The document discusses the future of mortgage regulation from a behavioral perspective. It notes that regulators are increasingly focused on (1) regulatory convergence across jurisdictions to address customer detriment and harm, (2) specific problem areas or "hotspots" in mortgages like buy-to-let lending and interest-only mortgages, and (3) a new approach of "behavioral regulation" that aims to design out biases and protect consumers. Behavioral regulation requires firms to identify and address biases, track acceptable consumer behavior, and ensure products meet consumer needs rather than being supply-driven. Exploiting biases risks regulatory intervention and damage to reputation.

1. The future of mortgage regulation
Tony Moroney, Managing Director

2. The future of mortgage regulation
1. Regulatory Convergence
2. Some Regulatory Hotspots
3. A new dawn –
Behavioural Regulation

3. Regulatory Convergence
• Horizon Scanning has taken
on a whole new meaning
– Look at customer detriment
and control point failures
across the globe
– Consider in detail the fines
and sanctions of regulatory
and other fining authorities
– Ask yourself, as a sector and
as individual firms,
• are we good or
• are we just lucky?
• US fining authorities focus primarily on
institutional infractions and accountability
with fines proportionate to the number of
affected consumers
• Australia authorities focus primarily on
individual accountability, using non financial
penalties (e.g. market bans) as the primary
enforcement mechanism

4. Some Regulatory Hotspots
• Customer Detriment
• Buy-to-let
• Interest only mortgages
• Existing customers
• Customers in distress

5. Hot-spot 1 : Customer Detriment
• Europe sees Conduct Risk as a Systemic Banking Risk
• European Banking Authority has developed detailed
product oversight and governance guidelines for
manufacturers and distributors of retail banking products
• The requirements for manufacturers and distributors:
– the manufacturer’s internal control functions,
identification of the target market, product testing,
disclosure, product monitoring, remedial actions and
distribution channels
– the distributor’s internal arrangements, identification
and knowledge of the target market, and information
requirements

6. Hot-spot 2 : Buy-to-Let
• Fitch believes that investment-property
loans will have a higher probability of
default in an economic downturn, as
borrowers will fight harder to protect
their primary residence
• The agency applies a 25% higher base
default probability in the case of a
mortgage collateralised by an investment
property, compared with an owner-
occupied property
• 1.7m mortgages (£200.5bn) end H1
2015; 15.8% stock and 17.1% of advances
• Could it be argued that an element of
regulatory arbitrage is behind the boom
in this segment in recent years?
• The vast majority of buy-to-lets are owned
by amateur investors; think “consumer” !!
• As an asset class, is buy-to-let priced
appropriately given inherent risks?
– Evidence from Australia suggests market
fundamentals were misunderstood with an
upward re-pricing portfolios
– Regulations are moving towards stress tests
which incorporate macro-prudential dimensions
i.e. Basel 4

7. Hot-spot 3 : Interest Only Mortgages
Citizens Advice Bureau: 3.3 million mortgage
holders who have interest-only products.
Polling commissioned by Yougov, estimates:
• 1.7 million have no repayment vehicle
• 934,000 of these have no plan for repayment
• 432,727 of these people have not even
thought about how they will repay the capital
• Government and regulators will
always seek to protect vulnerable
customers
• Advice and appropriateness of
solutions is critical to avoiding
conduct risk
• Is “extend and pretend” really
forbearance?
• From 2018, IFRS 9 will require
mortgage lenders to recognise
and provide for expected credit
losses
• Lenders will have to make full
disclosure of assumptions
• Regulatory Capital will have
primacy over bank internal models

8. Hot-spot 4 : Existing Customers
• Existing customers pay more
for their mortgage - fact!
• Two key-drivers of cross-
subsidisation
– customer apathy
– information asymmetry
• Mortgage lenders need a fair &
transparent basis for re-pricing
– Bulk of new business written on
short-term fixed rates
– What drives pricing?
….. NIM or Customer needs
• If you have to explain, you are
already on the back foot
Source: FCA Business Plan 2015/16

9. Hot-spot 5 : Customers in Distress
The risks to borrowers from potential
interest rate rises necessitates firms:
• better support and empower front-line staff
to make appropriate decisions at all stages
of the arrears cycle
• provide greater flexibility to support fair
treatment of individual customers, based on
their specific personal and financial
circumstances
• take proactive steps to identify borrowers who
could be susceptible to potential interest
rate rises and have strategies to treat these
customers fairly Can firms respond effectively and
fairly to a sudden downturn?

10. A new dawn - Behavioural Regulation
• The FCA is a financial competition and
financial consumer protection authority
• Consumers are subject to many biases
in financial markets
• Using behavioural insights to protect
financial consumers in a pro-
competitive manner is a central issue
for the majority of Regulators
The FCA behavioural weapons of choice include compelling businesses to design
out “asymmetric incentives”, such as quick-cash commissions and systemic
conflicts of interest; promoting “more functional market structures”; and banning
sales practices that “take advantage of consumer bias”.
Dr Roger Miles, BRG

11. New focus of regulation
Old controls – econometric – many discredited post-2008
• money-based
• time lag: retrospective; consolidation delays
• focus on numbers created “false certainty”
• forced false binary [yes / no] compliance reports
• ignored human decision factors: bias, habit, affect, culture
New behavioural controls – UK, US, EU, Australia & Asia-Pacific
• econometric plus human indicators...
• observe real-time interactions: “what actually happens?”
• note biases: understand, challenge and correct them
• scalar compliance....
progress, commitment, responsiveness

12. Behaviour regulation is different
Dynamic
• changing in individuals (e.g. ageing)
• changing in social groups (e.g. what is “acceptable” now?)
More qualitative than quantitative
• opinions, judgments, perceptions
• …… maturity continuum
Needs external calibration
• not just what we do…
• what do customers expect, tolerate – today?
• what does Risk Culture mean for us?

13. Behaviour-driven regulation brings…
New concepts, language, reporting
• bias effects
• rule-gaming
• culture
• conduct
• change governance
• personal liability
How to track and benchmark?
• outside-in: what is “acceptable” behaviour right now?
• dynamic, qualitative
• needs new controls, measures

14. Concern that risk governance is
compromised by…
‘Bad behaviour’ …. acquired
• seen as disrupting risk governance
• informal groups ‘game’ people, controls, reporting systems
• regulators demand better risk culture
Biases ….. wired
• seen as impairing decision-making
• regulations will prioritise targeted corrections

15. The de-biasing challenge
15
Why regulators target this risk:
• retail customers buying on “illusion of understanding”
• risk of “exploiting customers’ myopia”
New approach: regulators want you to...
• identify key biases, where and how they occur
... in corporate risk, product design, sales-side and customer-side
• intervene to correct for bias effects
• report on success of bias corrective actions
Recognise that you are not able to de-bias yourself

16. Key watch-outs
The sector must not exploit unfair advantage:
• deep pockets and longevity
• virtuality
• cross-subsidies and bundling
• biases and wilful ignorance
Overcome “asymmetric information”
• Consumers don’t understand products
“Business model is still supply-driven?”
• Firms must meet the needs of the customer!

17. Behavioural Regulation - Closing Thoughts…
Exploiting consumer biases will result in regulatory intervention
• Insights are not the sole preserve of regulators; just by competition authority too
• Measures to identify and measure behavioural risk
• Capturing experience of external pressure to change behaviour
Behavioural risks amplify reputational risk; identify and limit “unknowns”
Use behavioural economics to:
• Ensure customer outcomes are fair
• Protect against the risk of intervention
• Anticipate the outcome of regulatory intervention
• Pre-empt damage to brand position and franchise
Get ahead of the Regulatory agenda … don’t wait on rules!

18. Tony Moroney | Managing Director | International Financial Services
Berkeley Research Group, LLC
6 New Street Square, 15th Floor | London, EC4A 3BF
O +44 20 3597 5167 | F +44 20 7853 9955
tmoroney@thinkbrg.com | thinkbrg.com
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions,
position or policy of Berkeley Research Group, LLC or its other employees and affiliates. 21ST October 2015