UK: A Clearer Picture Emerges - Squaring Up To New Challenges

Last Updated: 21 June 2007
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017

Value creation in the mortgage industry

The mortgage industry is currently beset with a number of structural challenges and conflicting expectations placed on its participants. Traditional product volume based strategies may no longer yield adequate shareholder returns whilst limited new product and service innovation is resulting in a lack of differentiation amongst the leading players.

In response, competitors are repositioning across the value chain with new entrants threatening to bring disruptive influences to the traditional market. Whilst group companies are beginning to reconsider the role of the mortgage business within their broader retail and lending portfolios.

Increasingly, customers, analysts, intermediaries and the media are placing heightened and often conflicting expectations of success on mortgage participants.

The current irrational competitive behaviour is not sustainable, with the market increasingly demanding a focus on long-term value creation and strategic transformation.

The value creation challenge

The challenge for existing mortgage players is how to create and delivery strategies that deliver sustainable value.

Current product volume based strategies are becoming obsolete. They stem from the belief that customers can be acquired cost effectively using discounted headline rates and that these same customers will start making profitable contributions once they revert to products at the standard variable rate. With declining customer loyalty and increasing switching behaviour, cross subsidisation of loss making products with high margin ‘back books’ is no longer a realistic strategy. Mortgage origination businesses are currently struggling to maintain profitability whilst seeking to retain lending volumes at historic levels in order to meet market expectations. Industry commentators continue to focus on market share as the primary measure of success. This creates unrealistic expectations, often forcing organisations to focus on volume at the expense of value.

A value based approach to long term value creation

In order to break out of the current challenges, mortgage players must focus on all of the value drivers available to them and address them with a long term goal of value creation in mind. Traditional ‘jaws’ based approaches will deliver short to medium term value, but tend to focus on impacting the cash flows of the business which contribute to but do not create sustainable value creation.

Consideration of some additional value drivers such as the external environment and efficiency of assets will provide longerterm value creation opportunities by focusing on balance sheet utilisation and managing stakeholder expectations on business performance.

Disruptive new business models

The industry is witnessing a growing emergence of new entrants and new business models which could potentially disrupt the existing market. These strategies are designed around the use of funding and credit risk management as a means to generate profitability and deliver enhanced value creation. Investment banks and hedge funds are using their capabilities to create ‘off balance sheet’ funding mechanisms. They have become increasingly active in the UK mortgage sector by acquiring smaller scale players and/or purchasing entire mortgage portfolios. In addition, there is a growing trend toward start-ups targeting the market with propositions aimed at providing outsourced funding and treasury management services.

These business models all share a common approach. They are targeting an opportunity to profit from the margin spread associated with providing lenders with lower cost capital, whilst offering to manage credit risk at arms length through a variety of risk transfer and derivative instruments.

Asset efficient business models represent both a threat and an opportunity for existing mortgage lenders. They have the potential to change the dynamics of the industry and shift profitability away from product pricing and operational efficiency whilst positioning funding as a key source of longer-term value creation. This development may result in lenders establishing highly efficient origination businesses with little or no processing and servicing capability, and that are focusing purely on gathering assets for debt management in order to generate volume at scale.

Others may consider joining up with other parts of their own organisations or developing partnerships with external providers to reap the benefits arising from ‘off balance sheet’ funding and credit risk trading activities. Smaller lenders may consider the benefits of merging with larger entities that offer complementary capabilities or combined scale.

The result is likely to see a polarisation of participants: businesses which focus either on product origination or funding as their main source of competitive advantage and value generation.

Delivering value creation through strategic transformation

Responding to these challenges will require market participants to consider strategic transformation, which could consist of a number of steps delivering increased sustainability of benefits as implementation time and complexity increases.

These incremental steps may include:

  1. Stabilising current business performance through optimising channel volumes, aggressively addressing customer retention issues, changing the product margin mix by entering new segments or enhancing the service offering.
  2. Creating a lower cost operating model by introducing enhanced automation of credit decisions and straight-through processing, actively targeting and reducing reactive arrears and recovering costs by investing in new capability, and reconsidering the position in the value chain to outsource or offshore non-core functions.
  3. Developing an asset efficient business model by focusing on balance sheet rather than purely profit and loss led strategy, developing an asset and credit risk efficient treasure model, and managing liquidity, capital and risk appetite as enablers of value creation.

Effective competition within an evolving market will required clear strategic choices about where to participate and how to build distinctive capability through transformation to create sustainable value for the organisation, its customers and its shareholders or members.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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