There are 43 building societies in the UK with approximately 25 million members. They play a key role in the UK financial services sector managing more than £500 billion of assets and comprising 23% of outstanding residential mortgages. They're less diversified than banks, with business models typically focused on residential mortgages, retail savings and current accounts. Many smaller building societies are also, by nature, not geographically diversified.
Headwinds are plentiful in today’s adverse market conditions. While some of the larger building societies undoubtedly benefit from strong capital and liquidity buffers – Fitch Ratings confirmed a stable outlook for the five largest societies in July 2023 – smaller societies could be more vulnerable to competition from high street banks and are often price takers in their key markets.
The following six challenges will be impacting societies’ operational and financial resilience.
There's a downwards pressure on new business as demand for mortgages weakens. Materially higher interest rates and pressure on consumer affordability is contributing to a slowdown in the housing market. The outstanding value of all residential mortgage loans was £1.655 billion in Q2, 2023 (Q1 2023: £1.675 billion), the largest quarterly decrease since 2007. The biggest impact is in the buy-to-let mortgage market, where lending fell 40% in Q1 2023.
Loan-to-value (LTV) ratios are therefore being affected as house prices fall. Latest data from Nationwide shows that average house prices fell by 5.3% in the year to August 2023 – the biggest drop since the financial crisis in 2009. The full effect of 14 successive interest rate rises has not yet fully materialised, as 44% of households are still on fixed rate mortgages agreed before the Bank of England started raising interest rates, which means there's a risk prices will fall even further over the next year.
Historically, the sector has had healthy LTV ratios, but if the housing market continues to decline these could be challenged, which together with weakening new business volumes could put pressure on the ability to generate working capital.
Banks and building societies have reported that default rates and losses on secured loans to households (such as mortgages) increased in Q2 2023, and were expected to increase again in Q3.
The default rate on secured loans to householders increased 30.9% in the three months to May 2023, and was expected to increase a further 41.2% in the following three months. Losses to banks and building societies given these defaults increased 8.3% in the three months to May 2023. These losses were expected to increase a further 28% in the following three months.
The latest results of the largest building society, Nationwide, bears this out. In the 12 months to April 2023, the society had a net loan impairment charge of £126 million (2022: release of £27 million), reflecting a “deterioration in the economic outlook during the year”. The society expects future increases in arrears due to affordability pressures.
Smaller building societies may find corresponding increases in their impairment charges challenges their financial resilience.
Retail deposits typically account for a large portion of building societies' capital. However, as consumers deal with a high cost of living, they've been withdrawing from their savings accounts at unprecedented rates. During May 2023, households withdrew £4.6 billion from banks and building societies – the highest level of household withdrawals since 1997.
In addition to a reduction of retail deposits, building societies face significantly higher funding costs due to rising interest rates. This is especially true when societies refinance funding from the Bank of England’s Term Funding Scheme (TFS) with additional incentives for SMEs (TFSME), which many building societies currently benefit from. (Participants in the TFS, which ran from 2016-2018, were permitted to repay TFS drawings and redraw under the TFSME, subject to meeting certain terms and conditions.) The TFSME allowed societies to borrow at a reduced interest rate for terms of up to four years. Drawdowns were available until April 2021, which means that over the next couple of years, interest payments on funding will be substantially higher. This could put considerable pressure on net interest margins.
Building societies have a significantly higher cost base than many banks. In a bid to reduce costs, the number of bank branches has been steadily declining with banks encouraging customers online. According to ONS data, the number of bank branches fell by 5,050 (44%) between 2012 and 2022.
In contrast, building societies tend to hold a larger proportion of physical branches as their business model is more dependent on local connections generating customer loyalty. As such, the number of building society branches only fell by 235 (12%) during the same period.
However, as customers increasingly expect digital interactions with their finance providers, there's a risk that having costly physical branches brings less advantage for societies. This trend is only likely to increase as Millennials and Gen Z become key customers. A high fixed cost base can magnify financial stress in a period of falling income and rising costs. In addition, societies should be aware that in an environment of long leaseholds for these types of property, there can be difficultly in minimising the cost to exit.
The cost of compliance is significant for building societies. In March 2022, the FCA sent a Dear CEO letter to the sector. The regulator outlined concerns that, among other things, societies can fail to recognise the needs of vulnerable consumers, appropriate affordability checks are not always given, and that some customers are not treated fairly. Poor product design, or lack of clear information enabling a consumer to make an appropriate decision was also a concern.
The Consumer Duty came into effect on 31 July 2023, and all societies must ensure that they meet the four outcomes involving appropriate products and services, fair price and value, adequate consumer understanding and consumer support.
Societies must implement systems and processes to adequately ensure an appropriate customer journey, and have data strategies that allows them to identify, monitor and evidence these outcomes. This takes considerable time, staff training and resource.
In the past, building societies' ability to invest in new technologies has been limited by their size. While building societies (which are owned by their members) don't have to worry about shareholders, diverting funds away from member services for costly transformational projects such as IT infrastructure can sometimes be more challenging.
However, building societies will need to divert resources or consider financing alternatives to invest in these types of projects to deliver real-time data to members to retain the competitiveness of their offerings, and maintain their customer engagement and market share.
Building societies need to quantify and analyse what the combination of the above headwinds may mean for their business.
For example, what will the impact be of higher default rates and funding costs, combined with a fall in new business, on their working capital and debt servicing?
Stress-testing resilience in different scenarios by having appropriate planning and forecasting models in place can help provide greater clarity on areas that may lead to underperformance. Societies should be prepared to take proactive steps and make necessary operational changes to ensure that the firm is as resilient as possible to weather market forces. Customer servicing models also need to be reviewed to assess if they're fit for purpose.
As David Bailey, Executive Director responsible for the supervision of building societies at the Bank of England, said in a recent speech to the Building Societies Association: “We expect firms to be proactive in enhancing the way you manage the risks in your credit portfolios – rather than simply relying on historic approaches.”
For more insight and guidance, contact Chris Laverty or Jarred Erceg.
