The Bad Blood In Basel III

Warehouse lending could dry up if capital requirements become too burdensome

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CMB

Imagine reading a blog post about Basel III that says it could be the endgame for mortgages, pushing large banks even further away from the market. You ask around, call some friends, but no one seems to understand the nuance. Well, except your know-it-all mortgage friend who thinks you said “basil,” that spice he loves on margherita pizza. You shake your head and look for more reliable information on what Basel III really entails.

“Basel” refers to the city on the Rhine River — and is pronounced “BAH-zәl,” unlike the spice. The Basel Committee on Banking Supervision meets in Basel, Switzerland, and has roots dating back to 1974. The first Basel Accord, released in 1988, established minimum capital requirements to internationally active banks.

Basel II was released in 2004, revising Basel I capital frameworks by introducing more risk-sensitive capital requirements and enhancing risk management practices.

Basel II was criticized for its complexity and for potentially underestimating risks during the financial crisis, leading to a revision in 2009 in response to the global financial crisis of 2008. Basel III was subsequently introduced with new efforts to increase the resiliency of banks by strengthening capital requirements. The gold-plating additions force banks to deal with stricter definitions of capital and higher minimum capital ratios.

The impact will require banks to hold more capital based on new standards for assets like small business lending and consumer mortgages. Capital can be used for business, investment, or simply held to meet these increased requirements. Reserves must be liquid to meet these needs. To implement Basel III, the Federal Banking Agencies proposed an interagency Notice of Proposed Rulemaking which was anticipated to impose up to a 20% increase in the capital requirements for larger institutions.

How Basel III Considers “Capital”

Let’s do a level set and review what “capital” means in this context.

We know “capital” is the value of a business, including working capital and more liquid assets like money held in banks and longer-term investments and real estate holdings. Think of liquid capital as the assets a business uses to pay salaries and expenses tied to day-to-day operations. Longer-term investments help businesses “grow money” beyond regular business bank accounts. There are other types of capital that cannot be easily spent, such as goodwill, brand value, and intellectual property.

The capital banks hold is not only used for running operations, but to protect shareholders and depositors as well, like a safety net. A bank’s assets typically include cash, securities, and loans made to consumers, businesses, other banks, and governments. Banks use cash and other liquid assets in day-to-day operations. Longer-term investments like consumer, small business, and mortgage loans made to customers cannot be easily spent. However, mortgage servicing rights (MSRs) are more liquid assets for investment than holding whole-loan portfolio products. A portfolio loan can return more on the investment, but the asset repays over a longer period over time. An MSR could be sold for cash, but generally not overnight.

Combined with rising housing costs, delayed rate relief, and nationwide housing shortages, these efforts will only exacerbate the challenges lenders face today.

Bob Niemi, CMB

Director of Government Affairs

Weiner Brodsky Kider

These different assets (creators of capital) have different risk characteristics to which the Basel accords assign different risk weights. Those risk weights indicate the risk certain investments are for the bank to hold. Credit risk from small business lending, consumer loans, and mortgages must be reconciled by the bank with capital reserves should those loans default. Not all loans repay on the same schedule, either, or have the same underlying guarantees. Mortgage assets with higher risk carry a higher risk weight compared to that of a U.S. government bond, which has a zero-risk weight. A mortgage borrower may default, but the government won’t.

Banks finance investments and lending activities with capital, such as customer deposits, and debt. Banks do their own borrowing. While all businesses need reserves for unforeseen events, banks must hold money in reserve to make sure they can manage unexpected problems and maintain business continuity. The increased reserves can help the bank absorb losses to reduce the likelihood of a bank failure. In today’s digital banking world, challenges can materialize faster because consumers can empty their accounts almost instantaneously.

This increases the need for sound risk management practices and additional capital reserves.

The risk weighing impacts under Basel III are based on their perceived riskiness. Longer term mortgages and mortgages with higher loan-to-value ratios and lower borrower creditworthiness carry higher risk weights. Basel III applies a risk weight applied to MSRs of 250%, which dramatically reduces the incentive to hold servicing rights on a bank’s balance sheet. To hold an MSR worth $100, for example, banks would need $250 in reserve.

Risks For Independent Mortgage Bankers

Is this sound, or an additional incentive for banks to focus on lower-risk assets and move further away from mortgages? Possibly both. The increased risk weight for MSRs alone will impact first-time homebuyers as they find it harder to obtain loans with smaller down payments as banks implement these requirements. Smaller down payments mean higher loan-to-value ratios, riskier assets for banks, and higher capital requirements.

Basel III also increases capital requirements to offset banks’ risk from warehouse lines extended to independent mortgage bankers. Warehouse lenders are a critical component of the mortgage finance industry as they provide short-term financing for independent mortgage bankers to fund loans, which are then repaid when the loans are sold in the secondary market. These increased capital requirements and risk weighting will reduce a bank’s willingness (or ability) to engage in warehouse lending.

This could increase costs for existing warehouse lenders, reducing credit availability in the mortgage market.

It is important to recognize, however, that Basel III would only apply to the fewer than forty banks that hold over $100 billion in assets. These large financial institutions have been pulling away from the mortgage market since Basel II, due to the increased capital requirements, regulatory burdens, and profitability challenges from evolving markets. Nevertheless, banks continue to be systemically important to the independent mortgage bankers and servicers, as well as their business partners, and this attempt to strengthen the global banking system could create a fundamental shift in how mid-sized and U.S.-based regional banks operate.

But, Basel III could also reshape the dynamics of U.S. mortgage lending, making it more like Europe, where thirty-year mortgages are unheard of. Combined with rising housing costs, delayed rate relief, and nationwide housing shortages, these efforts will only exacerbate the challenges lenders face today. While the proposed rule has been tabled for further review, when the next iteration comes around, educate your friend over pizza.