However, their ratings are supported by their strongly performing mortgage books, stable funding and liquidity, and generally solid capitalisation and leverage.
The report, UK Building Societies – Peer Review says that building societies’ net interest margins have been declining for several years due to persistently low interest rates and intense competition among residential mortgage lenders.
An influx of lending capacity from the ring-fenced retail operations of the larger UK banks exacerbated this trend in 2019.
Fitch says that building societies, unlike banks, are limited in their ability to offset declining mortgage margins with more profitable types of lending. Their narrow business models and in most cases modest franchises mean revenue streams are correlated with base rates and competitive pressures.
Their mortgage-centric business mix is a function of their mutual status, which requires at least 75% of their business assets (predominantly customer loans) to be residential mortgages.
Net interest margins are likely to be squeezed further by rising funding costs, as drawdowns under the Bank of England’s low-cost Term Funding Scheme (TFS) mature in 2020-2022.
The need to issue debt to meet minimum requirements for own funds and eligible liabilities, which take full effect at the start of 2022, will also push up costs for some building societies.
Profitability is also being dragged down by increasing non-interest expenses. Many building societies have embarked on or recently completed programmes to improve their operational efficiency, which typically involve significant costs before they bear fruit.
Examples include restructuring and branch closures, as well as significant investment in IT systems to strengthen digital capacity, which is increasingly important for attracting and servicing deposits.
The challenges to profitability are mitigated by the building societies’ sound asset quality, stable funding and liquidity, and generally solid capitalisation and leverage.
Building societies have benefited from very low loan impairment charges in recent years due to benign economic conditions, while low interest rates and access to TFS funding have kept funding costs low.
Fitch expects loan impairment charges to begin to increase from present levels. This is in the context of the likelihood that the credit cycle has bottomed out and the uptick in higher-risk mortgage lending in recent years as several societies defend their margins.
However, an overall focus on low-risk mortgages should keep normalised impairment charges at moderate levels.
