OREANDA-NEWS. The UK Prudential Regulation Authority's (PRA) new approach to setting the supervisory capital requirement for banks, known as Pillar 2, published at end-July, endorses the use of very low risk weights (RW) for low loan-to-value (LTV) mortgage lending. Losses on these retail mortgages in the UK have been modest and this supports the low RWs, but only while there are no significant changes in the favourable operating environment, says Fitch Ratings.

From January 2016, Pillar 2-A credit risk capital requirements for UK mortgage lenders who assess credit risk under Basel 2's standardised approach (SA), such as Yorkshire, Leeds, Newcastle and Skipton building societies, will be benchmarked against a weighted average of RWs applied by banks using the internal ratings-based (IRB) approach. The PRA benchmark sets very low RWs for prime and buy-to-let (BTL) mortgages with LTV ratios under 80%.

RWs for retail mortgages have fallen sharply over the years: 50% under Basel 1, down to 35% for low LTV exposures under Basel 2's SA and potentially far lower for lenders using IRB models. PRA benchmarks are far lower. For example, prime and BTL mortgages with LTVs below 50% are, on average risk weighted at 3.3% and 4.1% and benchmark RWs only exceed 30% when loan to values exceed 80%.

Data provided by the Council of Mortgage Lenders shows three- to six-month mortgage arrears at end-2014 were 0.6% of total outstanding mortgages. Even during 1990-1995 when house prices contracted sharply, forcing a doubling of mortgage delinquencies, arrears peaked at a modest 2%. Losses upon defaults since have been significantly lower because housing shortages support prices and lenders have been able to recover loans from repossessed properties at close to indexed values.

Core capital requirements for UK banks are far higher now, which also supports market confidence. New measures to strengthen capital adequacy, such as capital add-ons to counter concentration risk and the enforcement of a leverage ratio of at least 3% to be introduced in 2016, will ensure additional buffers.

Nevertheless, given the high indebtedness of UK households and low personal savings rates, we can envisage scenarios where capital allocated against mortgage books may be insufficient to absorb unexpected losses and maintain market confidence. This could be the case, for example, if stresses exceeded assumptions used in the 2014 stress test applied by the Bank of England. This test was more severe than recent experience and envisaged a 4% base rate hike, unemployment rising to 12% and a 35% fall in house prices and reduced core capital for participating banks by nearly three percentage points to 7.3%. There was greater capital pressure for lenders using point-in-time rather than through-the-cycle probabilities of default to calculate RWs under IRB models.

As residential mortgages are a key product for many UK domestic banks, the possible risk of insufficient capital being set aside against low LTV mortgages could cause considerable macro-economic risks, a fact identified last year by the Bank of England's financial policy committee.

Both high UK household indebtedness and some concentration on residential mortgages for many banks are factored into our UK bank ratings. For banks that have a strong focus on mortgage lending and lack geographic diversification, there is limited potential for Viability Ratings to rise much above the 'a' category unless they show extremely strong and stable fundamentals.