Building Societies and the Future of Retail Banking

Speech by Jonathan Davidson, Director of Supervision – Retail and Authorisations at the FCA, delivered at Building societies annual conference 2018, Manchester.

Speaker: Jonathan Davidson, Director of Supervision - Retail and Authorisations
Location: Building societies annual conference 2018, Manchester
Delivered on: 23 May 2018

Note: This is the text of the speech as drafted, which may differ from the delivered version.

Key points

  • In the ever-evolving financial landscape, building societies have an opportunity to provide a valuable service for consumers. They can offer unique and complex products, but must also consider the unique and complex risks that come along with them. 
  • Mortgages are long-term products and considering affordability and lending risk is key.
  • Building societies should focus on healthy competition for the benefit of the consumer and the society, rather than unhealthy competition such as loosening underwriting standards or chasing significant differentials in front to back book pricing.

Today, I would like to talk about opportunities for the building society sector in light of wider developments in the market. The sector occupies a central place in the everyday life of consumers up and down the country. And this is a sector bearing witness to fundamental changes being wrought in the marketplace.

For both us as the regulator and you as industry, these changes – some social, some regulatory and some technological – are reshaping the landscape in which we operate, and challenging us both to think creatively and comprehensively about the opportunities we now face.

My main message to you here today, is that although change brings risk, it also brings opportunity. As a regulator, we want to work with you collaboratively in taking advantage of the opportunities for you to help finance a well-functioning mortgage market, provide innovative products, and help consumers to get good value for money.

Mortgage market

Benjamin Disraeli once said: ‘Change is inevitable in a progressive country. Change is constant.’ The UK has certainly lived up to this description in recent years – particularly in the housing market.

This is the market that Prime Minister Theresa May described just over a year ago as ‘broken’, with demand outstripping supply and housing becoming less and less affordable for young families. But it hasn’t always been this way. How did we get here and what does it mean for the building society sector?

To set the scene, I am going to talk about 3 eras that I have seen in the development of the UK mortgage market. The first is what I call the ‘homeownership era’. In this long period up to the early 2000s, home ownership was on the rise, driven in part by the government’s ‘Right to Buy’ policy. Home ownership rose for decade after decade eventually reaching a peak of over 70% in 2002.

Property wealth is becoming increasingly concentrated and less and less people are reaping the returns of property investment.

Then, in the run up to the financial crisis, came the ‘boom’ era, with strong growth in house prices, and correspondingly strong growth in the volume and value of mortgages. However, a significant proportion of this growth came through re-mortgaging and the withdrawal of equity. In the run up to the crisis, around 60% of new lending was re-mortgaging, and up to 12% of this new lending funded consumption. So, when the country went into recession, consumers were leveraged to the hilt.

After this, came what I call the ‘investment era’. The lucky ones even made money from their homes as house prices continued to rise – at least in some parts of the UK. A startling statistic is that in some areas the average home owner has been earning more from the growth in their home’s value than from their work. Last year’s government white paper pointed out that: ‘In 2015, the average home in the South East of England increased in value by £29,000, while the average annual pay in the region was just £24,542. The average London home made its owner more than £22 an hour during the working week in 2015 – considerably more than the average Londoner’s hourly rate.’

Who are these investors? The underlying trend is that property wealth is increasingly in the hands of baby boomers. Indeed, half of property wealth is in the hands of baby boomers.

Property wealth is becoming increasingly concentrated and less and less people are reaping the returns of property investment. For example, since the turn of the century, the rate of households owning a second home has increased 30%; the rate of private renting has doubled; and the overall rate of home ownership has fallen 7%.

By way of contrast, post-recession, young people were struggling to buy their first home, as the price of homes were, and remain, beyond the reach of many as a result of high property prices relative to income. And deposits were particularly hard to save for those facing rental costs. We also heard allegations that first time buyers were losing out as investors snapped up properties for buy-to-let. Strong growth in buy-to-let volumes stood out against a background of slow overall volume growth and value growth just keeping pace with house price growth.

All this led to government initiatives such as Help to Buy and other measures to cool the buy-to-let market. Now we have entered what I will refer to as an ‘era of diverse needs’.

Home ownership is increasingly in the hands of an ageing population. Many of the baby boomer generation will want to realise property value gains. This may come about through selling and downsizing. But also by borrowing against their equity. Some will want to release equity to help family members, what we might call ‘intergenerational wealth transfer’. Some may want to supplement retirement income. Some to fund home improvements or other purchases. Some may want to repay other debts.

Furthermore, as we go forward we are likely to see more people, who entered home ownership later, borrowing over longer terms due to high property prices and the need to make their mortgage payments affordable, carrying their mortgages into retirement.

These needs explain why the fastest growing area of lending that we see is lending to borrowers who will be beyond ‘retirement’ at maturity. In fact, lending to those who will be 76 or older at maturity is growing at 44% per annum, albeit from a low base. And lifetime mortgage lending is also on the rise.

The trends that we’re seeing create an opportunity for lenders, opportunities that building societies have been quick to snap up. As the regulator, we‘re keen to create the climate for you to provide responsible innovative products. Hence why we introduced new rules allowing for retirement interest only mortgages where the source of repayment can be sale on death or movement into long term care. The focus, however, is on ‘responsible’.

History tells us that competitive innovation that involves lenders loosening their criteria does not end well. The basic fact is this: when lending goes wrong, consumers suffer as well as firms.

Retirement interest-only is not an entirely new form of lending, but nevertheless it presents many challenges. For example, there is a natural caution to lend to older borrowers, not least due to potential challenges of assessing affordability, not to mention the potential challenge down the line by relatives as a person moves into care or passes away. But there is a real opportunity here to devise solutions that will really help and provide value to your members if done right.

But the older borrower demographic is only part of the story. The government is focused on building more homes, and schemes for first time buyers remain a priority. Younger borrowers face some significant challenges. The price of housing as measured by price to income is nearly at an all-time high. And this is a generation with little savings and high levels of other debt. Our Financial Lives survey showed that 23% of 25-34 year olds are over-indebted and about a fifth have no cash savings.

Not only are the millennials facing into an expensive housing market and financial challenges, they are witnessing big changes in the pattern of employment. While employment is at an all-time high, the number of self-employed people in the UK rose by 45% since the turn of the century; that is more than 1.5 million becoming self-employed. On top of that there are more than 900 thousand people currently on zero-hours contracts. The gig economy is growing strongly.

With all of this change, with new needs emerging and new challenges there are plenty of opportunities for building societies to help consumers.

But before I go into thoughts about these opportunities for you, I want to talk about competition.

A consumer’s perspective on competition

In addition to all this market change, as regulators we have also seen opportunity; opportunity to make the mortgage market work better for consumers both by protecting them from harm and encouraging healthy competition.

Historically, as we have approached the peak of the markets and when growth in the market has stalled, we have seen many market participants compete by loosening underwriting standards. History tells us that competitive innovation that involves lenders loosening their criteria does not end well. The basic fact is this: when lending goes wrong, consumers suffer as well as firms. So this is an area we will continue to monitor, as will our colleagues at the Bank.

Following the 2008 financial crisis, the Mortgage Market Review (MMR) and Mortgage Credit Directive (MCD) primarily focused on ensuring that consumers got good advice and didn’t end up with unaffordable mortgages. Yet we are still dealing with risks from the last boom and bust 10 years ago. Nearly 1 in 5 existing mortgages are on an interest-only basis. That’s 1.67 million interest-only mortgages outstanding in the UK, many of them made before 2008. Many present the risk of shortfalls in repayment plans, and could ultimately lead to people losing their homes.

We are dealing today with risks from lending that took place more than 10 years ago and we will still be dealing with them in 10 or 15 years. So it makes sense to ask how is the industry doing with its lending today?

There are several peaks in the maturity of interest-only mortgages. The first peak, which we’re seeing now, is likely to have fewer and more modest shortfalls as customers tend to be those approaching retirement with higher incomes, assets and levels of forecast equity in their property at the end of term.

However, the next two peaks, in 2027/2028 and 2032, include less affluent individuals who had higher income multiples at the point of application, greater rates of mortgages converted from repayment to interest-only and lower forecast equity levels. We are concerned that these customers are more at risk of shortfalls.

Our main objectives have been to encourage borrowers and lenders to take early action. Yet, we know that many customers remain reluctant to contact their lender to discuss their interest-only mortgage for a variety of reasons. We are very clear that people should talk to their lender as early as possible as this will give them more options when it comes to the next steps they can take. And we are encouraged to see that lenders have taken positive steps to engage with and help their interest-only customers.

While we are pleased that lenders have already taken positive steps to engage with and help their interest-only customers, it’s vital that complacency doesn’t set in.

Because it’s crucial we head this issue off at the pass.

We are dealing today with risks from lending that took place more than 10 years ago and we will still be dealing with them in 10 or 15 years. So it makes sense to ask how is the industry doing with its lending today? We think that the industry is currently doing a reasonable job on affordability. Nevertheless, the Bank of England recently called out some early warning signs of relaxation of lending standards. Our own data backs this up, showing that the proportion of lending at higher loan-to-income ratios is creeping up. The risk appetite of lenders will always occupy the thoughts of regulators, and in our case we worry whether any loosening of standards will harm consumers. So this is something we will continue to monitor.

We are also monitoring arrears. Although the number of mortgage accounts in arrears is at an all-time low, the level of more serious arrears (more than 5% of the loan balance in arrears) has remained relatively stable. All good, you may think. But the current rate of repossessions as a percentage of serious arrears is also at an all-time low. We do worry about the extent of forbearance being offered in cases where the borrower has no realistic chance of getting back on track. Can it really be in their interest for their arrears balances to continue to rise, if their equity continues to shrink, for an indefinite period? This is an area we are currently looking at and we will publish our findings later this year. We are also taking the opportunity to look at how firms are dealing with the changes to the payment of support for mortgage interest from a benefit to a loan, and the treatment of borrowers who do not opt for the loan that subsequently fall into arrears.

While irresponsible lending is unacceptable, we do want to see healthy competition – for example on the cost of mortgages. The Mortgage Market Study has therefore been an interesting opportunity to see how regulation has impacted the way that the market works. While the MMR focused on affordability and the role of advice in ensuring that borrowers bought a suitable mortgage, the Mortgage Market Study focused on the role of competition and how easily borrowers could find the best value deal.

The study found that changes to our rules, following the MMR, have resulted in almost all customers receiving advice before obtaining a mortgage with a new lender.

The good news from a consumer’s point of view is that the competition in the market from a cost perspective is also generally working well, though with some specific areas for improvement. Our study found high levels of consumer engagement in the market, good competition on headline rates, and little evidence that current commercial arrangements between firms are associated with material harm to consumers.

Going forward, we want to make sure that we build on the progress that has been made in relation to advice and suitability, and work with industry in considering what more can be done in helping customers get the best deal.

How might customers be able to get even better deals? Our research showed that consumers find navigating the market difficult, with there being scope for improvement in the tools supporting customers to shop around for mortgages or in helping them find the right broker. While there appears to be good competition on headline price, it is hard for consumers to get a sense at an early stage of which products they would qualify for.

This is especially the case for potential borrowers who do not have standard needs, for example, first time buyers, self-employed, retired or retiring borrowers. It seems to me that these borrowers represent an opportunity for

  • building societies that embody the values of membership and long term trust-based relationships
  •  know their members and the local community personally
  •  understand consumers as individuals rather than as archetypes in a risk-scoring model

We also need to think about the fair treatment of customers who do not or cannot switch mortgages.

While most consumers in the mortgage market are well engaged, there is a significant minority of consumers who stay on reversion rates for an extended period.

Some of these customers don’t have the option of switching. We estimate there are c.30,000 customers with firms authorised to lend who cannot change mortgages now due to changing lending criteria. We are planning to engage with industry and consumers to explore a number of possible options for helping these customers. And then there are other customers, who remain on a reversion rate for a longer period of time, who would benefit from switching to a new lower introductory rate but do not.

In summary on competition: I think there is an opportunity here for industry to do more to help customers find the best deal for them. We will be looking to explore a number of solutions with you, which could include looking at the role of technology in helping customers compare products or establish eligibility.

Remaining competitive – a building society perspective

Having talked about healthy competition in the interests of consumers; what does healthy competition look like for the building societies? We are conscious that price-based competition is intense for the building societies and there is noticeable and continuing squeezing of Net Interest Margins and reducing returns on capital.

I know that many building societies feel that competition is not a level playing field and feel that the large banks in particular enjoy unfair competitive advantages – not least in terms of lower capital requirements.

At the FCA, we have been looking carefully at the relative competitive advantages of the various business models in retail banking whether they are building societies, challenger banks, digital firms or big banks. In our work on retail banking business models, the two most important questions we have been asking are:

  • Why has banking been so dominated by the big banks?
  • How might competition change given all the tectonic change in the financial services landscape?

As an aside, I am often asked why are you doing this work given the work of the Competition and Markets Authority (CMA) and others in this area; and what regulatory initiative are you contemplating taking on the back of it? There may be some initiatives that come out of this but there are two more important primary reasons for the work. First, is to take a perspective across the whole business-model – not just current accounts. And the second is to fast forward to potential scenarios for the competitive landscape and consider whether they would represent markets that are working well for consumers.

We aren’t quite ready to share our research and analysis, so I will share with you some of the hypotheses we have been working on. The first hypothesis is that large retail banks have enjoyed competitive advantages not just from capital requirements but from other factors. For example, we hypothesise that banks enjoy a competitive advantage on funding costs from the personal current account, associated savings accounts and back books of cash savings on relatively low rates. While this effect is muted by low interest rates and the costs of running current accounts and branch networks it likely represents a competitive advantage over the many building societies without current accounts and with flat pricing of their back books. We also hypothesise that current accounts have been the source of relatively profitable fee income from overdraft charges, foreign exchange and interchange revenues.

I think we are at one of the hinges in the history of retail financial services. It’s full of opportunities for you if you choose to push on the door of innovation and go about it in the right way.

But these competitive advantages could well reduce significantly. The branch network was once a foundation for current accounts. You can open current accounts or their equivalent with a few taps on your mobile phone now as many fintech firms have demonstrated. In the last few years, combining developments in smart phones, with advances in KYC technology, Monzo has opened over half a million current accounts as of March this year.

At the same time, Payment Services Directive 2 (PSD2) and Open Banking are working to open up access to transaction data on current accounts, credit cards and some savings accounts to other firms. The effects of this are potentially radical. I was talking to someone recently who had a permission to provide consumer credit unsecured loans and had recently received their Payment Services Directive (PSD) permission to access the accounts of customers. The business had 1/2m customers and access to 1m bank accounts. He set up a business model where if his customer was about to go into overdraft the app would see this via their access to the clients bank account and lend that customer money. It was a win for him to lend money profitably and a win for his customers who got to borrow at a much lower rate than on overdraft.

Digitisation potentially has important implications for big retail banks. But what might it mean for you?

In 2015, the Financial Times ran an article with the title ‘UK building societies slow to adjust to demands of digital age’. The article argued that with the rise of digital providers, eg Apple Pay, the building society sector remained reliant on decades-old paper-based systems. I was pleased to read the Building Societies Association (BSA) spotlight on some of the societies that have made progress in the intervening years, and have launched innovative products including financial education apps, new mortgage processing systems and comparison tools.

More recently, I think that there is an ever stronger sense that economies of scale in technology don’t exist. This further reduces the competitive advantage of the big banks. In fact, there may even be diseconomies of scale in legacy technology.

I think that all this change is a positive development for you and your members. I think we are at one of the hinges in the history of retail financial services. It’s full of opportunities for you if you choose to push on the door of innovation and go about it in the right way.

Getting it right

What does getting it right look like for a building society? I ask that you look to the traditional values of the building society and consider 4 requests from me as your conduct and competition regulator:

First, be careful and take a long term view on affordability and lending risk, especially if you are competing head to head with the big banks in the core of the ‘standard’ mortgage market. Mortgages last a long time and the future is always unpredictable.

Second, focus on properly understanding your members as individuals with unique and complex needs and, by the same token, unique and complex risks, especially if you are competing in non-standard areas such as the self-employed or older borrowers.

Third, focus on healthy competition which is in the interests of your members as well as your society especially if you are tempted to compete by loosening underwriting standards or chasing significant differentials in front to back book pricing.

And finally, please maintain a two-way dialogue with us – especially if you are looking to pilot innovative products. Do consider engaging with our Innovation Hub, which can provide additional support, or consider testing your product ideas through our sandbox.

Conclusion

In conclusion, the inevitable change foretold by Disraeli will continue to shape and re-shape the market place, and both regulator and industry alike must stay alive to the threats and opportunity such shifts present.

As your regulator, we want to see you flourish, we want what is best for your members and we want to have a dialogue with you.

The building society movement has a proud and long history of serving its members. I am hopeful that you will take advantage of opportunities to continue to make a difference to your members and the market going forward.