Are banks justified in using interbank rates when calculating break fees?

RedOnion said:

The regulation unfortunately doesn't specify exactly how the breakage is to be calculated, but it is quiet specific that the cost to the consumer should not exceed the financial loss to the bank. A bank must provide a written breakage quote to the consumer, and list all assumptions used. All assumptions must be reasonable, and justified.

What this boils down to is that the breakage cost can't be more than the difference between what the bank was able to borrow money for for the original term in the inter-bank markets, minus what they can get for depositing the money in the inter-bank markets for the remaining term, times the remaining term.

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@RedOnion and others: Since the mainstream banks in Ireland seem to fund (most of) their mortgage lending from their customers' deposits, on which they pay very little interest, are they justified in using interbank rates when calculating break fees?

Paul F said:

@RedOnion and others: Since the mainstream banks in Ireland seem to fund (most of) their mortgage lending from their customers' deposits, on which they pay very little interest, are they justified in using interbank rates when calculating break fees?

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Yes. Because they hedge their fixed exposures with real swaps, so there is a real cost incurred in early redemption.

RedOnion said:

Yes. Because they hedge their fixed exposures with real swaps, so there is a real cost incurred in early redemption.

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Ah, right!

Paul F said:

@RedOnion and others: Since the mainstream banks in Ireland seem to fund (most of) their mortgage lending from their customers' deposits, on which they pay very little interest, are they justified in using interbank rates when calculating break fees?

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RedOnion said:

Yes. Because they hedge their fixed exposures with real swaps, so there is a real cost incurred in early redemption.

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@RedOnion Could you explain a bit more about hedging in this context? What are they hedging against? Do all lenders do it all the time? Do they do it less when they are swimming in customer deposits?

Thanks

Paul F said:

What are they hedging against? Do all lenders do it all the time? Do they do it less when they are swimming in customer deposits?

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Short answer until I have more time.

Interest rate risk.

One of the reasons that Northern Rock collapsed was because they were giving fixed rate mortgages to customers, funded by short term rate borrowings. At the onset of the financial crisis, the cost of their borrowing jumped overnight, but their income was fixed. (It was just one of their problems, but a big one).

All banks do it. The regulatory rules are tightening and forcing them to hedge better. If you Google "interest rate risk in the banking book" you'll find some of the recent developments in capital impacts of not hedging interest rate exposures.

The banks generally issue mortgages through dedicated subsidiaries, so if you look at the subsidiary annual reports you'll get an idea of the extent of the hedging. They should also be covering it in their risk management section of annual report.

In the context of this thread or indeed the mortgage regulations I'm not sure (actual) hedging strategies/funding composition really matter. They could and should do some of the above but from the perspective of a break fee it's more the opportunity cost banks faced when they gave out the loan.

Is the basis of the break fee very simple: The question is has the bank been made worse off by your early repayment compared to a scenario where they'd never gave you a mortgage on the first place? If yes then there's a break fee if not then you shouldn't be charged.

To work that out a bank is considered to have had two options - lend to you or deposit with another bank. The interbank deposit rate must be of similar duration as the fixed term of the mortgage this is where swap rates come in.

So the bank is only considered to be out of pocket if interbank rates have moved is such a way that it is worse off now - by taking your early repayment and effectively putting it on deposit with another bank for the remaining term of the fixed period - compared to what they would have gotten on the interbank/swap markets on the day you fixed your mortgage i.e., the alternative strategy.

So an increase in swap rates/interbank rates means the bank is better off than if you never darkened their doorstep so no break fee.

So none of it is based on what they actually do rather what they could have?

skrooge said:

So none of it is based on what they actually do rather what they could have?

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The relevant wording in the legislation:

"(2) A creditor shall be entitled to fair and objective compensation, where justified, for possible costs directly linked to the early repayment, but shall not impose a sanction on the consumer, and any such compensation shall not exceed the financial loss of the creditor."

skrooge said:

Is the basis of the break fee very simple: The question is has the bank been made worse off by your early repayment compared to a scenario where they'd never gave you a mortgage on the first place? If yes then there's a break fee if not then you shouldn't be charged.

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Is it not the following? Has the bank been made worse off by your early repayment compared to a scenario where you didn't make the early repayment?

skrooge said:

So none of it is based on what they actually do rather what they could have?

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RedOnion said:

The relevant wording in the legislation:

"(2) A creditor shall be entitled to fair and objective compensation, where justified, for possible costs directly linked to the early repayment, but shall not impose a sanction on the consumer, and any such compensation shall not exceed the financial loss of the creditor."

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I can see how the word "possible" in the legislation maybe allows the lender to use swap rates (or similar) in their calculation of the break fee. But should they only be using swap rates if they hedged your particular mortgage?

@Paul F
it might be worth splitting into a separate thread so we don't distract from the main topic?
I'll admit, its been a while since I read the MCD (my beef with AIB was done once they changed their policy after some 3rd hand briefing), so I might have jumped the gun with my earlier replies. If I get time I'll look through it again properly.