But the story for the banks is declining profitability and increasing risk – not a recipe for stability. How did we get here? How might it end?
By the late 1990s, UK banks started funding their mortgage originations with ever shorter funding strategies.
Thirty-year mortgages were never funded with thirty-year deposits, but back in the last century banks could count on consumer savings sitting in higher interest accounts for extended periods.
However, as house prices began to soar banks began funding their mortgage books in different ways.
If you’re over 30 you will remember the late Northern Rock which used short-term funds raised on money markets to extend mortgages, then sold them to bondholders… until they could not in 2009.
Other large UK banks also borrowed cheap short-term funds, as short as overnight, to fund their loans.
When markets froze, banks like RBS and Lloyds had large funding gaps as their market-based funding left while the loan book did not.
Of course, those funding and lending risks were left to the taxpayer to prop up in 2007-2008.
Everyone was rightly upset; the system was at stake.
UK mistakes were clearly from poor commercial banking practice including housing loans, while politicians aimed their sights on investment banking.
The coalition government in 2013 enacted a new policy for mid-to-large banks to separate their retail (housing and deposits) from large corporate banking and investment banking – known as ring-fencing.
Banks could no longer use consumer deposits to fund securities, but also, they could not be used for sizeable corporate lending and other uses.
Banks had to implement ring-fencing from January 2019.
Ring-fenced banks (RFBs) were set up in a simple way.
They capture retail assets and deposits and the banks had to ‘trap’ or lock in a substantial amount of their equity capital within the RFBs.
That equity commitment is what is required to cushion the RFB should losses occur, and since mortgages are long-term, it is there for the very long-term.
Shrinking a RFB isn’t easy. HSBC has been rumoured to have had more than £30bn of retail deposits that funded corporate loans which will be redirected to mortgage lending.
RFBs have added remarkable competition to the housing market which may have driven smaller lenders out.
That competition is certainly adding to consumer options: 40-year mortgages have appeared, five per cent deposit mortgages are widely advertised, two-year rate fixings go as low 0.6 per cent above two-year UK gilts.
My fear is that the market has become very short-term driven for what are very long-term products.
For example, the mortgagor who has borrowed for 40 years today on a two-year fixed rate is inherently assuming an attractive market for re-setting will exist every two years until 2057 (19 times to be precise).
This is a mega-gamble.
Over the next few years, the large banks that own RFBs will have to assess the value of their RFBs.
The trapped capital model may drive most competitors from the market and could, in the long run, offer pricing power back to the banks before considering issues such as competition concentration.
Could they raise prices and tighten terms? How would a group of lookalike RFBs react in a down-turn?
It’s going to be interesting to see what happens next.