The Building Society Industry in Transition

Building societies in the 1980s are major financial institutions. At the end of 1987 the total assets of the industry amounted to over £160bn. To put this figure into perspective this compares to the total assets of the ‘big four’ clearing banks of £266bn. Building societies have over 45 million personal investors, seven million borrowers, and outstanding mortgage balances amounting to around £131bn.

The decade of the 1980s has been one of profound change in the building society industry. In particular the competitive environment has intensified dramatically on both sides of the balance sheet. In the retail deposit market, the building societies traditional funding base, societies have faced strong competition from National Savings in the early 1980s from banks and from equity investments in the form of successive privatisation issues and competition from unit trusts. In the mortgage market, building societies have been subject to an unprecedented level of competition since 1981 when the banks, freed from lending constraints, began to enter the mortgage market in a significant way.

Despite their significant role in the financial system, building societies were late to enter the wholesale markets for funding. Just as banks were confident throughout the 1970s of their ability to fund their requirements in wholesale markets, building societies were confident that their funding requirements could be met from retail sources. Hence, prior to the 1980s banks and building societies were not competing in the same funding markets. In fact until 1983 building societies were largely excluded from the wholesale markets by official regulation which limited their ability to pay interest gross (a necessary requirement in wholesale markets).

The decade of the 1980s has witnessed a dramatic change in the competitive environment in which financial institutions operate and this in turn has created pressures for new and more appropriate legislation governing the way in which these institutions carry out their respective businesses.

The 1986 Building Societies Act established a Building Societies Commission (BSC) to take over the regulatory function previously exercised by the Chief Registrar of Friendly Societies. According to the new legislation the BSC should consist of between four and ten members appointed by the Treasury although this number can be increased at the discretion of the Treasury. The BSC formally came into being on 25 September 1986 with the first Chairman of the BSC being Mr Michael Bridgeman, the Chief Registrar of Friendly Societies.

Traditionally, maximising profitability has not been the dominant objective for building societies for a number of reasons. Firstly, as mutual institutions they have not been under the immediate pressure to adopt profitability as a central objective as in principle they have sought to balance the interests of all their customers. A second reason why profitability has been less of a central consideration with building societies compared with other sectors in the financial system is that because of their mutual status and regulation, building societies have not raised external capital on the capital market in competition with others. They have, therefore, not been required to perform according to the criteria applied by the suppliers of equity capital. Finally, the combination of mutuality, an effective cartel, a cohesive industry, and the absence for decades of an effective competitor in the mortgage market, meant that building societies collectively and individually had a degree of discretion over their objectives. They chose not to be avowedly profit maximising and any target with respect to surplus (profit) was set with a view to satisfying prudential capital requirements and as a by-product of growth objectives. While building societies collectively, through the operation of the Recommended Rate System, attempted to protect the interests of their borrower and investor members, individual building societies tended to use asset growth as a criterion for assessing their performance.*

The most established secondary market for mortgages is found in the US. The initial catalyst for the emergence of a secondary mortgage market there was a form of market imperfection associated with regulation — specifically, the need to even out regional imbalances in the supply of and demand for mortgage finance associated with regulations inhibiting inter-state banking. Historically, the slower growing North-east of the US has been a capital surplus region with savings deposits growing faster than mortgage originations. In contrast, the faster growing South and West faced a situation in which savings growth was not keeping pace with the demand for mortgage lending. Hence, the original rationale for a secondary mortgage market in the US was to move funds from the North-East to the South and West. The US secondary mortgage market expanded dramatically in the early 1980s, however, following the earnings crisis experienced by the Savings and Loan Associations and Mutual Savings Banks. This was again a product, in part, of regulation which limited the extent to which these thrift institutions could raise interest rates in line with market trends. When short-term interest rates began to rise sharply in the early 1980s the institutions found themselves holding low-yielding, fixed-rate, long-term mortgage assets.

Building societies were given the power to abandon their mutual status and to convert into Public Limited Companies (plc’s) under the Building Societies Act 1986, although this power did not formally become available until January 1988.

It was emphasised in Chapter 2 that the mortgage market has been characterised by increasing competition during the 1980s. Building societies lost their previous near-monopoly position as banks, foreign banks, insurance companies, and new wholesale funded specialist mortgage lenders entered the mortgage market. In spite of this increased competition, however, building society net mortgage lending grew by 72.45 per cent over the period 1980 to 1986 as the demand for mortgage finance increased strongly and building societies maintained an average market share of 73 per cent over the period. Although building society net mortgage lending did decline from £19 541m to £14 588m during 1987, reflecting a decline in market share from 73.5 to 50.4 per cent over the year, this can be attributed largely to restrictive regulation most especially with respect to wholesale funding. As building society legislation becomes progressively less constraining, however, building societies will be in a stronger position to defend their market share in the mortgage market, albeit in an increasingly competitive environment.

It has been stressed in the previous chapter, and indeed throughout this book, that there are strong arguments in favour of building societies utilising the powers available to them under the 1986 Act and the ‘Review of Schedule 8’ to diversify both their assets and the range of services which they provide. It is most especially important that building societies lessen their traditional reliance upon mortgage lending given: the slim profit margins available in this market; the intensely competitive market environment; and uncertainty surrounding the future growth in demand for mortgage lending. This latter factor is reinforced by the general proposition, alluded to in Chapters 3 and 6, that a more diversified asset portfolio will tend to be less risky than a concentrated portfolio.

It was in 1957 with the signing of the Treaty of Rome that the signatories (which at that time numbered six in total) made a commitment to establish a genuine ‘common market’ in stages over the following 12 years. In this context a common market implied free trade (that is, free from artificial and regulatory barriers), free movement of people, capital and services, and freedom of establishment or location for firms in Member States.