Britain's Banking Refuge Springs Leak

Buy-to-let lending rules may dent equity premium

A new reality is starting to set in for U.K. banks that have gorged on a housing boom fueled by cheap debt, skyrocketing prices and government subsidies.

The Bank of England on Tuesday outlined tougher lending criteria for loans to aspiring landlords, which it reckons will lower the temperature of the property market and lead to a loss of revenue for some banks and brokers. Chancellor of the Exchequer George Osborne had already announced fresh taxes and closed loopholes on property transactions and debt relief. Fears of waning demand for luxury homes in London are seeing lenders "freaking out" and charging higher interest rates to compensate for risk, according to Bloomberg News.

This new reality doesn't mean a 2008-style crash is on the cards. The BOE gave U.K. banks a seal of approval after a fresh round of stress tests last year, a sign that lenders' moves to bolster capital are paying off.

And as frothy as house prices are, if the banks themselves are to be believed, lending standards aren't going back to the bad old days -- Lloyds Banking Group, which underwrites about a fifth of U.K. mortgages, said that around 1 percent of its book had a loan-to-value ratio above 100 percent at the end of last year, down from 5 percent at the close of 2013.

But even if policy makers are trying to let the air out of only specific pockets of the bubbly housing market, a temporary chill may nevertheless have far-reaching effects.

Retail Returns

U.K. consumer-focused challenger banks have outperformed bigger rivals over the last month

Source: Bloomberg data

Even if new restrictions deter speculative investors (including foreign ones) targeting prime pockets such as London, that still figures into the tone of the broader market. The capital accounts for more than a quarter of Britain's total 6.2 trillion-pound ($8.9 trillion) housing stock value, according to Savills. That's a fair chunk of the overall market that is vulnerable to a slump in demand from abroad. And that's not even accounting for a hit that could come were "Brexit" to materialize.

Likewise, buy-to-let may only account for about 15 percent of the overall mortgage market, but its been growing at zippy double-digit rates recently. The BOE says its measures may hit new approvals by as much as 20 percent, unwelcome news to banks planning on taking market share in a competitive environment.

Land Grab

U.K. buy-to-let mortgage transactions have boomed in recent years but are seen flattening

Source: Council of Mortgage Lenders

Lenders were clearly already under pressure to boost revenues. For instance, new challenger Aldermore, spotting "significant growth opportunities" ahead, has expanded its mortgage portfolio by 30 percent in 2015 to 4.6 billion pounds across residential, buy-to-let and commercial property. Virgin Money meanwhile increased mortgage balances by 16 percent last year and said that 2016 had already seen its biggest-ever day for mortgage applications.

These banks, along with Lloyds, are trading at 1.2 to 1.4 times book value, some way ahead of the European average of around 0.7 times, reflecting investor enthusiasm for consumer lending over volatile trading and investment banking. The BOE's move is a knock to the safety of that island, as it means retail-focused firms will have to find other sources of growth and profits if they want to keep paying out rich dividends and maintaining a premium to peers.

Brit Banks Boom (Relatively Speaking)

Retail-focused lenders have outperformed European banks over the past year

Source: Bloomberg data

Some reshuffling of resources is already happening. Lloyds last year said it had stepped back slightly from the mortgage market to protect margins. It's appeared to offset a sub-par 1 percent growth in mortgages with a 17 percent jump in U.K. consumer finance such as car loans.

That strategy has limits. These types of loans may look like a less frothy prospect than housing, but Berenberg analysts have warned that consumer credit has historically generated 92 percent of credit losses despite representing around 8 percent of household debt.

Equity markets are sending a signal that investment banks are risky, even untouchable propositions, while retail banks are reassuringly reliable and profitable. That perception may see some rebalancing sooner than you might think.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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    Lionel Laurent in London at

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