Prudential Regulation Authority Rulebook

3.1

This chapter sets out the PRA’s expectations for the management and mitigation by societies of risks arising from their lending activities. The section outlines factors that the PRA will consider when assessing whether a society meets these requirements in relation to lending risk management, and sets out the supervisory framework, using three ‘approaches’ to lending (‘Traditional’, Limited’ and ‘Mitigated’), that have been designed to help firms evidence compliance with the requirements in the General Organisation Requirements and Risk Control Parts of the PRA Rulebook, and against which such compliance by individual societies will be evaluated.

3.2

The primary risk associated with mortgage lending is that the borrower will be unable or unwilling to service the loan (ie meet interest payments when due and repay the capital amount lent within the agreed term). Some types of mortgages present greater affordability risks than others. In particular, risks are likely to be increased for lenders (and in some cases also for consumers) as regards:

1. (a) residential lending to owner occupiers, where repayment commitments represent an unusually high percentage of disposable income and/or capital repayment is deferred to the end of the mortgage term;
2. (b) buy-to-let (BTL) mortgages, where the rental income received by the borrower is close to the repayment commitment made; or
3. (c) commercial lending, where the repayment commitment represents an unusually high percentage of the income generated by the property or by the business operated from the property.

3.3

The propensity of borrowers to repay can be lower where the:

1. (a) loan-to-value (LTV) is high, and thus incentives for the borrower to retain control of the property by maintaining payments are weaker; or
2. (b) the borrower has an impaired credit history that may indicate previous unwillingness to pay.

3.4

The PRA expects societies to ensure – and to be able to evidence – that they consider the affordability risk profile of the different types of lending that they undertake, have book and/or origination flow sub-limits and other mitigating controls in place where they consider it appropriate, and price their lending to reflect the perceived residual risks. This includes appropriate controls over interest-only lending, to ensure that repayment of the loan principal at maturity is achievable.

3.5

The PRA also expects societies to consider the affordability impacts that arise when product features such as fixed interest rates or discount periods expire, and to determine whether to set maturity profile limits. If large numbers of mortgage loans reach a product break-point or reset point simultaneously, the society may experience financial and/or operational strain in dealing with potential loss of earnings from redemption, together with associated administration and customer query costs.

3.6

Should the interest rate on follow-on products be significantly higher than at inception, societies may need to respond to a significant number of customers all experiencing payment shock at the same time. In such a situation, a society may experience increased arrears levels, and potentially increased impairment charges.

3.7

While non-sterling mortgages expose a society to foreign exchange risks as well as all other risks which normally attach to mortgage lending, they may also expose the borrower to exchange rate risk which, if it crystallises, impacts on their ability to afford the loan. The PRA expects that societies (other than those with the most sophisticated lending and treasury risk management controls) will therefore set very conservative limits for such business, and confine such loans to borrowers with income denominated in the relevant currency.

3.8

There may be cases where borrowers are relying upon a non-sterling income to service a sterling mortgage secured on UK property, or the reverse.^[3] Such mortgages are subject to additional requirements under the Mortgage Credit Directive (MCD), and clearly require additional consideration of affordability given the potential for exchange rate movements to affect ability to meet monthly instalments. Appropriate systems are expected to be in place for identifying and managing these exposures.

3.9

Societies must also comply with the general law and any other regulatory requirements relating to affordability when granting a mortgage.

3.10

If a mortgage fails to perform, a society ultimately relies upon realising its security to safeguard its interests and avoid losses, so the saleability of the security at a sufficiently high price to repay the loan (plus accrued interest) is essential. In order to achieve this, the society needs to have both a clear and comprehensive policy setting out the types of security that are acceptable, and a robust process for valuing that security. Societies may wish to consider purchasing mortgage credit insurance as a mitigant to the risk (in respect of higher LTV mortgages) that realisations from sale of a property in possession may not be sufficient to allow full recovery of the mortgage loan plus accrued interest. Such insurance can be taken into account in estimating the net credit losses that would arise under adverse scenarios as part of the society’s stress testing calculations for capital adequacy purposes; and it can be an effective mitigant against catastrophic losses in the event of a generalised market downturn – subject to assessment of reliance on the creditworthiness of the underlying insurer.

3.11

In respect of security types, the relevant factors include title/tenure, construction type, state of repair and insurability. In respect of leasehold tenures, length of lease and leaseholder obligations are also relevant factors.

3.12

In placing reliance on security valuations,^[4] the integrity, competence and expertise of the valuer are important, particularly where experience in more complex valuation areas is needed (for example, related to commercial lending). If a society uses an automatic valuation model (AVM), either as part of its loan origination process or subsequent revaluation for credit decision purposes, it is expected to do so within the terms of clear and well-considered policies.

3.13

In addition to general property price movements, significant local price variations can occur. Therefore lending outside a society's home area (or for larger societies, lending on overseas property) can carry an increased risk if local price drivers are not fully understood.

3.14

Societies are expected to consider such risks in setting their lending policy, balancing the potential impact against the advantages of lowering the geographical concentration risk to which they might be exposed.

3.15

Different types of lending carry different levels of credit risk to the lender, and it is vital that these are appropriately reflected in the price charged to the borrower. Calculation of the risk premium to apply can involve a combination of science and judgement: for the most sophisticated lenders, statistical models may be used to calculate (based on historical performance over a long period) the ‘probability of default’ (PD), ‘exposure at default’ (EAD) and ‘loss given default’ (LGD) for a given exposure or portfolio. Calculating the ‘expected loss’ (EL) arising from different types of lending allows the lender to calculate the risk premium necessary to achieve a target rate of return on capital (eg ‘risk-adjusted return on regulatory capital’ or return on ‘economic capital’ allocated to the exposure).

3.16

Having the capability to calculate EL under different economic scenarios will become increasingly important for societies that report results on an International Financial Reporting Standards (IFRS) accounting basis, given IFRS 9 requirements for calculating impairments. However, even those societies adopting UK Generally Accepted Accounting Principles (UK GAAP) standards (eg FRS 102) need to be able to estimate the level of their expected losses in order to be able to price new lending appropriately.

3.17

At a minimum, societies are expected to have risk pricing methodologies that take into account (at product level rather than individual account level) the:

1. (a) information available from credit reference bureaux at inception of the loan (more sophisticated societies would also take account of up to date behavioural information derived either internally or based on bureau data);
2. (b) outcome of their own internal stress testing;
3. (c) underlying cost of funding the loan (see paragraphs 4.120 – 4.126 in Chapter 4); and
4. (d) board’s target return on capital.

3.18

Societies should be careful in using peers and competitor prices as comparators: market prices will reflect an individual firm’s assessment and understanding of a given risk, but such assessments can be incorrect so it cannot be assumed that risks have always been priced correctly. Moreover, competitor costs (of funding and administration) may not be reflective of the society’s own costs. Societies are therefore expected to determine their pricing independently, based on their own risk appetite and profitability criteria.

3.19

Societies are particularly expected to be aware of the risk of ‘adverse selection’ ie that under-pricing risk relative to the market may attract the more risky cases and result in a worse quality portfolio than intended.

3.20

Traditional prime residential mortgage lending can be characterised as being to owner-occupiers with good credit histories, assessed against evidenced income for affordability (under stress) of regular payments comprising capital and interest, where the loan will be completely repaid by its original term and the loan amount is less than the value of the property mortgaged in order to provide a safety margin of security. Other loans may exhibit many of these lending characteristics, but present additional risks, when compared with traditional prime owner-occupied lending to individuals. The PRA expects societies to recognise this within their risk assessment and management processes, procedures and lending policy. The sub categories below are not exhaustive.

3.21

While the risk of default on lending to borrowers with impaired credit histories may initially be greater (all other things being equal) than that for traditional prime lending, the PRA recognises that this risk may reduce over time as a repayment track record is established. In these circumstances, the PRA accepts that societies may wish to reclassify impaired credit lending as prime (for the purposes of internal policy limits) once the loan has been fully performing for a reasonably long period.^[5]

3.22

While BTL lending is secured on residential property and therefore falls within the 1986 Act nature limit (the statutory requirement that at least 75% of lending should be secured on residential property), it presents different risks to those of conventional residential mortgages to owner-occupiers.

3.23

BTL lending may involve a range of borrowers from, at one end of the scale, individuals with a single property held for investment purposes to, at the other end of the scale, property investors with a large number (possibly hundreds) of properties that are owned and managed as a trading business. The types of properties that are purchased for BTL purposes also range from low yield ones (where the principal objective of the purchaser is to achieve capital gain, ie essentially speculative), to high yield properties (where the risks may be more concentrated on compliance with landlord legislation and costs of maintenance/repairs). Whereas the individual with a single BTL property (an ‘individual investor’) may be able to cover repayments due over rental void periods using alternative sources of income, the ‘portfolio landlord’ property investors may have surplus rental income from other properties but may not have other sources of income available to cover a higher than expected percentage of voids and other letting expenses. While individual investors may not have the time nor resources to be proactive property managers (so act more as passive investors), ‘portfolio landlords’ would normally treat portfolio management as their main economic activity, investing time and resources accordingly. Understanding the type of BTL property and borrower, the scale of his/her activity, the margin of security, the rental cover and the availability of other income, are all therefore key elements of safe lending.

3.24

The PRA has recently published Policy Statement 28/16 ‘Underwriting standards for buy-to-let mortgage contracts’^[6] and SS13/16 ‘Underwriting standards for buy-to-let mortgage contracts’^[7] specifying its expectations for underwriting standards for BTL mortgage contracts, the provisions of which should be considered in conjunction with this SS.

3.25

As set out in SS13/16, societies are expected to put in place, and operate in accordance with, a written policy detailing their approaches to BTL lending, differentiating between underwriting standards for BTL lending and lending to ‘portfolio landlords’ with four or more mortgaged properties (and taking into account that some BTL lending is FCA regulated). In the context of SS13/16, relevant factors which societies are expected to consider and address within their lending policy arrangements include:

1. (a) the degree to which the investor/borrower is dependent on the cash flow performance of the investment property to service the loan;
2. (b) the source and reliability of repayment of the loan principal (given that much BTL lending is interest-only);
3. (c) the impact of current and known future personal taxation provisions/allowances on borrowers net income arising from purchase/ownership of the relevant BTL property/properties;
4. (d) the basis on which the security is valued and rental income is assessed for underwriting purposes (including how rental voids are treated);
5. (e) the potential availability of security other than the BTL property itself (either through supported guarantee or through cross-collateralisation of other BTL properties owned by the borrower);
6. (f) the legal ability via the security charge to appoint a receiver for rents;
7. (g) the tenancy basis and types of BTL that are considered to be acceptable;
8. (h) the information required to assess at underwriting stage the extent of the investor-borrower's broader exposure to the BTL sector (eg total number of properties in portfolio and whether encumbered or unencumbered);
9. (i) the maximum permitted exposure to an investor-borrower or connected investor-borrowers (which may be based on value and/or number of investment properties held); and
10. (j) the additional post-completion loan administration that will be required for portfolio landlords including:

• the impact on costs (and therefore pricing) of regular monitoring of exposures (eg annual reviews, testing loan covenants); and
• any requirements for the investor-borrower to provide financial information on a periodic basis which enables the lender to have an appropriate understanding of their overall exposure.

3.26

Self-build lending encompasses a range of borrower types, ranging from those who directly organise the design and construction of their new home to borrowers who sub-contract all or part the of the planning/construction work to a building company. The range of activities that may be undertaken by the borrower, or outsourced, include:

• identifying the plot and obtaining planning permissions;
• installing services (roads, gas, water, electricity, telecoms etc.);
• designing the building;
• overseeing and/or undertaking the main construction work; and
• finishing off internally.

3.27

The extent of borrower involvement in the development process can therefore vary from case to case, depending on circumstances, skills and locations. Increasingly, ‘custom build’ developers have emerged to manage and oversee the building process – these typically identify plots, install services and offer bespoking options to allow the future owner to customise the property to their specific requirements, which they may then build (or arrange to be built) under contract.

3.28

The main risk associated with self-build lending arises in the period from commencement of construction until the building has been completed or made habitable^[8] – a half-built property has limited marketability and poses site security risks that may have significant implications for the value of the property, should the society need to realise its collateral. The risks here can significantly be mitigated through the involvement of specialist advisers and developers with experience of self or customised house building, who are aware of the pitfalls and can help the borrower to keep control of costs with standardised project management/fixed price building contracts. Societies are expected to consider protecting their position by requiring build-out insurance that will pay for completion, should the borrower (or developer) fail.

3.29

Societies undertaking such lending are expected to ensure that monies are released in stages during the build of the property, against architects’ certificates or updated valuations of the property, in order to ensure that funds are used in construction of the property and in line with the original construction budget. It would be normal practice to ensure that the customer’s own financial contribution is injected into the project ahead of any loan drawdown, and the risk can also be further reduced by lending against the value of construction work done, rather than funding such work in advance.

3.30

With appropriate risk management controls, self-build lending (including custom build) therefore can be carried out safely, but it needs additional expertise compared with traditional mortgage lending, and can be more costly to undertake because of the need for regular review and control (including site visits) during the construction phase. However, once the construction period is complete and the borrower has taken up occupation, the specific additional risks will run off, and the mortgage loan should perform similarly to traditional mortgage lending - so it may be reclassified as such.

3.31

Societies are expected to therefore consider placing appropriate limits on the types of self-build and custom-build lending that they are prepared to undertake, particularly in respect of the number/value of loans at any one time in the most risky build stage. Processes for monitoring, classifying and reclassifying such lending would also be appropriate, with a view to distinguishing between the risks involved in different permutations of the self/custom-build proposition and mitigating these appropriately.

3.32

Shared ownership lending can be more complex than mainstream mortgage lending. In addition to assessing the borrower's ability to afford the loan, which may be more complicated than for traditional lending, the value of collateral may be affected by conditions imposed by the social landlord on resale, for example to market the property only to those groups identified as a priority by the local authority/housing association.

3.33

Also, administering such lending is likely to be more resource-intensive than conventional lending, since the mortgage agreement is three-way and relationships with both the borrower and social landlord need to be maintained. Particular matters that societies are expected to consider include (but are not necessarily restricted to) the following:

1. (a) In the event of default, if monies raised by repossession and sale of the share purchase are insufficient to cover the debt, the society has protections allowing it to recoup certain losses from the social landlord's share of the property so long as they have complied with required procedures at the time of extending the original and any subsequent amounts and before taking action for arrears. Societies should ensure that they understand what protection is available and have procedures to ensure compliance with procedural requirements.
2. (b) Security is held over the leasehold on the owned portion of the property, not the freehold. If the borrower fails to pay rent to the social landlord, the lease may be terminated by the landlord; if terminated, security for the loan would be lost.
3. (c) While a social landlord must inform a society and give it time to remedy the breach to retain the security (costs recoverable under the mortgage protection scheme), the PRA expects societies to consider how they will manage such risk situations and decide as a matter of policy which if any costs they will consider paying.

3.34

Given the added complexity and costs of administering such lending, societies are expected to set a maximum proportion of their lending book for such loans, to ensure that they retain a balanced portfolio.

3.35

Lifetime mortgage loans to release equity in a property, where no principal repayment is made until the property is sold, and where interest is meanwhile rolled up into the loan principal, present a range of complex risks for the lender. As a result of compounding interest, balances on lifetime mortgages increase steadily and, unless the value of the property grows at a similar rate to the interest charge (or faster), the LTV will increase over time. In order to protect the borrower (and their family), such loans may be offered with a ‘no negative equity guarantee’ (NNEG) that caps the amount recoverable on the loan to the value of the property on final sale. Hybrid product types also exist (eg interest initially paid, but only for a period then rolled-up, staged drawdown etc), all carrying degrees of similar risks.

3.36

Repayment of lifetime loans with interest roll-up features is thus dependent on the future value of the property held as security, crystallised at the time the borrower either dies or sells (or, where there is more than one borrower, when the longest surviving borrower dies or sells). Moreover, the realised value of the property may be affected by the willingness and/or ability of the borrower(s) to maintain the property. To mitigate the lender risks involved (whether or not NNEGs are offered), the PRA expects those societies prepared to extend loans on an interest roll-up basis to do so only after a full evaluation of longevity risks, and to set the initial LTV of loans at levels which allow for interest roll-up in line with assessed life or morbidity expectancy. If larger LTV advances are proposed for borrowers with shorter life expectancy (or earlier morbidity), societies will need to ensure that they have appropriate actuarial expertise to enable them to assess the associated risks.

3.37

In order to provide borrowers with certainty about the speed at which their lifetime loan balance will increase (through roll-up of compounded interest), many lifetime loans are at fixed interest rates that apply until maturity. While some hedging instruments may be available for societies to mitigate the resultant interest rate risk for the lender, most commercially available derivatives are likely to have break clauses that may be exercised by the hedge provider earlier than the likely maturity date of the loan, and they will require cash margin for adverse mark-to-market movements that can become significant in both cost and liquidity management terms. Given that the actual maturity date of each loan is uncertain, extensive modelling at portfolio level is required in order to determine the expected behaviour of loan balances and to estimate exposure levels that need to be hedged – bearing in mind that these will initially increase then amortise over an extended period. Achieving hedge accounting treatment may therefore be difficult, and fair value accounting may expose the society to significant profit volatility.

3.38

By implication, societies undertaking lifetime mortgage business will be expected to have the appropriate specialist treasury and risk management skills to measure and mitigate the many and various risks involved. If all the borrower protection features are included in the product, the society will need to be able to price, manage and mitigate a combination of interest rate risk, house price risk and morbidity/mortality risk, in an exposure with uncertain maturity and no intervening cashflows (assuming that the exposure is in Sterling on UK property – if not there would also be currency and non-UK house price risk). This is likely to be extremely challenging, even for very large organisations with sophisticated risk management expertise. Given the risks and complexities involved, the PRA expects only those societies with the most sophisticated level of treasury risk management capabilities (ie those capable of operating on the Comprehensive approach) would consider offering lifetime mortgage products.

3.39

Home reversion plans are likely to carry even more complex risks, since they not only have an actuarial and funding rate risk, but also expose lenders directly to variations in the market value of the property with which the individual plan is associated. As such, only societies with the most sophisticated risk management capabilities would be expected to enter those markets.

3.40

For all types of lifetime mortgages, societies are expected to set conservative book limits on the amount of such business that can be originated, particularly bearing in mind that, because the balances of interest roll-up products grow over time (at least initially) in line with the interest, this may potentially inflate the proportion of the overall loan book represented by the product.

3.41

Loans to retired borrowers, whether to release housing equity or for other purposes, where interest is covered from income and the capital amount is either amortised, or not amortised but recovered from eventual sale, pose fewer risk management problems than lifetime loans with interest roll-up features. However, they do carry credit risk and, depending upon the interest rate structure applied, can also present some of the interest rate risks associated with interest roll-up lifetime mortgages.

3.42

If rates are fixed for the life of the loan, the risks to affordability will be mitigated to an extent, as long as the available income in retirement is properly assessed and found to be adequate. However, permanent fixed rates that continue until repayment is triggered by the mortality/morbidity of the borrower(s) pose similar risks to lenders as with lifetime roll-up products – there will still be a need to understand the likely amortisation profile at portfolio level in order to determine what term structure is involved, and finding effective interest risk hedging instruments can be highly complex. As a result, the PRA expects that only societies operating on the Comprehensive treasury approach to offer permanent fixed rates with undefined maturities, or long term fixed rates that need to be modelled against the expected amortisation profile of the book.

3.43

In contrast, loans in retirement at variable or short-term fixed rates mitigate the interest risks to lenders, but increase the possibility that the borrower may be unable to afford higher interest instalments should rates rise significantly. Consequently, this type of lending will need careful consideration of retirement earnings prospects, and of initial LTV criteria. The volume of lending in retirement as a proportion of the loan book will need to be controlled in order to avoid a concentration on a single borrower type.

3.44

Traditionally, prime mortgage lending would normally have been undertaken on the basis that the loan will be repaid in full from income earned in employment. However, growth in house prices and the increase in general longevity have made it more common for loans to be taken for longer terms, later in life – resulting in the possibility or likelihood that retirement will occur whilst part of the loan is still outstanding. This is ‘lending into retirement’, and the PRA expects societies to be cautious in assessing such lending for affordability during the whole life of the loan, and in allowing a significant build-up of this type of lending in their books.

3.45

Lending for long terms (30+ years) shares some of the risk characteristics of interest-only lending – in that capital repayment during the early years of the loan, whilst not nil, can be minimal (especially at higher rates of interest), potentially extending the period of higher LTV exposure if house prices do not increase. Extending loan terms in order to reduce the level of monthly instalments allows borrowers to meet current affordability criteria for larger loans, but also increases significantly the amount of interest that they will pay over the life of the loan. Therefore, it is expected that societies will take special care to understand the rationale for a longer loan repayment period and will consider the lending risks arising.

3.46

Where the proposed end repayment date of a loan, whether long term to a younger borrower or shorter term to an older one, can be expected to fall after the borrower has reached retirement age, the underwriting process will need to seek appropriate information and assurances about the level of retirement income that will be available to meet continuing mortgage instalments. Given the uncertainties surrounding the level of pension income that can be expected to arise from defined contribution schemes, and the implications of statutory freedom to access pension funds from age 55, societies are expected to be rigorous in understanding sources of retirement income or, if the property is to be sold to repay any outstanding balance at retirement, that sufficient equity will be available post sale to meet the borrower’s future housing expectations.

3.47

As with lending in retirement, societies are expected to set internal limits on the volume of lending into retirement as a proportion of the loan book, in order to avoid a concentration on a single type of borrower.

3.48

Commercial property will generally require different valuation skills to owner-occupied housing, and historically has a significantly higher default rate than conventional residential mortgage lending. The PRA expects societies’ stress testing to take account of this latter point. CRE lending may or may not fall within the nature limits, depending on whether the business of the commercial enterprise is secured on residential property – but all lending for commercial purposes needs to be captured by internal risk limits, regardless of the nature limit definitions.

3.49

CRE lending can be divided into three broad types: i) owner occupied; ii) development; and iii) investment, the latter two being further sub-divided by property type (residential use, and various forms of commercial use eg retail, industrial, office, or warehouse/distribution). Each of these broad types typically has different associated risk profiles and is likely to require different resource levels, underwriting expertise and risk management capabilities.

3.50

Individual commercial loans tend to be large relative to the total book, particularly those falling into the commercial development and investment categories. Therefore, when considering the risks associated with any commercial lending, societies need to be mindful of the absolute size of individual loans, their total exposure to commercial lending, and the extent to which they are exposed to concentration risk, whether geographic concentration, concentration to particular counterparties, particular property types or to particular sectors of the economy.

3.51

Societies need to recognise the risks involved where they lend on an interest-only basis – and in particular that, on maturity, the borrower may not be able to dispose of the property or refinance the loan and so repay the capital amount lent. Societies also need to take account of the length and terms of any underlying leases, particularly where these expire before the loan maturity, and be mindful of the additional complexity that may attach where commercial property is owned by a special purpose vehicle, or where it is financed by a syndicated loan.

3.52

Societies undertaking commercial lending need to establish that a realistic alternative use exists for the property in case they later have to enforce the security.

3.53

In general, the PRA considers it unlikely that smaller societies will be able to justify the cost of the specialist individuals and systems needed for CRE lending, bearing in mind the likely overall size of the book and the level of additional risk involved. Even larger societies may find that the economic costs of implementing adequate risk controls outweigh the potential benefits in terms of margin uplift and diversification.

3.54

Lending to housing associations can be difficult to evaluate and for smaller societies these can represent significant sized loans relative to their book. While lending may be low LTV, margins also tend to be low, whilst the saleability of underlying properties varies, and would usually not be with vacant possession.

3.55

Societies considering such lending need to consider not only the portfolio valuation but also the financial management record of the landlord, including arrears management and cashflow strength to accommodate voids, and the regulatory and/or political environment in which it operates. The skills necessary to undertake such assessments are those of underwriting commercial lending rather than residential lending, combined with a good understanding of the sector and its risk profile.

3.56

Therefore, societies are expected to ensure that they have appropriate underwriting skills for this type of lending and that they set a maximum proportion of their lending book for these loans, to ensure that they retain a balanced portfolio.

3.57

To comply with the PRA Rulebook (General Organisation Requirements 2.1 and Risk Control 2.1), all societies should have a lending policy. This should be consistent with each society's strategic plan and its financial risk management policy statement.

3.58

Societies are expected therefore to adopt formal, board-approved lending policy statements that include limits on the type of lending that will be undertaken (both as a proportion of periodic flows and of stocks), as well as set out the key underwriting policies and controls. The aim of a society’s lending policy should be to ensure that, as far as possible:

1. (a) credit risks arising from its lending are aligned with its management expertise and risk appetite through careful underwriting; and
2. (b) any additional risk taken is appropriately priced and managed so that loss levels sustained under stressed conditions would not result in failure of the society.

3.59

Societies are expected to inform their supervisors of all material changes to their lending policy, and provide a marked-up version on request. Supervisors will review lending policies periodically as part of their assessment of credit risk management and, among other things, against the guidance in this SS.

3.60

The board and management are expected to take steps to ensure that staff that are particularly involved in any aspects of lending are fully aware of the lending policy, both on an ongoing basis and, particularly, where the lending policy has been changed. The steps that would be most appropriate to achieve this will depend on the number of staff concerned and the complexity of the lending policy.

3.61

To comply with General Organisation Requirements 2.8, the PRA expects societies to check, on a regular basis, that staff are complying with this lending policy.

3.62

This section sets out the expectations of the PRA on the issues which it would expect to be addressed in the lending policy. The list of issues is not exhaustive, not all points will be relevant to all societies and societies may wish to combine some of the subjects within sections of their policy.

3.63

The introduction section would include:

1. (a) background to the society's approach to the management of credit risk, including its high-level lending strategy and its risk appetite expressed in a clear and numeric way that can be easily understood by all staff;
2. (b) a ratification process for obtaining board approval, including amendments to the policy statement as well as complete revisions; and
3. (c) arrangements for, and frequency of, review (which is expected to be conducted at least on an annual basis).

3.64

The objectives of the policy would cross-refer to the society's general statement of risk appetite (as set out in its Individual Capital Adequacy Assessment Process (ICAAP) for Pillar 2 capital adequacy purposes), and would outline the society's general philosophical approach to lending.

3.65

The policy would set out the society's business and operational characteristics, including:

1. (a) board controls and organisational structure/reporting lines;
2. (b) high level framework for ensuring compliance with FCA’s Mortgage Conduct of Business (MCOB) and other regulatory requirements;
3. (c) delegation process and authorities;
4. (d) new product development process and approved sources of new lending business;
5. (e) marketing and administration controls; and
6. (f) processes for ensuring compliance with policy (including arrangements for internal audit review).

3.66

The risk management section would include a description of:

1. (a) the risk management structure and reporting lines;
2. (b) controls over underwriting quality and adherence to delegated limits;
3. (c) how risks associated with untypical cash flow characteristics (including interest roll-up and payment holidays) are to be managed;
4. (d) training and competence requirements for underwriters and mortgage sales staff;
5. (e) the process for developing internal risk scoring systems and procedures for risk categorisation including monitoring of manual overrides;
6. (f) large exposure limits for connected counterparties, by loan and borrower type;
7. (g) concentration risk exposure limits by portfolio or product type, borrower type, security type, introducer and geographical area (expressed in terms of the overall lending book: societies would also consider whether it would also be appropriate to set limits as a proportion of new lending in a given period, and similar limits for the volume of reversions to standard lending rates);
8. (h) limits on the acquisition of individual loans or portfolios of loans, either by way of sub-participation or syndication;
9. (i) the processes for ensuring how the success of risk management is to be assessed and potential lessons captured and used to amend underwriting policy as necessary; and
10. (j) the management information to be reported to the board.

3.67

The section setting out permitted lending would include details of the lending which the society is prepared to undertake, specified by borrower type, property/security type and origination source including, as applicable (the list below is not intended to be exhaustive and this section of the policy statement would include details of any other particular types of lending undertaken):

1. (a) prime residential mortgage lending to individuals (by LTV band, with or without mortgage indemnity insurance);
2. (b) near/sub-prime residential mortgage lending to individuals;
3. (c) BTL mortgage lending to individuals;
4. (d) shared-ownership residential lending to individuals;
5. (e) self-build lending;
6. (f) second-charge residential lending to individuals;
7. (g) lifetime mortgage lending to individuals (sub-divided as appropriate between the various categories of lifetime mortgages as referred to in paragraph 3.35 above);
8. (h) home reversion plans for individuals;
9. (i) commercial mortgages for owner-occupiers;
10. (j) commercial mortgages for investors (both individuals and corporate bodies, potentially split by property type – see paragraph 3.49 above);
11. (k) commercial property development loans, both on residential and commercial real estate;
12. (l) lending to registered social landlords; and
13. (m) unsecured lending to individuals (by way of personal loan, overdraft, credit card or otherwise).

3.68

The policy would also set out:

1. (a) which types of security are acceptable (title, tenure, construction, location etc.);
2. (b) the maximum original LTV ratio permitted for each lending type;
3. (c) requirements for additional security from borrowers such as guarantees, charges over other assets, life cover, accident/sickness/unemployment cover;
4. (d) requirements for additional credit insurance (eg mortgage indemnity guarantee or similar), including procedures for checking that such insurance can be relied upon and is effective, and arrangements for checking the credit worthiness of the provider;
5. (e) requirements for buildings insurance cover; and
6. (f) arrangements for obtaining a reliable security valuation (including procedures for appointing valuers and use of automated valuation models).

3.69

The underwriting requirements for each type of loan would be specified in the policy, including:

1. (a) minimum required levels of income (or rent) net of expenditure to confirm affordability of the loan for the borrower (including at higher rates of interest);
2. (b) information requirements for verifying stated income/outgoings levels (for both individuals and corporate borrowers);
3. (c) credit checks, credit scoring requirements, manual override flexibility arrangements;
4. (d) requirements for face-to-face interviews, site visits, use of specialist advisers;
5. (e) evidential requirements to establish the previous track record of the borrower; and
6. (f) any requirements for third party references.

3.70

The policy would set out the basis for pricing new lending, including:

1. (a) the required hurdle rate of return for new lending products;
2. (b) requirements for adjusting pricing to reflect risk, term, etc.;
3. (c) the approach to setting fees, routine charges and early repayment charges, etc.; and
4. (d) the methodology for setting and collecting early repayment charges.

3.71

The policy would be consistent with the provisions relating to conduct of business that apply to the society.

3.72

The PRA expects that all societies will put in place risk management controls that are appropriate and proportionate for the types of business that they intend to undertake. Risk control arrangements are expected to ensure that there is segregation between:

1. (a) staff whose duties involve acquiring new lending business; and
2. (b) staff whose responsibility is to underwrite such lending business, in order to minimise conflicts of interest and ensure dispassionate evaluation of the credit risks involved.

3.73

The scale and breadth of the risk function is expected to reflect the scale and breadth of the activities that are undertaken by the society, and to keep pace with the development of the business. The key objective of the risk function is to provide a ‘second line of defence’: that is, independent challenge, from a risk management perspective, of proposals that are made by the society’s management, and the provision of information to management and the board that explains and informs them of risk trends/positions.

3.74

The PRA has devised three models (‘approaches’) of increasing sophistication for lending book management to assist societies in meeting supervisory expectations for the level of risk management that would apply to different business models. These supervisory lending ‘approaches’ are named as ‘Traditional’, ‘Limited’ and ‘Mitigated’. This section outlines the three supervisory approaches to managing the lending book.

3.75

The PRA expects each society to conduct its lending activities in accordance with the most suitable of these three models in order to demonstrate that it has complied with General Organisational Requirements 2.1 and Risk Control 2.1 in the context of loan book management.

3.76

Appendix 1 sets out indicative standards for:

1. (a) the types of assets that are expected to be originated or held;
2. (b) the type of risk management controls that societies are expected to put in place (and, where appropriate, to document clearly within their lending policy);
3. (c) the expectations of the PRA on credit risk management processes and procedures; and
4. (d) the criteria which societies would use in assessing their controls over their lending book under each of the three defined lending approaches.

3.77

The specification of indicative prudential standards and limits for each approach is designed to draw management and supervisory attention to those areas of a society's credit risk management strategy or policy which go (or seek to go) beyond the PRA's general expectation for societies on each respective lending approach, bearing in mind the level of risk management capability expected to be in place for that approach.

3.78

Societies can expect their supervisors to focus in greater detail on those areas of difference, to identify whether business risks have been fully evaluated and whether controls are aligned with those risks. Where this is judged not to be the case, supervisors will expect the society to develop plans to address the misalignment or to re-assess the business strategy. As such, the approach standards in Appendix 1 should not be interpreted as hard requirements, but as input into the process of establishing appropriate policies, and as the basis for supervisory dialogue.

3.79

The actual lending limits, that societies following one of the three lending models will have in their lending policies, need to be set by reference to available management expertise and risk management capability. The PRA expects these limits therefore to resemble those set out in Appendix 2. As with the risk management characteristics table in Appendix 1, the limits suggested are designed to draw management and supervisory attention to those areas of a society's lending activity which go (or seek to go) beyond the PRA's general expectation for societies that adopt each of the lending approaches.

3.80

If a society plans to become exposed for the first time to mortgages of sub-types not covered in paragraphs 3.20–3.47 above, they are expected to speak to their supervisor before entering the market, and again if their exposure reaches an internal limit pre-notified to the society’s supervisor, based on the perceived risk characteristics of the sub-type.

3.81

Societies can expect their supervisors to focus in greater detail on those areas of difference between internal limits and those set out in Appendix 2, to identify whether business risks and controls are aligned and, if not, to understand plans to address that misalignment. As such, the limit expectations set out in Appendix 2 should not be interpreted as hard requirements, but as input into the process of establishing appropriate policies, and as the basis for supervisory dialogue.

3.82

Under section 6 of the 1986 Act, societies are required to ensure that a minimum of 75% of their commercial assets are fully secured on residential property. Since such lending will always be such a significant part of a society's business, it is essential that the risks arising from further concentrations within the total lending book are properly managed and mitigated to align with the board's risk appetite.

3.83

Societies adopting the traditional lending approach category would restrict their lending activities mainly to prime quality residential mortgages for owner-occupiers. The traditional approach would suit small societies where lending decisions are fully underwritten on an individual basis, typically by the Chief Executive or a direct report, under clearly delegated mandates.

3.84

Societies adopting this approach would have board-approved lending policies that:

1. (a) set a minimum limit of at least 80% of the loan book for prime owner-occupied mortgages (subject to a mortgage indemnity guarantee or other recognised collateral for LTV in excess of 80%). Self build, shared ownership, shared equity, lending in retirement and lending into retirement can be included as sub-sets of prime owner occupier lending, as detailed in note 3 of Appendix 2;
2. (b) set limits for other types of lending within the maximum 20% balance: prime BTL, social landlords and small ticket (<£1 million per connection) secured residential investment and commercial lending to owner occupiers (including loans fully secured on other land) only;
3. (c) require the use of approved independent valuers;
4. (d) require stress tests to be undertaken at least annually to identify potential shortfalls in the value of security and allow it to review the appropriateness of its lending limits; and
5. (e) limit exposure to connected counterparties to <10% capital resources.

3.85

The limited lending approach would be suitable for societies that have a slightly higher appetite for credit risk than those on the traditional approach. Societies adopting this approach would control the amount of risk assumed through a comprehensive system of policy limits and specialist underwriters. These limits would prevent the society from becoming over-exposed to non-traditional lending, and should take account of the differing risks associated with the type of lending and the type of security held.

3.86

In general it is anticipated that the limited approach would suit medium-sized and larger societies where:

1. (a) there is operational segregation between underwriting and the review/audit/compliance functions that check compliance with policy and legislation and that review lending/underwriting quality;
2. (b) there is operational segregation between underwriting and the mortgage sales function;
3. (c) lending decisions are fully underwritten on an individual or systematically credit-scored basis, under clearly delegated mandates; and
4. (d) relevant specialist expertise is employed for non-traditional lending, adequate to cope with the additional time commitments associated with the regular monitoring required of such lending, and with access to appropriate sources of external and/or internal information to be able to monitor/challenge how risks are developing.

3.87

Societies adopting this approach would have board-approved lending policies that:

1. (a) set a minimum limit of at least 65% of total loan book for prime owner-occupied mortgages;
2. (b) set sub-limits in terms of total loan book for other types of lending within the maximum 35% balance (see Appendix 2 for guidance on sub-limits); and
3. (c) require stress-testing and scenario analysis of outcomes to be undertaken at least semi-annually.

3.88

The mitigated lending approach would be suitable for societies that undertake a diverse range of lending. Societies adopting this approach would mitigate their risk through sophisticated credit risk management systems that control the amount of risk assumed through a comprehensive system of policy limits, specialist underwriters, self-developed stochastic risk models, and through use of risk transfer or insurance techniques to protect against concentrations or catastrophic credit events.

3.89

In general, it is anticipated that the mitigated approach would suit only the largest societies where:

1. (a) there is a segregated and independent risk function headed by a Chief Risk Officer (CRO), reporting directly to the board (or a board risk committee);
2. (b) there is full segregation between credit underwriting and the review/audit/compliance functions that check compliance with policy and legislation, and which review lending/underwriting quality;
3. (c) underwriting is independent of the mortgage sales function;
4. (d) lending decisions are underwritten on an individual or systematically credit-scored basis (but subject to manual override), under clearly delegated mandates; and
5. (e) relevant specialist expert teams are employed for non-traditional lending, with access to appropriate sources of external and internal information on how risks are developing.

3.90

Societies adopting this approach would:

1. (a) have board-approved lending policies that set appropriate limits for each type of lending; and
2. (b) undertake full econometric risk analysis, stress-testing and scenario analysis of outcomes at least quarterly.