Competition on the horizon for Nordic banks

Background

The current Swedish mortgage lending players
The Swedish lending market is largely comprised of four major players, making up a market share of about 80% together, and four minor players making up the rest. The market is thus highly concentrated, which coupled with the high profitabilities in the industry suggest competition, in general, is fairly low. This factor has most certainly contributed to the record-breaking net interest incomes we have seen in recent years coming from the banks. Currently, most rates are very similar among the 8 active banks, which are displayed below.

As for the rates of financing among the players, let’s lift Swedbank as an example. In their 2017 balance sheet, Swedbank show funding sources as a mix between deposits and market financing at a ratio of 1:1, where deposits cost them 0.14% annually and a covered mortgage bond costs them 0.4% annually on a 7-year fixed contract. Following that, their average mortgage return is 1.96%, which indicates a quite broad net interest income (without mentioning any specific number). Combine that with the fact that the average return on equity for the whole of the Swedish banking sector is 20%. In other words, there is definitely room to push margins and return on equity lower in the face of increased competition.

A ridged market
Although current lending rates are quite similar to one another at various banks, Danske Bank stands out with up to 52 basis points cheaper two-year fixed contract. However, their market share is still just 6% of the total housing loan market. This is partly because Danske Bank recently lowered their prices but also because there is a certain rigidity in the market today.
Changing a housing loan is not necessarily an easy process according to the Swedish competition authority, who argues that new regulations regarding amortization requirements and ceiling for total mortgage sizes depending on income may limit mobility on the housing market. This is because the new regulations, aimed at limiting Swedish households indebtedness, are mostly targeting new housing loans, which limits the mobility in the market, thus ‘locking’ people in to their existing mortgage deals and limits negotiating power when it comes to moving mortgages across providers. This benefits incumbent players at the expense of challengers.

Threats on the horizon

Threats on the asset side
But the years of high margins and easy money may now be at risk. New entrants are threatening the lending market with a business model that is well suited for the one purpose of mortgage lending. The new entrants are housing loan funds by the names “Enkla bolån”, “Alma bolån”, “Stabelo” and “Hypoteket”, who each offer housing loans at rates far undercutting the rates offered by the traditional banks, as can be seen in the table below.

There are a few differences among the players but most noteworthy is that none of the new players are banks and thus do not use deposit based financing or in other words run fractional reserve banking. Instead, they finance the loans Krona-for-Krona, with externally raised money by allowing insurance companies and pension funds to invest directly in housing loans instead of covered bonds issued by banks. This is relevant because the players are not under any capital requirement regulations, as are other banks. With Krona-for-Krona financing, financiers money are not at any liquidity-related risks as is the case for bank-depositors money. Therefore, none of these regulations apply, which results in a more efficient use of money for the new players. In fact, cost of lending could be as much as 0.4-0.5% cheaper in the absence of these regulations

There is also the advantage of introducing a more digitized process for mortgage origination and take-overs compared to the bank’s existing ones. Enkla bolån is an example of such a player who claims to have a fully digitized solution. In addition, they only take over existing mortgages rather than originate their own. This means that Enkla bolån can save on a lot of FTE costs compared to the bigger banks.

So far, these players have gathered little market share, but that could quickly change. In The Netherlands, similar players have managed a stake of about 11% of the total loan market. Not an insignificant amount! Moreover, with the entry of new competitive players comes price cuts for the incumbent banks to keep their existing clientele.

Questions that remain to be answered: To what extent can the success from The Netherlands be replicated in Sweden?
The key question to whether these new loan-funds will succeed is to what extent they are able to attract investors. What we know from The Netherlands is that the key market for these retail housing loans are pension funds and insurance companies, namely life insurance companies.

However, there are a few distinct differences between Sweden and The Netherlands in terms of market structure.
First, Swedish loan customers prefer much shorter duration contracts on their loans compared to The Netherlands. This may be an important factor for the attractiveness of these loans in Sweden as the target market has long duration liabilities and is therefore in the market for long duration assets to offset the interest rate exposure. In 2017, 70% of Swedish mortgage lenders had the shortest possible duration loan possible with a 3-month fixed mortgage contract.
Second, 13 of all Dutch housing loans are covered by a government guarantee-system, which entails that if a person with a mortgage becomes unemployed, the government pays the maintenance on that mortgage. Any person with a mortgage can join the scheme in exchange for a monthly fee, which does not exist in the same aspect in Sweden. However, Sweden has the unemployment insurance scheme, so the net effect on the security of the mortgages is questionable.
Third, Solvency II is a lot friendlier towards mortgage investments compared to Basel III, with regards to capital requirements, which makes these investments so attractive to insurance companies. Dutch life insurance companies are under Solvency II, but Swedish firms are not yet. The regulation covering Swedish insurance companies is not as friendly towards mortgage investments as is Solvecy II. Though, this will change in 2019, when Sweden adopts Solvency II as well.
Fourth, the strength of Swedish banks in contrast to Dutch banks. According to a prominent Dutch mortgage fund company, DMFCO, Dutch banks have a difficulty attracting decently priced capital market financing. Thus, because the value of outstanding mortgages is higher than the value of bank deposits, there is a gap in issuing new mortgages as capital market financing is not sufficient to fill that gap. New mortgages are reportedly even discouraged. This has allowed mortgage funds to take that place with investments from pension funds and life insurance companies. This need not be the case for Swedish banks though, who have healthy stocks of capital market financing already thus not leaving any gap in the market with regards to mortgage issuances.

In other words, the biggest differences are the duration on the loans and to what extent that can affect demand from pension funds and (life) insurance companies as well as the gap in the market with regards to mortgage issuances. But the duration gap is not impossible to close without long duration assets as interest rate swaps can cheaply be used between life insurance companies and banks, who often have opposite duration exposures. However, there is a considerable rollover risk with reissuing short duration loans with longer-term liabilities. As banks tend to have shorter duration liabilities compared to (floating rate deposits), they might be better suited for holding short duration mortgages compared to insurance companies and pension funds. As the Dutch mortgages are longer duration than the Swedish ones as a rule of thumb, the Dutch mortgage funds are better equipped than the banks there to handle the duration exposure, which is not the case in Sweden.

The case with a gap in the issuances of mortgage may also be an important point as such a gap does not seem to exist in Sweden the same way it does in The Netherlands. Therefore, issuing new mortgages may not be a priority for Swedish mortgage fund companies.

As for what interest rate these mortgage fund players are willing to buy the mortgages for and what demand volumes exist in the market let’s study how The Netherlands operates. There, a mortgage bond (or a mortgage-backed security), fetches an implied rating of AA at a supposed price point of 150-160 basis points above the swap rate at short duration levels and as low as 100 basis points above the swap rate for 10-year and longer duration levels. This would imply that financing would be available for Swedish floating rate mortgages at about 1.2% (1-year Swedish swap rate + 150bps), for 3-year fixed at 1.5% (3-year Swedish swap rate + 150bps) and 10-year at 2.2% (10-year Swedish swap rate + 100bps). Comparing these numbers to the offerings we see today in Table 2, Stabelo and Hypoteket both look reasonably priced to stay profitable while Enkla and Alma appear to be on thinner ice. But only time will tell as these players could survive by only “stealing” existing mortgages and utilizing fully digitalized processes. This way, a lower margin would be required for internal costs. In the end, the entry of these new mortgage funds may not crash the banking system as we know it but it is likely to have an impact across the board. According to the Swedish Competition Authority, prices may be lowered across the board by about 0.2% – 0.4% for shorter duration mortgages. Inferring what we know about the Dutch pricing model, we can expect a lot more on longer duration mortgages if only the Swedish consumers stop looking only towards the near floating mortgages. However, the real effect will likely be seen in 2019 as Solvency II is adopted in Sweden and insurance companies get properly compensated for taking the risk directly instead of through covered bonds as they do today.
But that is not all the risks. The next section will cover the threats from the other liability side!

Threats on the liability side

On the market today are a number of active players offering substantially higher interest rates on deposits than the major banks. Currently, almost all the major banks offer interest rates of 0%, while the challenger players offer rates as high as 0.75% for liquid accounts and as high as 2.25% for longer duration deposit accounts, all being covered by the national deposit insurance scheme rendering all the accounts equally safe.

Alternative players offering higher rates than the major banks is nothing new, what is new is the ease of which a consumer can change or add another bank to their name. With the advent of online digital identity certification using Bank-ID or Mobile Bank-ID and the sky-rocketing acceptance of this identification form at small as well as bigger banks in recent years, it is easier than ever to move your money between bank accounts. This has also been seen recently as people are changing or adding new bank accounts at different banks in an ever faster pace with the motivation of seeking better offers from other banks. The result of this may very well be that money starts flowing out of 0-yielding deposit accounts at the major banks for more attractive rates elsewhere. It is therefore reasonable that banks may have to start competing to a greater extent based on deposit rates than they do today, which ought to increase borrowing costs as deposits today are the cheapest source of financing for the banks.

Another point that should not be forgotten is the effect on the bank covered bond market as pension funds and insurance companies migrate from investing in those products to direct investments in mortgages through the new mortgage funds. There, it is likely that banks are going to see higher financing costs as well.

Summa summarum

The current situation involves downward pressures on lending rates, upward pressures on covered bank bond rates and upward pressure on deposit rates, resulting in a squeezed net interest income ratio for Swedish incumbent banks.

On the asset side, we concluded that mortgages across the board might get 0.3% cheaper, which is equal to a 15% drop in sales price in the example of Swedbank where the average mortgage rate is 1.96%.

On the liability side, we don’t have estimates from the competition authority so instead, we have to make a conservative estimate. Let us say the total borrowing costs from increased competition on deposits as well as less interest in covered bonds push up borrowing costs by 0.1%. That is still not insignificant considering Swedbanks mortgage financing costs, which is likely lower than 0.64%, a number we estimated earlier.

All in all, the possible ramifications for ignoring the new competitive threats might be lost market shares and decreased profits. There is no time for complacency and banks must act today to keep their market shares.

Investments for future profitability

Simply fighting the challengers with lower lending rates and higher deposit rates is not a sound solution. The major banks have such a strong market position that such a solution likely would lead to unnecessary bleeding. Instead, banks should focus on investments in their other service offerings to give an alternative competitive advantage.

Focus on the customer journey 
In a world of emerging one-hit-wonder players, who only offer one service, banks need to emphasize the simplifying benefits of having several services under one roof. For example, mortgage, salary account, and savings account. In even more integrated players, insurance policies could be included on this list as well. Different customer levels could thus be introduced with different benefits to reward loyal customers, who utilize many different services in the bank.

However, focusing on customer oriented solutions in general with more intuitive interfaces and processes as well as knowledgeable support staff should get many customers to stay put in the face of more attractive offers elsewhere.

Cut costs by digitizing 
Just like the new players have innovated the onboarding process for new loans, banks need to adapt. If investments are not already in place to digitize the current process, this ought to be prioritized in the foreseeable future. Otherwise, the banks risk becoming elephants with regards to onboarding new mortgages.

However, the case could be made that groundbreaking changes are very hard to practically implement due to legacy IT systems being so hard to replace. As astronomical sums of money pass through these old IT systems, any IT migration that would go down for maintenance would be very costly. Though, shame on those who don’t try.