The Mortgage Market Review and Non-bank mortgage lenders is enhanced Prudential Supervision on the way?

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1 JULY 2010 The Mortgage Market Review and Non-bank mortgage lenders is enhanced Prudential Supervision on the way?

2 Introduction Since the publication of the FSA's latest Mortgage Market Review consultation paper 1 on 13 July 2010 there has been considerable discussion about responsible lending and the implications for consumers particularly on the themes of affordability, responsible borrowing and product regulation. However, the discussion in Chapter 6 of the consultation paper raises critical issues for non-banks to consider in the context of possible future prudential requirements. Chapter 6 focuses on whether there should be a risk-based prudential regime for non-bank lenders in the mortgage market along similar lines to the regulatory capital framework for deposit taking banks. The concept is not entirely new and such an approach was mooted in the FSA's discussion paper, DP09/3 on the Mortgage Market Review which was issued in October Indeed in a number of EU countries lenders are already required to be authorised as deposit taking institutions. The discussion in Chapter 6 of the current consultation paper indicates that the regulator's thinking has developed considerably since then. What is the rationale for such a proposal? According to the FSA, non-bank lenders have played an increasingly significant part in the UK mortgage market, accounting for an estimated 15% of total regulated mortgage lending in 2007 and approximately 20% of the buy-to-let market 2. The relative low barriers to entry and a pattern in this sector of participants entering and exiting the market quickly is thought by the FSA to have had a procyclical effect, contributing to house price volatility and the housing bubble. In the FSA's view, non-bank lenders collectively can produce market sustainability issues and bring instability to the market. Another reason why the FSA is contemplating an enhanced prudential regime for these lenders is the tendency of lenders in this end of the market to follow an originate-to-distribute model. Here, the removal of lenders' exposure to the credit risk of the original mortgages contributed to a weakening of lending standards in order to secure competitive advantage 3. What might a risk-based prudential regime look like? CP10/16 envisages four areas of the prudential framework for banks which might be applied to nonbank mortgage lenders: a securitisation position capital requirement where non-banks would be required to retain an economic exposure to the assets they securitise by holding securitisation positions and to post capital against those positions; a credit risk capital requirement formulated on the basis of the standardised approach to credit risk set out in BIPRU Chapter 3 where exposures both on and off balance sheet would be risk weighted and a capital charge calculated on the basis of the risk weighted exposure; an operational risk capital requirement where the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events, including legal risk would be offset by a capital charge; and a liquidity requirement where firms would be required to hold sufficient liquid assets (such as government gilts) to ensure they could meet their liabilities as they fall due. The requirements might be based on the BIPRU liquidity regime for simpler banks and building societies and could include a standardised liquidity buffer ratio. 1 CP10/16: Mortgage Market Review: Responsible Lending, published on 13 July See DP09/3 issued by the FSA in October See CP10/16 paragraph 6.12 et seq and DP09/3 paragraph 3.42 et seq.

3 The implications of an enhanced prudential regime The four areas identified by the regulator as being potentially appropriate to bring into the MIPRU regime would have the collective effect of dramatically increasing the capital requirements of nonbank lending firms. Consequently, the volume of business and the range of products which this sector has been able to offer up to now may be restricted in light of the capital costs of doing business in future should these proposals be taken forward. Given the potential impact of the changes suggested, it is worth examining more closely each of the areas of focus suggested by CP10/16 Chapter 6. Securitisation Position Risk Requirement The Capital Requirements Directive ('CRD') which implements the Basel II framework in Europe has been amended to prohibit credit institutions from investing in securitisation positions unless the originator, sponsor or original lender has retained an economic interest of at least 5%. This requirement will affect the originate-to-distribute model of non-bank lenders when it becomes effective on 31 December 2010 as non-banks will not be able to sell securitisation positions to banks unless they retain a 5% economic interest in a securitisation to which the provisions will apply. Whilst the CRD amendments will force non banks to retain an exposure to the securitised assets, the FSA points out that they would not necessarily need to post capital against those positions. Hence the suggestion that the securitisation framework in BIPRU Chapter 9 be applied to securitisation positions which non-banks hold on their balance sheets. BIPRU Chapter 9 sets out the rules for calculating the risk weighted exposure amounts for securitisation positions. The capital calculation rules are complex and there are two approaches that may be adopted: the standardised approach and the internal ratings based approach. The internal ratings based approach is typically used for capital calculation only by credit institutions who have a wavier from the FSA and who have sophisticated systems for measuring and managing risk. In the non-bank mortgage market, it is anticipated that the standardised approach would be adopted. This is a more prescriptive approach and offers no flexibility in credit risk modelling unlike the internal ratings based approach. Under the standardised approach, securitisation exposures are risk weighted at anything from 20% of the exposure to 1250% of the exposure 4. The risk weight to be applied to a rated securitisation depends on the credit quality of the issuer and on whether the rating agency has made a long term or short term credit assessment. So, for example, if there is a short term credit assessment the risk weight will range from 20% where the issue has been rated AAA to AA- by Fitch (or an equivalent rating by any of the other eligible credit assessment agencies) 5 up to 1250% where the rating is Fitch B+ or below (or an equivalent rating). Unrated securitisation positions are risk weighted at 1250% of the exposure value. If one were to assume that a securitisation of 100 million were completed and the originator were to comply with the CRD requirements and hold a 5% economic interest, then under the standardised approach the capital charge for that 5 million exposure would be arrived at by calculating 8% of the risk weighted exposure amount of the position this could be anywhere from 80,000 to 400,000 depending on the rating of the issue. Securitisation positions with risk weights of 1250% may be deducted from capital at the value of the exposure as an alternative to being included in the calculation of risk weighted assets. The consultation paper notes that the CRD amendments allow the originator to retain exposure to the securitised assets in a variety of ways. Essentially the originator can retain a vertical slice of the securitisation structure or a subordinated exposure, a horizontal slice. If the originator adopts the former approach the amount of risk retained on the balance sheet might be relatively small. In addition, the requirements do not apply to whole loan sales. That said, however, the illustration above 4 See BIPRU Chapter 9 Specifically section 9.11 of that chapter. 5 For a chart of the credit quality step mapping see

4 shows the potentially significant impact the extension of the banking prudential regime in this regard will have for non-banks. Under current MIPRU rules there would be no capital charge associated with a securitisation position. On balance sheet credit risk The standardised approach to credit risk set out at BIPRU Chapter 3 specifies risk weights to be applied to credit exposures before calculating the credit risk capital component of a firm's capital, at 8% of the aggregate risk weighted exposures 6. In relation to exposures secured by mortgages on residential real estate where the loan to value is 80% or less, the risk weight is 35%, such that the capital charge for maintaining the loan is 2.8% of the amount of the loan (i.e. 8% x 35% x Exposure Amount). This is substantially greater than the prudential requirement under MIPRU. However, the extent of the impact of the credit risk capital component does not end there. To the extent that the loan to value ratio exceeds 80%, the exposure above 80% is risk weighted at a much higher rate, which might be 75% or 100% depending on whether the exposure qualifies as a "retail exposure" 7 (75% treatment) or not. Again, an example might illustrate the requirement: A lends B 199,500 to finance the purchase of a property worth 210,000 which is mortgaged to A. The LTV is 95%. Accordingly, the first 168,000 is risk weighted at 35% and the balance of 42,000 is risk weighted at 75% (assuming the exposure may be treated as a retail exposure). The capital required to support the loan will be 4,704 (being 8% x 35% x 168,000) plus 2,520 (being 8% x 75% x 42,000). The total capital charge will be 7,225 contrast this with 2,100 under the MIPRU regime. It should be noted that a firm may not apply the 35% risk weighting unless the firm is satisfied that the mortgage is legally enforceable, the property is valued by an independent valuer at least once in every three years (more frequently if there are significant changes in market conditions), and the property is adequately insured. If on-balance sheet credit risk capital requirements are applied, then they will likely apply across all of a firm's exposures. Accordingly, where non-banks engage in unsecured lending activity, then the exposures under the unsecured loan book may need to have capital posted against them in accordance with the BIPRU rules typically, those exposures will avail of a 75% risk weighting for retail exposures but exposures to other exposure classes may be risk weighted at 100%. The rule changes to address capital shortfalls in the non-bank mortgage lending industry may therefore have wider implications for this market than might at first appear to be the case. Assuming a credit risk capital requirement were to be introduced for non-banks, then one expects affected firms would be entitled to avail of the credit risk mitigation exemptions set out at BIPRU Chapter 5. That chapter identifies a range of acceptable credit risk mitigation techniques which are broadly divided into funded credit protection (such as cash collateral, certain life assurance policies and certain financial collateral such as government gilts) and unfunded credit protection (such as guarantees, letters of credit and credit default swaps). The availability of either funded or unfunded credit protection may have the effect of reducing the risk weight which might otherwise apply to an exposure and hence reduce the capital charge arising from a particular loan. Operational Risk Requirement As stated above, this is capital posted against the operational risks of loss due to human or systems error or external events such as legal risk. There are two approaches to calculating operational risk 6 See BIPRU R 7 See BIPRU R broadly the exposure must be to an individual or SME, must be one of a significant number of exposures with similar characteristics (so that risk is well diversified) and no more than 1 m must be outstanding to the same individual

5 the basic indicator approach and the standardised approach. Under the former approach (which is likely to be the one that would apply to many non-bank lenders), the capital charge is generally based on the average net interest income and net non-interest income over the last three years and will be 15% of the sum calculated. To be eligible to use the standard approach, a firm (i) must have sophisticated operational risk management systems and controls which are regularly evaluated and (ii) must have implemented a system of management reporting which addresses its operational risks. Under the standard approach, it is likely that the capital requirement will be lower than 15% of average net interest and net non-interest income. Liquidity Requirements The FSA's liquidity regime was introduced earlier this year and will become fully applicable to banks, building societies and certain other firms by October The regime requires banks to maintain liquid resources sufficient to meet their obligations as they fall due and also sufficient to withstand certain stress tests as set out in the rules which are both short term micro stresses affecting the firm and longer term macro stresses affecting the market as a whole 8. The introduction of the new liquidity regime was in response to the financial crisis where banks heavily reliant on external funding suffered significant liquidity pressures as the wholesale lending market dried up. Banks engage in maturity transformation by taking deposits payable on demand or in the short term and transforming them into longer term loan assets. One of the key liquidity risks that banks face is maturity mismatching which puts pressure on liquidity resources as banks are required to repay short term obligations before long term assets mature. Non-bank mortgage lenders are not deposit takers and, therefore, do not have the same risks in liquidity management as banks do. However, the FSA's view is that whilst non-banks have a relatively simple business model, it is appropriate that a tailored liquidity regime should apply to them. On the basis of the consultation paper, it seems likely that the simplified liquidity regime set out in BIPRU 12.6 might be adapted for non-banks should the FSA proceed with this proposal. Under this regime a firm must maintain a standardised buffer ratio which is based on projected outflows including a certain percentage of deposits (which are categorised as Type A or Type B the former being more likely to be called in times of stress than the latter), a percentage of facilities offered to retail customers but as yet undrawn and a percentage of wholesale outflows over a certain time horizon. Under the simplified approach a firm must perform the stress tests prescribed by BIPRU 12.4 (referred to above) and must have robust strategies, policies, processes and systems in place that enable it to identify, measure, manage and monitor liquidity risk. A firm's processes should enable it to assess and maintain on an ongoing basis the amounts, types and distribution of liquidity resources that it considers adequate to cover: the nature and level of the liquidity risk to which it is or might be exposed; the risk that the firm cannot meet its liabilities as they fall due; and the risk that its liquidity resources might in the future fall below the level, or differ from the quality and funding profile, of those resources advised as appropriate by the FSA. Instruments which may be included in a liquidity buffer under the simplified approach are restricted to eligible government debt securities and debt securities issued by multilateral development banks (such as the European Investment Bank or the European Bank for Reconstruction and Development). Needless to say the yields on these instruments are generally lower than on other debt instruments 8 See BIPRU 12.4

6 and therefore, the cost of compliance with liquidity requirements is increased by the relative financial advantage that is lost to the firm in having to comply with the buffer restriction. One other point to note about the liquidity regime is the requirement to prepare an individual liquidity systems assessment (in the case of the simplified approach). This involves performing and reporting on the micro and macro stress testing that is required under BIPRU 12 and the submission of the assessment to the FSA, who may give guidance or direction on the amount of the liquidity buffer or other aspects of the firm's liquidity posture, such as its liquidity management processes. The stress testing and reporting requirements are time consuming and potentially costly exercises and so the burden of complying with a liquidity framework will be both financial and administrative. Eligible Regulatory Capital Currently the regulatory capital requirements for mortgage lenders are set out in MIPRU. Under that regime, non-banks are required to hold 1% of balance sheet assets plus total undrawn commitments or 100,000, whichever is the higher. Furthermore, a MIPRU firm (other than an intermediary which holds client money) may meet its capital requirement by solely using subordinated loans. It does not have to retain higher quality capital instruments such as common equity or reserves. The prudential regime for banks is broadly based on the Basel II framework which sets minimum quantitative capital requirements at 8% of risk weighted assets. Of course, this minimum is subject to regulatory review and direction and in the UK it is highly unlikely that any bank would be allowed to operate with capital as thin as 8% of risk weighted assets. Bank capital is divided into Tier 1 capital (comprising core tier one capital instruments such as common equity and reserves and other tier one capital instruments like preference shares and hybrid instruments), Tier 2 capital (comprising perpetual and long term subordinated debt instruments) and Tier 3 capital (being the capital class with the least effective loss absorption capability. This class is generally composed of short term subordinated debt instruments). Tier 1 capital resources may not exceed core tier 1 resources and tier 2 capital resources may not exceed tier 1 capital resources. Accordingly, tier 1 capital must form at least 4% of risk weighted assets and core tier 1 must account for half of that, whilst tier 2 capital resources may not be more than 4% of risk weighted assets in total. This matrix means that if the prudential regime for MIPRU firms were to be more aligned with the banking regime, it would not be possible for non-banks to meet all their capital requirements with subordinated debt. The FSA does point out, however, that they would expect eligible capital for non-banks to be loss absorbing on a 'gone concern' rather than a 'going concern' basis. Accordingly, it is likely that any proposals will allow non-banks to include a greater proportion of tier 2 capital in their capital resources compared with banks. Conclusions It is clear from Chapter 6 of CP10/16 that the FSA is not currently consulting on proposed changes to the prudential supervisory regime applying to non-banks. At this stage, the regulator is inviting comments on the issues discussed in that chapter before finalising their views. If appropriate, they say they will consult on any proposed changes later this year. This note is a very high level summary of the potential impact of some of the potential changes to the prudential supervision of non-banks based on the themes discussed in Chapter 6. It is premature at this stage to predict with any accuracy what the final outcome of the FSA's further deliberations might be. However, it is clear that changes along the lines of those considered in the consultation paper will have far reaching implications for and a significant impact on the businesses of non-banks in the mortgage lending sector. Firms should be thinking about how any changes to the prudential regime might fit with their business models and the threats that such changes might pose to the sustainability of their businesses as currently organised and operated. Indeed, if second charge lending is to be

7 regulated by the FSA in the future and if buy-to-let lending becomes FSA regulated, the impact of prudential changes will be felt among a broad church of market participants. The FSA is seeking comments on Chapter 6 by 30 September Now is the time to engage in the debate and make sure that your views are heard by the policy makers. If you have any questions about the points raised in this note or would like further information, please contact any one of the Financial Regulation Group members below.

8 Financial Regulation Group contacts David Heffron ( * John Ahern ( * Adam Bennett ( * Amanda Hulme ( * Jonathan Watson ( * David Blair ( * Rosanna Bryant ( * Stephen Makin ( * 2010 Addleshaw Goddard LLP. All rights reserved. Addleshaw Goddard LLP is a limited liability partnership registered in England and Wales (with registered number OC318149) and is regulated by the Solicitors Regulation Authority. Ref Extracts may be copied with prior permission and provided their source is acknowledged. All material is by Addleshaw Goddard LLP lawyers, and is made available for information only. Existing law is stated as it applies in England and Wales at the date of publication. While provided in good faith and believed to be accurate, the application of the material to any specific situation depends on the law as it applies or is interpreted at any given date and also depends on the precise facts and circumstances applicable in that situation and any other relevant factors. It may be affected by detail which, for reasons of space, it has not been possible to include. Accordingly, it should not be acted on or relied upon without further specific advice. If we can be of further assistance, please contact the partner with whom you normally deal or any of the persons listed. Addleshaw Goddard LLP is not authorised under the Financial Services and Markets Act 2000, but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of The Law Society. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide.

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