Pricing competition in UK retail banking: six key forces at play for 2023

Relevant to: Board Members, CEOs, Chief Strategy Officers, CFOs, COOs

As inflation and interest rate hikes continue to shake up the UK retail banking and building society market, the competitive landscape in 2023 is intensifying. The global market turmoil is also starting to impact the UK, prompting the Bank of England to consider significant reforms to the deposit guarantee scheme, which could further escalate the cost of funds. Adding to the mix, the UK Consumer Duty Act will require banking executives to carefully evaluate its effects on their operations this year.

Against this complex backdrop, it is essential for UK retail banks and building societies to exercise caution, discipline, and a proactive approach in managing the interplay between lending and deposit pricing. Executing the strategy rightly, the coming months could present a unique opportunity to optimise the financial resource allocation and margins.

In this article, we outline the six critical driving forces that management should carefully consider when navigating the pricing landscape.

1. Growing divide between secured and unsecured lending markets

Increased mortgage lending costs and dampened credit demand will weigh on margins

• Successive rate hikes by the Bank of England (BoE) in 2022 has increased mortgage lending costs, which will weigh on housing and credit demand in 2023. The value of new mortgage commitments in 2022 Q4 was 33.5% lower than the previous quarter and 24.5% lower than a year earlier, at £58.4 billion.
• As of April 2023, the spread between the UK 5-year swap rate and the weighted average interest rate on newly drawn 5-year fixed mortgages (75% LTV) was 137bps. With average 2-year fixed UK mortgage rates of 4.54% at the start of March, banks are only now able to gain a spread of 54bps on these products compared to a spread of 169bps at the start of 2022.
• With around 1.8 million fixed rate mortgages set to reach the end of their deal period this year, refinancing activity is expected to strengthen further through 2023. Internal product transfers are typically not subject to affordability tests if the loan amount is unchanged. Therefore, with tighter affordability, it is likely that internal product transfers will continue to take a greater share of overall refinancing since the start of the rate-rising cycle. External re-mortgaging is likely to show less pronounced (but still robust) activity levels.
• In contrast to declining mortgage demand, unsecured consumer lending remained high in Q422, with households taking on debt to maintain existing expenditure during the cost-of-living crisis. This is expected to continue into Q123. Further, this is evidenced by the rapid increase of Buy-Now-Pay-Later (‘BNPL’) adoption and volumes by consumers. These trends appear to have alarmed regulators and practitioners who are now expecting an increase in non-performing loans for 2023 as the economic outlook deteriorates.

Pricing implications:

• Strengthen customer engagement: Banks can strengthen customer retention by establishing a clear understanding of the potential value attached to customer relationships at the product/customer level, utilising metrics such as lifetime value and lifetime value/customer acquisition costs (‘LV/CAC’). This can enable banks to offer personalised financial advice and investment opportunities and preferential rates / discounts based on a customer’s financial goals and risk tolerance and which in turn enhances, among other metrics, LV/CAC, optimising the overall ‘return on relationship’ and outcomes for customers.
• Monitor market pricing movements: Given deteriorating mortgage volumes, increased competitive pressures require closer monitoring of competitors’ market pricing to measure price elasticity and devise profitable customer retention strategies.
• Tighten pricing governance: Consumer Duty brings increased scrutiny of pricing practices. While it remains important for front line businesses to retain pricing decisions, a joined-up approach paired with pricing governance forums should enable clear control frameworks and guidelines on pricing practices. Business lines will need to implement this in their decisions on setting prices. The frameworks should be designed to ensure good customer outcomes and minimise regulatory risks while empowering the front-line business to take decisions on prices.

2. Tightening underwriting criteria amid affordability concerns

Banks to tighten lending standards amid affordability concerns, prompting borrowers to seek longer-term options and increasing credit loss provisions

• Recent data from the Bank of England shows that banks are tightening their lending standards at the fastest rate since the pandemic across most product sets. In Q4 2022, the proportion of mortgage lending to borrowers with a high loan to income ratio decreased by 2.2 percentage points from Q3 to 49.3%. This is 0.8 percentage points lower than a year earlier and the lowest observed since 2021 Q3.
• Borrowers are increasingly seeking longer-term borrowing options in order to lower initial payments and meet affordability requirements - a trend that is showing no signs of slowing down. Meanwhile, credit losses are expected to rise, as evidenced by the big six banks raising provisions by £7.8bn in 2022 compared to a release of £4.1bn in 2021.

Pricing implications:

• Calibrate risk-adjusted pricing: Dynamic calculation of IFRS9 provisions and consideration of the cost of risk allows pricing to be updated frequently as the macroeconomic environment shifts. This allows banks to offer more competitive pricing to creditworthy borrowers while maintaining profitability. Pricing should be optimised for the desired asset allocation, risk appetite and limits. In periods where lending standards are being tightened to maintain the desired asset quality mix, banks can make positive pricing adjustments for the most creditworthy and ‘best-fit’ customers.
• Conduct portfolio reviews: Conducting more regular and comprehensive portfolio reviews to assess credit risk and asset quality concentrations across sector, credit quality and geography should, in turn, help identify emerging risks and trends. Consequently, this can facilitate better-informed loan pricing decisions based on up-to-date risk assessments.

3. Increasingly customers are moving deposits from low-yield current accounts to alternative higher-yield savings products

NIMs may have peaked due to pressure from the inverted yield curve and increased velocity of customer deposits

Despite the fallout from recent events, both the trend of small bank to large bank deposit flows and customers moving low-cost deposits to money market funds and other higher-yielding saving products appears less severe in the U.K. than in the U.S. There is yet to emerge any notable change in smaller bank deposit pricing that might be indicative of a tougher competitive environment for retail deposits.

• Medium term rate expectations appear to have peaked: Concerns around a potential recession and recent financial instability in Q1-23 mean we expect lower terminal rates than previously anticipated. As rate rises slow, or begin to reverse, we expect NIMs to moderate and potentially narrow during 2023 as funding costs rise with banks increasing rates on current accounts and savings products in order to retain customers.
• Retail deposit rate betas rising: Deposit betas continue to rise, in some cases above 50% following a number of deposit rate increases, and we expect elevated retail funding costs for the remainder of the year. Competitive pressures mean this has also resulted in rises in fixed-rate products.

Pricing implications:

• Dial up personalisation strategy: Banks can enhance customer engagement by adopting a customer-centric approach to better understand individual financial needs and preferences, allowing them to offer tailored savings products that provide the best outcomes for their customers which can include personalised product recommendations leveraging detailed customer data, enhancing digital channels and customer support, and rewarding customer loyalty.
• Deepen understanding of customer behaviour: Comprehensive analytics platforms, which enable detailed tracking of customer deposit migrations and analysis augmented by intelligence on changes in market rates can identity emerging trends in deposit migrations, enabling banks to offer tailored, fee-generating savings products that proactively address customers’ evolving financial needs.
• Conduct price elasticity analysis based on pricing spreads relative to competitors, per segment: Implement a dynamic pricing tool that analyses customer segments and their price elasticity in response to rate changes, allowing banks to offer competitive, tailored rates for each segment while maintaining profitability and attracting new customers based on market conditions and competitor offerings.
• Optimise the pricing strategy, considering margin objectives and financial resource constraints: Develop an AI-driven pricing optimisation platform that dynamically adjusts deposit rates for various customer segments, considering margin objectives, financial resource constraints, and market conditions, to enhance profitability while providing competitive rates to attract and retain customers.

4. Increasing velocity of mortgage overpayments

The Consumer Duty Act spurs regulatory scrutiny, mandating fair and transparent loan pricing strategies and product design adjustments

Mortgage borrowers paid down housing debt after interest rates on home loans soared, with lump-sum repayments and redemptions jumping from £1.7bn in October 2021 to £2.4bn in October 2022, with successive rate increases proving a strong incentive for borrowers. Overpayments lead to lower LTV ratios which may prove beneficial for borrowers, as they may be able to negotiate better terms when they refinance or take out a new mortgage in future.

Pricing implications:

• Capitalise on opportunities to engage with customers: Utilise increasing mortgage overpayments as a catalyst to proactively engage customers through more efficient pricing structures at lower LTVs, enhancing customer engagement that focuses on proactive cross-selling, refined behavioural assumptions, and improved customer data monitoring. This enables banks to offer better terms on refinancing or new mortgages, ultimately fostering long-term relationships and optimising pricing strategies.
• Identify opportunities to cross-sell: Overpayments are a sign of high price elasticity when rates are higher, but it is also a sign that clients don’t feel that they have suitable alternatives for their excess savings. Retaining high value clients with high overpayment rates could be achieved by referring them to investment advisors and savings teams who can assess the ability to drive ancillary revenues that could enhance the long-term relationship with the customer.
• Change behavioural assumptions: Accelerating overpayment rates in the face of rising rates will need to be factored into behavioural assumptions used to determine cost of funding for new mortgages.
• Enhance customer data and MI: Timely monitoring and reporting of LTV ratios can be accommodated by efficient loan processing, monitoring, and MI systems. This will also prompt conversations over renegotiation of loan terms or provision of alternative products for borrowers who are making above-trend overpayments.

5. Heightening regulatory scrutiny on consumer duty

The Consumer Duty Act spurs regulatory scrutiny, mandating fair and transparent loan pricing strategies and product design adjustments

• The FCA’s new Consumer Duty Act represents a paradigm shift in expectations in the treatment of retail customers across the whole of the Financial Services sector. From our work to date with both clients and the FCA, we understand the complexity and challenges faced by firms as they are not only required to demonstrate compliance, but also the shift to a more proactive focus to deliver good customer outcomes while also identifying and preventing foreseeable harm before it can materialise. Compliance with Consumer Duty is not a finite exercise, and firms will need to adapt and keep evolving their approach to product design, pricing, communications and serving. They will need to embed this in their way of working, from the front line all the way through the organisation to the Board.
• Overall, the Consumer Duty Act is likely to have significant implications on bank loan pricing strategies in the UK, and banks will need to be proactive in addressing these changes to ensure they remain compliant while maintaining profitability.

Pricing implications:

• Fair treatment of customers: The Consumer Duty Act requires banks to act in the best interests of their customers and treat them fairly. This means that banks will need to ensure that their loan pricing strategies are fair and transparent and do not take advantage of vulnerable customers. Banks are required to provide clear and concise information about their loan products and pricing. As a result, banks will need to be more transparent about their pricing practices, and regulators are likely to scrutinise these practices more closely.
• Rationalise pricing and product design: The Act may also put pressure on banks to reduce their loan pricing, particularly for customers who are deemed to be vulnerable. Banks may need to re-evaluate their pricing strategies to ensure they are not charging excessively high rates or fees. Banks may also need to make changes to their loan product design to ensure they comply with the Consumer Duty Act. This may involve offering more flexible repayment options or reducing the length of loan terms to make them more manageable for customers.

6. The shift of housing markets under the UK’s Net Zero transition agenda

The UK's net zero agenda can pave the way for green lending opportunities and energy efficiency-linked pricing strategies

In the green mortgage market, we see significant challenge ahead in aligning the UK government’s ambition, through which it is looking to lean on lenders to drive (part of) the transition through their mortgage lending activity, with the ‘greening of homes’ for which there are a number of other barriers to uptake, aside from financing (such as customer confusion and apathy and a lack of energy installers), over which banks do not currently have much control.

Banks at the forefront of green mortgage lending will need greater focus on product development and innovation to create propositions that benefit customers and create value for the bank – although we observe only relative moderate progress to date.

Analysing the UK housing market in the context of the UK government’s transition strategy and stated target of net-zero by 2050, we have identified three primary challenges that we think are of primary consideration:

• Tackling energy efficiency levels of existing housing stock: is one of the biggest infrastructure challenges of this generation and is part of the Government’s Clean Growth Strategy which aims by 2035 to bring as many homes as possible up to EPC Band C level where practical, cost-effective and affordable. In the near term, the expected downturn in housing prices may hinder the accumulation of capital necessary for improving energy efficiency and transition to low carbon heating.
• Understanding the proposition: Banks still have more work to do in understanding green buildings and developing enough data to prove that ‘green’ really does mean lower risk. Information availability and lack of a mature supplier market hinders cost benefit analysis at a level banks are typically comfortable with.
• Untapped potential for green lending: UK Committee on Climate Change has estimated that £250 billion needs to be invested in UK home upgrades by 2050, which means there is the potential for significant capital flows in green mortgages in the coming years. Despite strong demand for green mortgages and lending, the scarcity of qualifying homes (predominantly limited to new builds) and a lack of targeted product design hinder market penetration. To drive uptake, we propose exploring partnerships with builders and energy companies, leveraging their funding to offer more attractive loan terms and incentives (such as allowing re-mortgagers to use their mortgage to borrow further via linked energy efficient home improvement loans).

Pricing implications:

• Align interest rate tiers to the bank transition strategy: Offering tiered interest rates for green mortgages and loans, with lower rates for borrowers who commit and achieve specific energy efficiency will enable alignment of pricing to the bank stated transition target.
• Introduce energy efficiency-linked loan discounts: Collaborate with energy companies to provide discounts on loans for homeowners who implement energy efficiency measures, such as installing solar panels, upgrading insulation, or replacing old heating systems. Under this model the bank provides the improvement loan financing and the energy company provides a managed service to install appropriate energy efficiency solutions - which helps the customer to identify what measures would deliver the greatest savings potential - and provision of a range of in-life energy services.
• Consider both servicing and operational costs in pricing decisions: Green mortgages typically price at a discount to conventional mortgages. However, administrative costs are typically higher for green mortgages and will require investment in infrastructure to support additional data requirements for green lending including the capability to effectively identify and monitor these assets.

References:

1. ‘Bank of England considers major reform of deposit guarantee scheme’ | Financial Times (ft.com)
2. ‘Commentary on Mortgage lending statistics Q4 2022’ | FCA
3. Quoted Rates | Bank of England | Database – accessed as of 29 Mar 2023, Refinitiv historic UK 5-year swap rates
4. ‘Household Finance Review – Q4 2022’ | UK Finance (ukfinance.org.uk)
5. ‘BNPL expected to double market share in UK e-commerce within the next four years’ | Finextra (finextra.com)
6. ‘Buy now, pay later demand soars among all age groups in the UK’ | Financial Times (ft.com)
7. Big 4 banks such as HSBC, NatWest, Barclays and LBG have all increased their IFRS9 provision levels vs. 2021 in anticipation of a deteriorating economic outlook per their 2022 annual reports.
8. ‘Commentary on Mortgage lending statistics Q4 2022’ | FCA
9. ‘Mortgage overpayments surge as borrowers fend off rising interest bills’ | Financial Times (ft.com)
10. ‘Decarbonising heat in homes’, The UK Government’s Department for Business, Energy and Industrial Strategy (BEIS) Committee, 3 Feb 2022