutual typically the choices for raising new capital – if needed – can be more limited than for joint stock companies.

29. From what I know about Building Societies, you have a widely known reputation for fair treatment of your customers. Your proud record of service and customer loyalty have combined to give you one of the most trusted brands in financial services. Add in your strong regional identities and reputation for community support, and you have an excellent base for success in the market. These strengths are valuable, and I'm sure you will do everything you can to keep them.

30. One area where you will, of course, be subject to particular scrutiny is in your corporate governance arrangements, and I was pleased to see that the BSA is looking forward to playing an active part in discussions with Paul Myners in the coming months. We have noted the leadership of the BSA in encouraging voluntary disclosure of directors (management) remuneration and the willingness of many societies to take this step without the need for regulations such as those for companies. No doubt you are already looking at the standards set by the Combined Code to see which may be relevant for a mutual building society – these are, after all, standards your owners could expect you to meet, and as mutuals under constant public scrutiny, you need particularly to be able to demonstrate that your governance arrangements are robust.
Before I go I would finally like to touch briefly about one or two recent developments on the European stage that will affect the way building societies operate in the coming years

Basel II

The first of these and one area that I know many of you here will be interested in is the implications of Basel II and its effect on the competitiveness of building societies and the mortgage market as a whole. The theory goes that smaller societies will be disadvantaged by their lack of adequate data on the move to Internal Ratings Based (IRB) modelling since they do not carry out sufficient transactions to enable them to take advantage of the capital treatment afforded to larger competitors.

This remains a matter of discussion. We at the FSA will follow the EU Directive when the capital rules are proposed to come into effect in 2007. We are of course unable to treat smaller UK lenders differently to other EU authorised firms, but I would like to say now that we would be happy to work with those societies who decide to adopt a 'pooled approach' to IRB modelling. And we should be very clear that though the rules will not come into effect for 3 years, the implementation of complex systems will be very time-consuming and all societies should be starting to look at their plans for doing this now. And indeed we shall be visiting some societies over the coming months to better assess any issues that are arising.

International Accounting Standards

Another area of importance for many of those here – at least those societies that have issued public debt securities or Permanent Interest Bearing Shares (PIBS) – are the consequences of moving to International Accounting Standards. Of course there are cost considerations for societies of implementing these IASs, but the FSA supports the introduction of these for listed companies as we believe there will be huge global benefits of having businesses undertaking similar activities being subject to broadly the same accounting treatment wherever they are.

Of course there are parts of these standards that will create some problems (at least initially) for the building society sector e.g. IASs 32 and 39 on hedge accounting. The hedge accounting rules are not perfect and the argument that they will increase volatility in equities is valid. However, what is less clear is whether that volatility arises solely from the accounting model or whether it reflects the real underlying risk. If the standard setters had more time, they might have been able to resolve this issue, but we are where we are.

Those societies represented here that have listed bond issues are no doubt aware how tight the timetable is for overhauling existing accounting systems in order to produce IAS comparative numbers for the end of this year and are I would hope well on the way to doing this already. Indeed, we at the FSA, are already in the process of making supervisory visits to check that the appropriate project plans are in place in order to achieve this.

Conclusion

31. So, in summary, 2004 looks like being a pivotal year for building societies, with a number of interesting challenges to be faced. I have only touched on a few of these today, but it is good to see that the others are covered elsewhere in your very full & wide ranging programme for this conference. Your past history suggests you have successfully risen to all the competitive and regulatory challenges put in your path, and I am sure you will similarly overcome the current set.

32. Many thanks for you attention and I would happy to take any questions.

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