Banks Use ‘Deficient’ Models for Mortgage Risks, BOE Says

  • Tougher standards proposed for assessing mortgage risks
  • Lenders’ internal models need updates to reflect risks

U.K. banks are using flawed methods to calculate the riskiness of residential mortgages on their books, the Bank of England said, proposing tougher standards for the industry.

The bank’s Prudential Regulation Authority said in a proposal on Friday that it has found “material deficiencies” and “excessive variability” in the models lenders use to determine how much capital they have to use to fund residential lending. The changes it proposes could increase capital requirements for U.K. banks on average, it said.

Regulators around the world are clamping down on lenders’ ability to employ internal models to determine the risk of everything from mortgages to derivatives to the potential for fraud or even cyber-attacks. The Basel Committee on Banking Supervision, which includes the BOE and U.S. Federal Reserve, is planning to complete a series of rules by the end of the year in an effort to prevent banks from gaming capital requirements.

The models U.K. banks use to calculate the probability that a mortgage isn’t repaid are inadequate, according to the PRA. Banks may need to rethink them, it said.

House Prices

In addition, the industry’s assumptions about how much house prices may decline vary significantly, it said. The PRA called for a new standard that would force banks to assume a plunge of at least 25 percent in property values to calculate how much capital they’d need to absorb losses. That will cause higher capital requirements, but reduce potential deficits in stress tests, it said.

The PRA’s proposal follows a review of U.K. lenders that found differences in how banks model risks that can be detrimental to financial stability in a downturn. The banks hold around 1 trillion pounds ($1.3 trillion) in U.K. residential mortgage exposure. The central bank has warned that bank models can contribute to capital requirements that are low in an upturn leading to “credit exuberance in a boom and deleveraging in a downturn.”

Housing market sentiment plunged following Britain’s vote to leave the European Union, with an industry index in July showing that more real-estate agents are recording lower prices in London than higher ones. The reading was the weakest since early 2009.

U.K. mortgage approvals fell to their lowest level in more than a year in June as nervousness gripped the housing market even before the referendum. Banks and mutually owned lenders signed off on 64,766 loans for house purchase, the fewest since May 2015, the BOE said on Friday. The figure was down 3 percent from May and below the 65,500 predicted in a Bloomberg survey of economists.

The consultation is open to public comment until late October. The new supervisory policy would take effect March 31, 2019.

Before it's here, it's on the Bloomberg Terminal.