The Financial Conduct Authority’s (FCA) strategic review into the retail banking sector also revealed these factors made it harder for smaller lenders to compete.
The review looked separately at the ‘Big Four’ banks Lloyds Banking Group, Barclays, HSBC and NatWest, as well as scale challengers Santander, Nationwide, Virgin Money UK, and TSB.
It also looked at mid-tier firms such as Co-op, Metro, Tesco and Sainsbury’s. It also examined digital challengers Starling and Monzo, and non-PCA (personal current account) providers such as Aldermore, Shawbrook and Close Brothers and traditional building societies.
It based its groupings on similarities in size and product offering.
The FCA conducted the review to look at how digitalisation, consumer expectations and the need to reduce costs has impacted banking and competition. It said this had been accelerated by the pandemic and while its review included mid-year results for 2021, it said the period had been “atypical”.
Competition in the mortgage market has intensified and caused yields to fall, it found. Increased broker usage also led to lower levels of standard variable rate (SVR) mortgages, further reducing yields.
In 2015, around 22 per cent of mortgages were on standard variable rates (SVR) compared to around eight per cent in 2020. Yields on SVR mortgages fell by 40 basis points from an average of 3.6 per cent to 3.2 per cent over the same period.
New mortgage sales completed through intermediaries also grew from a 63 per cent share to a 73 per cent share during this time, meaning brokers were helping clients to avoid SVRs and move onto lower rates.
Overall, mortgage yields have fallen by around 90 basis points between 2015 and 2020, or around 30 per cent on average across the residential mortgage book as a whole.
The FCA said intermediary-led sales had also “increased product availability, so that some customers have been able to get mortgages who might not otherwise have been able to”.
Mortgage yields and liquidity
Mortgage yields tend to be sensitive to changes such as the base rate rising from 0.1 per cent to 0.25 per cent in December, which caused prices on new fixed rates to increase in the latter half of last year, the report said.
It said banks with a greater share of mortgage lending would see yields rise faster meaning returns will likely stabilise or improve as a result of rising interest rates.
The mortgage market has historically been profitable for larger banks, especially when measured in terms of return on equity, the review said.
However, policy changes introduced by the Prudential Regulatory Authority (PRA) which came into effect this month will reduce some of the differences in risk weight calculation methods.
The regulator had a consultation on internal ratings-based mortgage risk-weights in July last year, and based on that decided to not bring in a proposed seven per cent minimum risk-weight on individual risk UK mortgage exposures. Instead it would “carefully consider” incoming probability of default and loss given default parameter floors for mortgage exposures as part of the regulator’s implementation of Basel 3.1 standards.
Not introducing the minimum risk-weight would mean the mortgage risk-weights below the proposed value will still be permitted, according to Moodys. It also noted that firms that might have been hit by heightened capital requirements from the increase in mortgage-risk weights would no longer be impacted.
Another outcome of the consultation was that mortgage exposures classified in default will be excluded from the 10 per cent average minimum risk weight expectation.
The 2019 ring fencing regulation also increased liquidity for larger banks as this is now being used for mortgage lending, especially as demand for consumer credit fell in 2020.
However, the FCA said this only partially explained the growth in market share for larger banks which rose from 46 per cent in 2018 to 53 per cent in 2020. At the same time, scale challengers, mid-tiers and building societies’ market share declined by the same amount.
“Among the Big Four firms, some have achieved increased growth through expanding their brokerage network,” it said.
Lender competition
The review found that smaller banks and building societies struggled to compete with larger firms in the low-risk lending market causing them to exit altogether or seek yields in other segments including high-risk markets.
This includes higher loan-to-value (LTV) lending or products which require specialist underwriting. Additionally, some banks have entered into forward flow agreements to fund specialist lenders in higher yielding mortgages, enabling them to participate in these market segments indirectly.
The FCA mentioned the buy-to-let (BTL) sector as a key example and said while big banks were able to focus on consumer landlords alongside prime residential mortgages, scale challengers and specialist lenders increased share by lending to professional landlords.
As a result, the Big Four’s share of BTL lending fell from 51 per cent to 40 per cent between 2015 and 2020. Meanwhile, market share for specialist lenders and scale challengers has grown by a corresponding amount.
Digital drive
It found the historic advantage larger banks had over smaller lenders had been weakened through innovation, digitisation and changing consumer behaviour.
This included digitilisation opening up the opportunity for branchless banking as well as technological development and lower regulatory barriers to entry through challenger banks causing a loss in market share.
It said the “gap in profitability between large banks and smaller challengers has reduced in recent years, driven by competition in mortgage prices, innovations in banking services and reduced ability to lower fundings costs, with rates on customer deposits already very low”.
The review also noted that larger banks adopted the innovation led by digital challenger banks, resulting in better customer outcomes.
Additionally, banks told the FCA that a further impact of increased competition had been innovation in the broker channel.
As a result, banks have developed software for brokers to help them identify appropriate mortgages for customers more easily and quickly, which is likely to improve the service clients receive. Additionally, banks said they developed improved credit-decisioning functionality to enable them to compete effectively in the broker channel.
Kate Collyer, chief economist at the FCA, said: “Competitive pressures and innovation are starting to deliver for retail banking customers, with greater choice, lower prices and more convenient ways to bank.”
