London: British banks have been warned that they may have to use minimum floors when they calculate the capital they need for their mortgage books, as the UK regulator seeks to tighten standards. The Prudential Regulation Authority has said it does not want to see lenders running down capital after a temporary standard on risk weights lapses this month. The watchdog, part of the Bank of England, is planning to consult on the area, as it examines the way banks calculate the risks in their portfolios.

Regulators have become increasingly suspicious of the models banks are deploying in assessing risk-weighted assets. In an exercise ordered in 2012, the UK regulator asked banks to apply a minimum 15 per cent risk-weighting to their residential mortgage portfolios.

That temporary standard ended at the beginning of July. In a little-noticed paper, the PRA said last month it intended to consult on the way in which capital requirements for residential mortgages reflected risks in their books.

The regulator said: “In the interim, the PRA expects firms not to reduce their capital in such a way that it could present them with challenges if similar adjustments for residential mortgages were introduced following the consultation.”

David Strachan of Deloitte said: “This is a clear indication that one of the outcomes of the PRA’s consultation — although by no means the only possible outcome — is that it will cement the floor on risk-weighted assets in the residential mortgage book at 15 per cent.

“This is a signal to banks that it would be premature for them to assume they can ignore the 15 per cent floor and take any capital benefit just because the floor [lapsed] on July 1.”

The development is a particular issue for lenders such as Nationwide, which have large residential mortgage books skewed towards less risky loans. The building society has an average risk-weight lower than many of its competitors.

In its annual report, released in May, Nationwide said that with a 15 per cent risk-weight floor in place, its “PRA adjusted” common equity tier one capital ratio would fall to 11.2 per cent for the year ended April 4, 2014.

It said in a statement: “However, given that our CET1 ratio currently stands at a market-leading 14.5 per cent (as at year-end 2014, and with an additional 0.5 per cent contribution from the sale of our German commercial loan book), we have sufficient flexibility to withstand such an impact and still maintain a strong and competitive CET1 ratio.”

Paul Sharma, a consultant at Alvarez & Marsal, said the problem with a risk-weight floor — as well as a leverage ratio that measures capital against assets not adjusted for risk — is that they punished less risky mortgages. “Banks can arbitrage that by getting out of low risk-weighted mortgages and moving into higher risk loans,” he said.

He added: “One answer might be to impose floors that are more dynamic — starting at less than 15 per cent for lowest-risk mortgages, and stepping up to higher than 15 per cent for loans that are at higher loan to value or loan to income levels.”

— Financial Times