Capital Adequacy rules will stop any foreign bank cutting mortgage rates in Ireland.

Discussion in 'The Fair Mortgage Rates Campaign' started by RedOnion, 29 Sep 2018.

  1. RedOnion

    RedOnion Frequent Poster

    There's been a lot of excitement over the last week about a new entrant to the Irish mortgage market, and speculation about what rates they might offer. I've seen posters here, and elsewhere, pointing out rates available in Germany and Spain for example, and talk about those rates being made available here.

    However, German mortgage rates will NEVER be available here. Why?

    The 1 key measure that bank investors (and therefore banks) care about is return on equity.

    Apart from bad debt losses, the others big influence on return is Net Interest Margin. That's the number people are focused on - the margins are higher here. Fantastic opportunity for a foreign bank.

    However, the equity part of the equation is overlooked.

    If a foreign bank offered the same rates here as in Germany, their return is lower. Because they must allocate much more capital under capital adequacy rules.

    In Germany the risk weight of mortgages is 15%. In Ireland it's 40 on new business (it's as high as 80 for example on back book in Ulster Bank). A foreign bank moving here would need to use standardised Irish risk weight models, so would be using weights of 35-40% depending on LTV.

    So the risk weighted assets of their balance sheet is higher, requiring more capital.

    Irish banks have the additional impact of counter cyclical buffers requiring more capital against their RWA.

    What's the impact of this?

    The below estimates are from Goodbody in relation to Bankinter:
    " We would note that Spanish mortgage risk weights
    average 15% vs c.40% in Ireland (on new business). Any new entrants here would
    have to work off Irish models or standardised risk weights, so the starting point
    would be RWA densities of 35-40%. We estimate a 2.0% interest rate on 35-40%
    risk weights generate ROEs of 8.5-9.5% vs 22% on a 15% risk weight

    No bank is going to allocate capital to Ireland to earn less than half the return they can get at home, before factoring in potentially higher losses here, or sharing profits with a partner like An Post.
  2. Brendan Burgess

    Brendan Burgess Founder

    OK, let me get my head around this.

    I want to set up a new mortgage lender and I can choose to lend in Ireland or Spain.

    Say I target €100m of mortgages to keep the numbers easy


    Assuming that I have the same costs and defaults in each country, this will be reflected in the profitability and Return on Capital as follows:


    Or look at it another way, with €3m to invest, I could do about double the lending in Spain than I could do in Ireland and so make twice the profits.

    Or look at it yet another way, if I invest my €3m in Ireland, I would need to charge a higher margin to get the same profits.

  3. Brendan Burgess

    Brendan Burgess Founder

    And here are the risk weightings across Europe


    So here are the figures for a bank lending in Sweden vs. a bank lending in Ireland.

  4. Brendan Burgess

    Brendan Burgess Founder


    Who sets the rate at 42.5%?

    Let's say that EBS had decided back in 2003 that it was going to stick rigidly to 80% LTV and 3.5 times income, and, as a result had very, very low mortgage defaults. Would it still have the same capital adequacy requirements as Ulster Bank today?

    If a very conservative lender from Germany set up in Ireland and limited their loans to 50% LTV and 3.5 times income, would they too be caught by the 40% risk weighting.

    This is the point that I don't understand. 90% LTV lending should be more expensive in Ireland than 90% mortgages in Sweden because they are a lot riskier.

    But 50% LTV mortgages in Ireland are no riskier than 50% LTV mortgages in Sweden and show they should have the same risk weighting and the same mortgage rate.

    MugsGame likes this.
  5. RedOnion

    RedOnion Frequent Poster

    Last edited: 6 Oct 2018
    This isn't what I do, so apologies if I'm light on details.

    Edit: post heavily edited after discussion, as my initial reply was about 6 years out of date!

    The Central Bank decide whether banks can use standardised approach or Internal Ratings. In Ireland, with the exception of EBS, all the banks use internal ratings. I'm not close to the details, so I don't know the exact mechanics of this, other than it relies heavily on past loss / default rates for the bank.

    No, as their loss rates would be lower.

    Yes, for their Irish lending. I think the lowest risk weight is about 35%.
    a new entrant to the market would be forced to use a standardised model, where weights would be set by CBI (I understand based in the loss experience of all the banks - it would take 3 years for a new entrant to build enough data to use their own experience here).

    There used to be a bigger gap, but it's shrunk. Which is why banks stopped differentiating between LTV bands.

    That should be the case, but the calculations factor in past loss experience and default rates. There has been much more default on 50% LTV mortgages here vs Sweden.
    Even without a financial loss in the long run, the EBA rules around capital requirements in default mortgages hits the banks capital requirements you front, so leads to an accounting loss.
    Last edited: 6 Oct 2018
  6. Protocol

    Protocol Frequent Poster

    Again, great work by people on AAM.

    A bit technical for much of the media.

    Somebody should explain this in simple English and publish a press release.

    Most politicians won't know this.

    Will our RWA % ever fall? Who determines it?
  7. Brendan Burgess

    Brendan Burgess Founder

    Hi Red

    There have been some defaults, but I understand there have been no losses.

    Or put it another way, one lender told me that there were close to zero losses on mortgages which were handed out at 80% LTV and 3.5 times Loan to Income.

  8. RedOnion

    RedOnion Frequent Poster

    Brendan, your first reply above summarises my understanding brilliantly. A table paints a thousand words!

    Possibly the sample size of mortgages that met those criteria post 2003 isn't big enough to be used as an argument with external rating agencies? Or maybe the inability to repossess the collateral weighs heavily?
    If you've a contact in the CB they might be able to help with the specifics.
  9. RedOnion

    RedOnion Frequent Poster

    Goodbody have a short piece on this in their daily briefing today.

    The angle is from an investor perspective, but none the less explains the amount of capital needed here (50 per 1000) Vs average in Europe (16 per 1000). By their calculations, adjusting for cash back and lost fee income, the return on equity here is only 75% of the norm in Europe.

    So why would a foreign lender come here?
  10. NoRegretsCoyote

    NoRegretsCoyote Frequent Poster

    This is fascinating.

    There are roughly too reasons why probability of default and loss given default are so high in Ireland:
    1) very poor underwriting standards between about 2002 and 2008
    2) serious difficulty with securing collateral

    While repossession is still very difficult, underwriting standards are a lot better in 2019. There are prudential rules in place by the Central Bank and, anecdotally at least, banks tightened up a lot on underwriting even before these were introduced in 2015.

    Given that new mortgages are likely to be of a much better quality than the historical pattern, is there no way for banks to use lower ratings for capital purposes on new lending?
  11. Zebedee

    Zebedee Frequent Poster

    From what I understand the capital requirements will start reducing as the losses in their models get diluted by more favourable returns since the crash. However this may take some time.

    (Ps not an expert)
  12. RedOnion

    RedOnion Frequent Poster

    Yes, over time it will reduce. It's a question of how long, and especially how long before a new lender could benefit from the lower risk weightings.

    Jon the club!
    I thought I understood this until I tried to explain it.