Why mortgage rates are lower in UK

Why mortgage rates are lower in UK

UK retail banking customers enjoy the benefits of a highly competitive market which has seen aggressive pressures on mortgage pricing, personal loan pricing, and savings rates.

To put this into context, the average two-year fixed mortgage rate has fallen to under 2.5% while the average five-year fixed mortgage rate is materially below 3%. 

This means that spreads over the Bank of England base rate of 75 basis points are at all-time lows.

Personal lending facilities are also available at rates of below 3%. 

Competition for savings has also been intense, with attractive deposit rates available from the likes of Marcus and many specialist banks.

The UK Competition and Markets Authority’s investigation into retail banking in 2016 pointed to a high degree of concentration in the market — with the largest banks — Barclays, HSBC, Lloyds, RBS, and Santander UK — as well as Nationwide Building Society responsible for the lion’s share of the retail banking market. 

There are some key reasons underpinning the competitive forces at play.

Firstly, these large credit institutions have substantial fixed cost bases. 

This enables these institutions to capture scale benefits and much of any incremental net interest income from low-yielding mortgage lending falling straight to the bottom line.

Almost 80% of mortgages in the UK are distributed via brokers — in stark contrast to the Irish position. 

Secondly, the relative dominance of these large institutions in the market for retail deposits — and the low propensity of deposit customers to switch provider — gives these scale players access to low-cost funding.

However, the most important factor underpinning low UK mortgage rates are the low risk weights and, consequently, low capital requirements, attached to mortgage lending there.

Mortgage lending is a high-returns product. Even though rates have compressed materially in recent years we still hear executives of the large institutions speak every quarter about the highly attractive returns on equity available on this product. 

This, essentially, means that the large UK players must fund mortgage lending with much less equity capital than younger banks or banks operating in certain other jurisdictions, like Ireland.

Put simply, if one bank’s equity capital requirement is twice that of another bank — if its risk weight is double — then it will need to charge a price that is almost twice as much to earn the same return.

The average risk-weighted asset intensity on the large UK banks’ mortgage books is just over 10%, while the corresponding figure for the main Irish banks is 38%. 

Why mortgage rates are lower in UK

This means that Irish banks must hold almost four times as much equity capital against their mortgage books. 

One doesn’t need a PhD to work out why mortgage rates are much lower in the UK.

A lot has been written about the rise of challenger banks in a UK retail banking market context. 

There are specialist lenders like Paragon and OneSavings, who focus on the provision of niche lending products outside of the mainstay of the large credit institutions — for example, professional buy-to-let lending. 

Additionally, digital banks like Monzo and Starling have emerged and these players have had success at growing a customer base quickly but have yet to demonstrate sustainable profitability capability. 

New challenger banks that compete predominantly in mainstream mortgages have struggled as they don’t enjoy the benefits of lower risk weights and, therefore, carry higher capital requirements — as well as suffering from lack of scale.

Metro Bank is a recent case in point — while the bank has developed a novel retail funding proposition, it simply can’t deliver sufficient profitability as it has elected to compete in the retail lending market and its share price is down around 85% from its dizzy heights.

While the relative dominance of the large lenders has gone largely unchallenged thus far, the landscape will undoubtedly evolve significantly over the coming decade.

John Cronin is financials analyst at Goodbody, specialising in UK bank stocks

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