Potential benefits from improved completeness

Estimating the benefits from improvements in completeness is by its nature difficult. This is because the benefits occur in the form of increased utility for customers that would switch to the new product rather than and the utility from customers that would not previously had access to the product itself. Demand elasticities are important here and are likely to be different by country due to different cross-elasticities (e.g. with the rental sector). However, we have not attempted to differentiate demand elasticities by countries due to lack of data in this area.

As described above, we attempt to quantify the benefit gained from the introduction of new products by first categorising the impact of the product introduction a demand effect in the existing market (i.e. products that address existing customers) or the creation of a new market

(products that increase access to the mortgage product). For each of these we estimate the additional (consumer and producer) surplus created.

„Increasing the availability of fixed rate products is the first

completeness gap to assess. There are two products considered here: long-term fixed rate products with and without early repayment fees. Assessing the likely take-up of these products is difficult, as consumer preferences are a key driver. However, based on European averages31 we estimate that in total 30-60% of customers would choose to purchase long term fixed rate products if both prepayable and prepayment protected options were available. Estimating the proportion of these customers that would choose the prepayment option is harder as no market offers both options for otherwise identical products32_{. Demand will depend upon the preferences of the} borrower and the cost of the prepayment option. We have made the assumption that one-third will choose to pay the higher interest rates

77 Footnotes

28_{This assumes that the risk benefits of diversification and insurance are acknowledged by}

regulators when setting capital requirements.

29_{Note that this estimate is for the benefits accruing to mortgage borrowers and producers}

only and do not include any externalities associated with changes to the mortgage markets.

31_{36% of new residential lending in 1999 was fixed rate for longer than 5 years- Source EMF}

1999

32_{Denmark is currently introducing legislation that will allow banks to offer both prepayable}

78

for the prepayment option, although this is open to challenge. Finally, we make the assumption that customers would be prepared to pay an additional 10-20bp (2-4% of total costs) for the preferred product. Applying these assumptions to the markets where these fixed rate products do not exist yields overall benefits of 1-3bp for prepayment- protected products and 1-4bp for prepayable FRMs.

„We use a similar approach to estimate the value from introducing a reasonably priced indexed adjustable rate mortgages in Germany. Assuming that 20-30% of customers would be willing to pay an

additional 10-20bp for the product, gives an EU benefit (adjusting for the fact that this is only relevant for Germany) of 1-2bp.

„Access to new borrowers (from the rental sector or from overcrowding) and the creation of new mortgage markets creates the greatest benefit from improvements in completeness. The introduction of products for subprime and non-conforming borrowers in particular will provide wider access to the mortgage product and lead to greater benefits for consumers. Based on margins after risk costs in UK and US, observe that customers are willing to pay higher amounts than the increased risk profile would suggest, suggesting inelastic demand. We therefore estimate that the total surplus i.e. the average amount that customers would be prepared to pay above the cost of the industry to supply the product are roughly 2% of the loan. Secondly, we estimate that an additional 5-10% of the market could be served via the introduction of these products. This is based on the UK where approximately 7% of mortgage completions are sub-prime loans alone. Given that such products are small or non-existent in 70% of the EU market the overall potential benefit from their introduction could be as high as 10-15bp. In some markets (e.g. Netherlands, France, Germany) rental subsidies may act to reduce these benefits by suppressing demand for such products.

„Finally, we estimate the benefit of introducing higher LTV loans in a similar way. Here we estimate that an additional 5-10% of the market will now access the mortgage product, as the equity requirement is lower. We estimate the average benefit as 1%, since for these customers as demand is likely to be more elastic than for non-conforming loans. Maximum LTV restrictions of 90% or less apply in 60% of the EU market. Applying the projected benefit to this proportion of the market

estimates the overall benefit as approximately 3-6bp

We estimate that the benefits from improved completeness of EU markets could be a 10% expansion in the market size through providing access to new borrowers and provision of more suitable products to approximately 25% of the existing borrower population, thus improving overall utility from the mortgage product. We have not estimated the impact on price of these benefits since that will depend on demand and supply

elasticities. Given the broad assumptions evaluating utility from the mortgage product outlined above, we estimate a total potential benefit from completeness improvements (accruing to both consumers and producers) of 15-30bp of current outstanding residential mortgage lending which equates to roughly 0.06% to 0.12% of EU GDP33_.

Footnotes

33_{Note that this estimate is for the benefits accruing to mortgage borrowers and producers}