Convergence in European mortgage systems before and after EMU

Journal of Housing and the Built Environment15: 29–52, 2000.© 2000Kluwer Academic Publishers. Printed in the Netherlands.

Convergence in European mortgage systems beforeand after EMU

MARK STEPHENSDepartment of Urban Studies, 25 Bute Gardens, University of Glasgow, Glasgow G12 8RS,Scotland, U.K. (E-mail: m.stephens@socsci.gla.ac.uk)

Abstract. The European Union’s mortgage finance systems remain diverse, despite the in-troduction of the European Single Market. However, 11 of the 15 members of the EuropeanUnion have now entered the Economic and Monetary Union (EMU). In this article a three-parttypology of convergence is created and linked to two meanings of efficiency. The typology isused to assess the impact of EMU on mortgage system convergence. It is suggested that thesingle currency will help to shift European mortgage markets from their currently diversepositions, with a variety of intermediation systems, mortgage products and prices, towards anintermediate position of financial integration (‘financially competitive convergence’) wherebythe risk and option-adjusted prices of mortgages will be similar, although institutions andmortgage products will continue to vary. This will be achieved through two mechanisms:first the much greater transparency of pricing of mortgages, and second by making retailsavings markets more competitive. However, convergence will also be inhibited by the con-tinued privileged availability of cheap funds to some intermediaries. Even if this barrier wereremoved, non-financial features of mortgage systems, such as legal frameworks, will preventthe development of a fully integrated market with a standard pan-European mortgage product.

Key words: Economic and Monetary Union, European Union, mortgage markets

1. Introduction

Neither the trend towards the free movement of capital in the 1980s northe European ‘Single Market’ programme made a significant impact on thediverse nature of mortgage systems in the European Union (EU). This articleassesses the current situation in EU mortgage finance systems. It goes on tosuggest what impact the introduction of the Euro might have on the progresstowards convergence between countries. The second section considers whydivergence in housing and financial market institutions is important in termsof both individual choice and macroeconomic management within the contextof a common monetary policy. The third section examines the literature onthe prospects of convergence prior to the introduction of the Euro. The fourthsection outlines some of the key differences between mortgage systems in the

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EU and establishes a ‘convergence typology’ to allow a systematic prognosisof the likely impacts of the Euro. In the fifth section, an examination of theliterature that has attempted to quantify the relative efficiency of mortgagesystems establishes that there has been a chronic information problem actingas a barrier to competition and convergence. This arises from opaque pricingstructures, in large part due to different currencies and monetary policies,which should be removed by the Euro. Following on from this observation,the sixth section narrows the focus to the impact that the Euro might have onmortgage systems. Using the ‘convergence typology’ established in Section3, this section expands upon the nature of convergence likely to arise from theEuro. The implications of the findings are discussed in the final, concluding,section.

2. Implications of divergent mortgage systems

Divergence in European Union mortgage finance systems matters for twobroad reasons. First, it matters to individuals and society in terms of tenurechoice and the distribution of wealth and debt. Mortgage finance is not theonly determinant of tenure choice, but it is an important one. In systems wherecredit availability is constrained, access to owner-occupation is similarlyrestricted by the need for potential buyers to save for a deposit. Since a houseis likely to be an owner’s most valuable asset (or second most valuable aftertheir pension), levels of owner-occupation affect the distribution of wealth insociety, as well as the distribution of risks and opportunities associated withchanging asset values. These effects often extend to other generations in thesame family through inheritance. It has been suggested that owner-occupationaffects life chances by, for example, providing equity for children’s educationand may also affect other social policies, notably pensions. Kemeny (1995)argues that in societies with large owner-occupied sectors, governments areable to pay low levels of pensions, since retired owner-occupiers’ housingcosts are very low because mortgage debt has been repaid. It is cheaper totop up the minority of tenant pensioners’ incomes with housing allowances.Some authors suggest that the restricted access to mortgage finance in Italydelays household formation and contributes to the low birth rate (Maclennanet al., 1998).

Second, divergent mortgage and housing systems have implications formacroeconomic management, especially within the context of the singleEurozone interest rate set by the European Central Bank for participantsin the Economic and Monetary Union. Maclennan et al. (1998) arguethat features of mortgage and housing systems, such as different rates ofowner-occupation, levels and structures of housing debt result in asymmetric

CONVERGENCE IN EUROPEAN MORTGAGE SYSTEMS 31

responses of house prices to changes in short-term interest rates (see Table1). Further, other features within housing systems, such as transaction costs,mean that the liquidity (or spendability) of housing wealth varies betweencountries. Consequently, the impact of changing house prices on consumerexpenditure differs between countries, with obvious implications for macro-economic management: an interest rate suitable for one country may beunsuitable for another. The risk within the Eurozone is that a single interestrate may lead to deflation in some countries or, conversely, to inflation whichmay spill over into other member states.

The importance of differential asset price movements is often neglectedin the economics literature on single currency areas (Eichengreen (1997)provides a recent example) but is gradually being appreciated by somenational central banks and finance ministries (see HM Treasury, 1997). Afrequent criticism of the formal ‘convergence criteria’ established in theMaastricht Treaty is that they concentrated on ‘nominal’ indicators, such asinterest rates and inflation, while neglecting ‘real’ indicators, such as outputand employment. A further limitation of the convergence criteria is that theyneglect asset values generally and house prices in particular. A belated andsuperficial consideration was given to house prices by the European MonetaryInstitute (the forerunner of the European Central Bank) when examiningprogress towards economic convergence among the member states (EMI,1998).

The extent to which housing systems converge is of great importance notonly to those countries, especially Sweden and the UK, which have yet todecide whether or when to join the Euro, but for the success of the Euro itself.Finland, Spain and Ireland are examples of countries outside the core of theEurozone (Benelux, Germany and Austria) whose housing finance systemshave characteristics liable to make them sensitive to changes in short-terminterest rates. These characteristics are identified by Maclennan et al. (1998)as: high levels of owner-occupation unbalanced by a satisfactory privaterental alternative, a reliance on floating-rate debt, high levels of personalmortgage debt within the economy, high loan-to-value ratios and a history ofhouse price volatility. Although not all of the countries exhibit all of thesecharacteristics, they share a sufficient number of them for the authors torecommend reform of their housing systems in order to lessen their sensitivityto changes in short-term interest rates. The authors recommend reforms, suchas encouraging the growth of the private rented sector and the greater useof fixed rate debt. However, they also suggest that, from a monetary policyperspective, greater convergence of housing finance systems within the Euro-zone would also be beneficial. This implies a shift towards less restrictedfinance systems in some countries.

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Table 1. Diversity in European housing and mortgage finance systems

Country Owner- Mortgage House Primary Mortgage product Mortgage prices

occupation debt: GDP price lendersd (i) LTV (ii) Duration (iii) % Floating- (spreads) (1997)f

(%)a (%) volatilityb (%) (years) rate debte (percentage points)

Austria 54 (1995) 30–33 1.7 BN, SB 80 20–30 Mixed –Belgium 67 22 2.2 CB 80 15–20 0 3.1Denmark 50 (1995) 65 6.6 MB 80 30 10 –Finland 62 (1995) 30 15.0 CB 70–80 10–15 90 –France 54 21 7.0 CB, MB, SB 70–80 15–20 20 3.7Germany 38 51 1.8 BN, CB, MB, SB 60–80 25–30 40 3.6Greece 76 6 3.1 CB, MB 70–75 15 70 –Ireland 79 27 5.1 BS, CB 80 20–30 57 –Italy 68 7 7.7/11.6c CB 40 15 40 0.9Luxembourg 70 – 2.0 CB, PB 15–20 Mostly –

(reviewable)Netherlands 48 (1995) 60 2.6 CB, INS 75 30 10 2.9Portugal 67 26 3.5 CB 80 20 100 –Spain 78 22 9.4 CB, SB 70–80 15–20 80 0.4Sweden 39 51 8.2 CB, MB 70–75 20–30 Mainly fixed –

(renegotiable)UK 67 (1995) 57 10.0 BS, CB 90–95 25 70 0.7

a Around 1990, unless stated otherwise.b Standard deviation of annual changes in real house prices 1986–1997.c Different indices in Italy produce remarkably different results.d BN = Bausparkassen, BS = building society, CB = commercial bank, MB = mortgage bank, INS = insurance company, PB = public bank, SB = savingsbank.e Interest rates altered either at discretion of lender (reviewable) or adjusted according to an index (variable).f Unadjusted mortgage rate less money market rate.Sources: Maclennan et al. (1997); Lea et al. (1997); mortgage prices – see Table 3.

CONVERGENCE IN EUROPEAN MORTGAGE SYSTEMS 33

Having established the importance of divergence between European mort-gage systems, this article now turns to the potential for convergence. In thenext section the article examines the literature on convergence in the periodpreceding the introduction of the Euro.

3. Convergence before the Euro

The European Commission has had a long-standing commitment to thecreation of a single market in mortgage finance. A draft mortgage directivewas issued in the 1980s, but it was superseded by the directives designed tofacilitate cross-border operations by credit institutions in general, as part ofthe Single Market programme. The Second Banking Co-ordination Directiveallows credit institutions to operate throughout the European Union on thebasis of their home state banking license. This removes the need to gaina separate banking licence from host state regulatory authorities and to besubjected to separate regulatory regimes. To prevent prudential standardsbeing subjected to competitive erosion, all credit institutions, regardless ofwhether they operate outside their home state, must meet common prudentialrequirements established by the Own Funds and Solvency Ratio Direc-tives. Additionally, the Single Market programme abolished capital controlsbetween EU countries, while the Exchange Rate Mechanism (ERM) of theEuropean Monetary System was intended to limit exchange risk by limitingpermitted currency fluctuations. The ERM proved to be the least stable part ofthe Single Market structure, not least because of the inherent tension betweenoperating a semi-fixed exchange rate in combination with free movement ofcapital (see Connolly, 1995). It was able to withstand speculative attacks in1992 and 1993 only by the suspension from membership of several currenciesand the widening of the permitted fluctuation bands.

A number of studies consider whether the Single Market framework islikely to lead to convergence in European mortgage systems. These studiesfall into two camps. A minority suggest that the single market legislationwould remove most significant legal barriers to cross-border competition andthat convergence would occur. Lomax (1991) argued that technological devel-opments would reduce financial barriers to cross-border competition, such asthe need for an extensive branch network, by making forms of centralizedlending viable. He further suggested that the success of foreign lenders in theUK market in the 1980s demonstrates that the barriers arising from customerloyalty and resistance to foreign brand names may have been exaggerated.Lomax characterized the mortgage market as being ‘contestable’, that is “onein which prices are held down to the levels of marginal cost by the threat ofpotential entry . . . ” (Lomax,1991, p. 58). Consequently, he did not expect

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convergence to arise necessarily from cross-border competition. Rather, “it ismore likely that deregulation will encourage previously protected nationalbanking sectors to adapt, heightening potential competition and resultingchanges in perception could induce substantial adjustment” (ibid., p. 62).

This view is contradicted by the majority of studies. Boléat (1994) was themost emphatic in arguing that the most significant barriers to convergence donot arise from legal difficulties in establishing cross-border activities:

The obstacles to cross-border housing finance are differences in landlaw, tax law, language, financial structures and the long-term nature ofmortgage loans, none of which are directly influenced by the SecondBanking Directive. The obstacles which it removes are not the obstaclesto housing finance institutions operating across national borders. (Boléat,1994, p. 41)

This analysis was in essence shared by Whitehead (1994) and indeed echoedthe findings of an earlier report by the House of Lords Select Committee onthe European Communities (House of Lords, 1985). McCrone and Stephens’(1995) survey of the European operations of UK lenders indicated thatcross-border activity often resulted in financial losses, sometimes in hastywithdrawal, and was invariably so small in scale as to have negligible impactson the structure of national mortgage finance systems. The performance ofUK lenders in Europe has shown no sign of improvement since the survey wasconducted.1 Since cross-border activity typically involves raising funds in thehost country and employing products based on the host country’s customs andpractices, it might be questioned whether it represents cross-borderlendingat all. Certainly it is difficult to see how efficiency gains can be transmitted inthis manner.

The evidence so far is overwhelming in suggesting that there is nounambiguous trend towards convergence. Whitehead (1998) observed that,historically, European mortgage finance systems shared one characteristicbut differed in two other respects. All shared the characteristic of having aspecialist circuit of mortgage finance which, through regulation or subsidy,delivered mortgages at below-market interest rates. Mortgage finance systemsdiffered in two important respects, however. First, some were dependent onspecialist deposit-taking institutions, while others relied on (sometimes state-owned) mortgage banks which issued bonds secured on pools of mortgages.Second, some systems were characterized by direct government assistance(usually in the form of interest subsidies) which was often tied to new housingor investment in housing. Analysing a survey conducted by the EuropeanNetwork for Housing Research, Whitehead concluded that “it is the similaritythat has been disappearing over the past decade, as much as the difference”

CONVERGENCE IN EUROPEAN MORTGAGE SYSTEMS 35

(Whitehead, 1998, p. 23). In the next section European mortgage systems areanalysed in more detail.

4. European mortgage systems

In this section, key features of European mortgage systems are analysed inorder to develop a ‘convergence typology’ (Tables 1 and 2). The purpose ofthe typology is to allow us to examine the ways in which the introduction ofthe Euro might facilitate convergence.

4.1. Intermediation

The basic purpose of an intermediation system is to channel funds frompeople who wish to save to those who wish to borrow. The example of theUnited States shows that a mismatch between net borrowers and net saversmay have a distinct regional element, and inefficiencies can emerge as a resultof formal restrictions on the geographic operations of intermediaries as wellas market-related ones, such as the use of different currencies. The intermedi-ation process involves three distinct functions, namely origination (i.e. sellingthe mortgage), funding and management. These functions can be separated.Such secondary market activity most commonly occurs where third parties(such as mortgage salesmen, brokers or other financial institutions) are usedfor origination. So-called centralized lenders (i.e. those lenders with no or fewbranches) are most likely to rely on third parties for origination. Funding andmanagement operations have traditionally been separated, although the devel-opment of legal frameworks to facilitate the securitization of loans representsa specific type of secondary market activity.

There are broadly two types of intermediary: retail-funded and wholesale-funded. In principle, there is no reason why one model should be morecompetitive than the other, and in many countries these systems co-exist.The former relies on the (usually short-term) savings of individuals placed inaccounts, whereas the latter relies on individuals’ (usually long-term) savingsplaced in institutions (such as pension companies) which invest in bondsissued by mortgage lenders.

Nevertheless, the retail model is dominant in 11 of the 15 member statesof the European Union, with an estimated market share of 60 per cent (Leaet al., 1997). There is a variety of retail-funded institutions, including savingsbanks, which are the largest lenders in Spain and Germany. Governmentownership (at regional or municipal levels) brings with it indirect governmentguarantees and, where backed by a central institution (such as theLandes-bankenin Germany), liquidity and long-term finance. Similar benefits are

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provided by the central institutions which back associations of co-operativebanks. Rabobank in the Netherlands, Crédit Agricole in France and the DGBank in Germany are the prime examples (Lea et al., 1997). The buildingsociety model, once dominant both in the UK and Ireland, is now in rapiddecline in the UK, due to the conversion of many of the largest of these mutualorganizations into commercial banks (Stephens, 1997). Commercial banksare also important in Belgium, the Netherlands and Portugal. An importanttype of retail-funded institution is theBausparkassen, which operates a‘closed circuit’ of finance in Austria and Germany through a contract-savingsscheme subsidized by government (Stephens, 1993). A similar system (PEL)is operated in France, but through French general retail lenders (Stephens,1993). However, in this system the circuit is not ‘closed’ and cheap fundingcan be used to fund non-PEL mortgages with a competitive advantage (Lea etal., 1997). The wholesale-funded system, operating through mortgage bankswhich issue mortgage bonds secured on pools of mortgages, is dominant inDenmark and Sweden. Mortgage banks also operate in France, Germany andthe Netherlands.

4.2. Mortgage products

The mortgage products arising from these systems vary greatly in a numberof respects. The size of loans in relation to the value of properties is a keydifference. Some systems, such as the UK and Ireland, make 100 per centloans available, while others are limited to 60–80 per cent. Where low loan-to-value ratios arise primarily from the lack of security offered by the systemof land law (often accompanied by poor valuation systems), loan repaymentperiods tend also to be relatively short. This holds for France and Italy, whereit can take up to three and seven years, respectively to repossess a property(Lea et al., 1997). In contrast, where the source of the restriction arises fromregulations placed on institutions or funding instruments, relatively smallloans can be accompanied by long repayment periods. Loans supported bymortgage bonds in Germany cannot exceed 60 per cent but are repaid over25–30 years. In the UK and Ireland high loan-to-value ratios are accompaniedby long repayment periods. High loan-to-value ratios are also facilitated bymeasures that reduce the risk of default to the lender, notably the availabilityof state mortgage insurance in the Netherlands and the use of mortgageindemnity guarantees (MIGs) in the UK. (MIGs are an insurance premiumusually paid by borrowers with high loan-to-value mortgages which protectthe lenderfrom losses arising from default.)

The interest rate structure attached to a mortgage falls into two broadcategories of ‘fixed’ and ‘variable’, according to the source of finance. Thelong-term nature of mortgage bank finance allows lenders to offer long-term

CONVERGENCE IN EUROPEAN MORTGAGE SYSTEMS 37

fixed interest loans. In contrast, retail funders are less able to offer long-termfixed interest loans because of the danger that the cost of (short-term) fundswill rise above the (fixed) mortgage rate. In these systems the risk of interestrate rises is passed on to the borrower, feeding back to the lender only throughthe risk of default.

The reality is a little more complex, with interest rates seldom fixed for theentire duration of the loan. In many cases loans are fixed for certain periodsand then become renegotiable. Belgium, the Netherlands and Germanyprovide examples of this. Retail lenders sometimes break the basic rule ofavoiding a mismatch between the interest rate variability attached to theasset (the mortgage) and the liability (funds) that support it. In the UK themismatch is illusory: primarily retail-funded lenders are able to use interestrate swaps to remove the risk of offering fixed rate mortgages, but the periodof the fixed rate seldom exceeds five years (Coles, 1993). But in France retaillenders lend ‘long’ while borrowing ‘short’, apparently carrying much of theinterest rate risk themselves despite access to centralized facilities (Lea et al.,1997). In Finland, Belgium and Spain it is illegal for lenders to vary interestrates at their own discretion; they must be adjusted according to a formulalinked to an interest rate index (Lea et al., 1997). This is one example of theway in which consumer law affects mortgage contracts. The rules relatingto prepayment provide another example. This is permitted within the Danishmortgage bank system but not in the German equivalent (Lea et al., 1997).

4.3. Pricing

There is also suggestive evidence that the pricing of mortgages varies. As willbe demonstrated, establishing the comparative price of mortgages betweencountries is extremely problematic. Part of the problem arises from thediffering characteristics of mortgage products outlined here and the distribu-tion of risk between different parties. Even if prices (in this case mortgageinterest rates) were identical, it would be necessary to adjust for thesefeatures. Other problems, which would persist even if mortgage productswere identical, arise from the interpretation of interest rates. These issueswill be discussed below. However, studies suggest that there is variety inthe pricing of mortgages, not all of which can be attributed to the terms ofmortgages or risk allocation.

4.4. The convergence typology

The purpose of establishing a convergence typology is to isolate those partsof the mortgage finance system that are likely to be affected by the Euro fromthose that are not.

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Table 2. A typology for convergence

Convergence test➼ Types of Cost of Loan-to- Interest rate Pricea Adjusted Efficiencyintermediary funds value ratio regime priceb

Diverse ✘ ✘ ✘ ✘ ✘ ✘ ✘

Financially competitive convergence✘ ✓ ✘ ✘ ✘ ✓ NarrowFully convergent ✓ ✓ ✓ ✓ ✓ ✓ Wide

a Crude mortgage spread or margin.b Spread adjusted for contractual differences and the allocation of risk.

The preceding survey of European mortgage finance systems indicates thatthey differ in several respects, which may be summarized as follows:• the types of intermediary;• the cost of funds (which may be affected by subsidies or regulations that

lower the cost of funds to lenders);• mortgage products, characterized by loan-to-value ratios and interest

rate regimes;• the crude price of mortgages; and• the price of mortgages, even after risk allocation and contractual terms

have been taken into account.Together these factors determine the efficiency of the system.

These characteristics can also be employed as indicators of convergence.Together they are used to create the convergence typology which is composedof three parts: fully convergent, divergent and financially competitive conver-gence (see Table 2).

The first category (which can be labelled ‘diverse’ or ‘divergent’) existscurrently in the European Union where there is a variety of types of inter-mediary, producing a range of mortgage products at prices that reflectdiffering levels of efficiency. The opposite category, ‘full convergence’,implies identical institutional forms, prices, products and hence efficiency.An intermediate category, ‘financially competitive convergence’, describesthe convergence of prices and products given the non-financial structure ofthe mortgage system. In the model of financially competitive convergenceit is quite conceivable that different types of financial institution delivermortgages equally efficiently, but product types and prices might vary dueto country-specific non-financial features of the system, such as valuationsystems and laws regarding repossessions. Although the outcome of boththe fully convergent and financially competitive convergent models can becharacterized as ‘efficient’, the meaning of efficiency is narrower in the lattercase, as will now be demonstrated.

‘Efficiency’ is a term with several meanings. Ambiguity arises in part froma lack of precision about whose efficiency is being discussed. It arises from a

CONVERGENCE IN EUROPEAN MORTGAGE SYSTEMS 39

failure to distinguish between narrow meanings of efficiency relating to costminimization and broader economic definitions of allocative efficiency.

4.4.1. Economic efficiency of the housing finance system (‘wide efficiency’)The broadest definition of efficiency, both in relation to the boundaries drawnand the adoption of the concept rooted in economics, is the economic effi-ciency of the entire housing finance system. This may be broken down intoseveral components. First, it includes the intermediation efficiency of themortgage lenders, that is, the cost efficiency with which they mobilize fundsand turn them into mortgages. Second, it refers to the efficiency with whichrisks are allocated as a result of the regulatory system, including non-financeinstitutions such as the valuation system and the security offered to lendersby land and property law. Third, ‘wide efficiency’ measures the costs andbenefits of the subsidy system, including both subsidies to lenders and toborrowers through mechanisms such as mortgage interest tax relief. It isthis third component of ‘wide efficiency’ that places it beyond the scopeof our concerns. Indeed, no study has attempted to make such an ambitiousassessment as this.2

4.4.2. Intermediation efficiency of the mortgage delivery system (‘narrowefficiency’)This is quite a finely defined concept, as employed by Diamond and Lea(1992) in their study (see p. v). It includes the “institutional, transactional,subsidy, and risk allocation arrangements with the lowest total public andprivate costs of providing housing credit” (ibid., p. 4), but is more restrictivethan ‘wide efficiency’ in two important respects.

First, a distinction is made between economic efficiency and non-efficiency considerations. “[T]he extent to which subsidies and regulationare costly to a society” is measured, but “whether these social costs areworthwhile expenditures of resources due to the effects on housing markets,homeownership, aggregate savings, etc.” is not (Diamond and Lea, 1992,p. 6). Second, a distinction is made between the efficiency of subsidiesdirected at the intermediation process itself, and those employed in the widerhousing market. “Thus, subsidies [paid] directly to developers or purchasersof houses, including homeowner tax deductions, are not included” (ibid.,note, p. 6).

Consequently, the measurement of the intermediation efficiency of themortgage delivery system is asymmetric in two ways. First, it includes factorswhich are beyond the control of financial institutions, but stops short ofproviding an assessment of the whole of a government’s housing financepolicy. Second, it measures the costs of subsidies to the intermediationsystem, but disregards their benefits.

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In economic or public policy terms this asymmetry weakens this frame-work, but for the purposes of analysing convergence between mortgagesystems it is useful. Subsidies within the intermediation process (that lowerthe cost of funds to the lender) are likely to give some institutions advantagesover others. These are included within this framework. In contrast, subsidieswhich fall outside the intermediation process but within the housing financesystem as a whole do not affect the relative competitiveness of lenders. Taxrelief on mortgage interest is an example of such a subsidy. Such subsidiesare omitted from this framework. Further, the concept of narrow efficiency iscompatible with ‘financially competitive convergence’ in our typology. In thiscategory, the crude price of mortgages will differ, but once distorting factors,such as risk allocation and contractual differences, are taken into account,prices are equalized. However, as the next section demonstrates, the difficultyin interpreting price information in European mortgage markets has been oneof the key barriers to convergence.

5. Quantifying intermediation efficiency: A chronic informationproblem

Price convergence plays a central role in both the wide and narrow meaningsof efficiency outlined in the previous section. In the ‘wide’ definition of effi-ciency, the outcome is full price convergence risk allocation and contractualterms. In the ‘narrow’ version of convergence, prices are equalized once riskallocation and contractual terms are taken into account. Price convergence istherefore the key indicator of convergence, while differences in prices arean indicator of divergence that might trigger competition and subsequentconvergence. However, the analysis in this section demonstrates that it isdifficult to measure price differences. This difficulty is not only a method-ological problem, but represents a chronic case of market failure in the formof imperfect competition.

5.1. Intermediation efficiency

The crude indicator of the price of a mortgage is the interest rate. Whenconsumers choose between mortgage lenders within their own country, theycan make a reasonably informed choice based on the mortgage rate andany important contractual differences between products (because a standardlegal framework applies to all mortgages). However, the comparison of crudemortgage interest rates is unsatisfactory when making comparisons betweensystems operating in different monetary jurisdictions.

CONVERGENCE IN EUROPEAN MORTGAGE SYSTEMS 41

Before the introduction of the Euro, European countries had their owncurrencies and the ability to determine their own monetary policy, includingthe setting of interest rates. The choice was constrained by internationalagreements (such as the Bretton Woods agreement until the 1970s, andthe Exchange Rate Mechanism in the 1980s and 1990s), although, as bothsystems demonstrated, ultimately currencies could be withdrawn from them.Consequently, central bank interest rates varied between currencies. Evenwhere interest rate setting was constrained by international agreement to limitcurrency fluctuations, there was always a risk that agreements would breakdown. Differing interest rates between countries, of course, make comparisonbetween crude mortgage interest rates redundant as an indicator of efficiency,since the principal determinant of the mortgage interest rate will be the centralbank interest rate.

Studies that attempt to compare mortgage prices between countries indifferent monetary jurisdiction therefore rely on the concept of intermedi-ation efficiency using interest rate spreads or margins to make comparisons.In principle the technique is simple. The mortgage rate is compared witha benchmark interest rate. In practice it is fraught with difficulties, as thisreview of three studies indicates.3

5.2. The choice of mortgage rate

Some studies – for example, the study conducted by Price Waterhouse onbehalf of the European Commission to establish the impacts of the EuropeanSingle Market (CEC 1988) and Merrill Lynch (1994) – simply take the grossmortgage rate to be compared with the benchmark. They do not take intoaccount loan-to-value ratios, other elements of the loan contract or subsidies.Diamond and Lea’s study (1992) takes a more sophisticated approach giventhe nature of efficiency which they wish to measure. While their presentationof a ‘gross spread’ is not very different from the others (it includes annualizedfees, which the others do not), their ‘adjusted spread’ includes originationfees and the cost of subsidies less the value of contractual terms (‘options’).Therefore, the adjusted spread is based not purely on the private cost of themortgage but also on the social costs. It includes factors not under the controlof lenders, as well as those that are. The calculation, the authors concede,required a number of ‘heroic assumptions’ to be made (see Diamond andLea, 1992, p. 8).

Further, Diamond and Lea believe that the adjusted spread is ‘too narrow’a measure of efficiency, omitting, inter alia, the contractual treatment of risk.Importantly, the authors found that it was not possible to quantify risk andinstead relied on a second, qualitative, exercise (ibid.).

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5.3. The choice of a benchmark rateDifferent benchmark interest rates represent quite different meanings of effi-ciency, as this review of the three reports indicates. The CEC and Diamondand Lea employ hypothetical benchmarks, rather than the actual cost of fundsto the lender. The CEC uses the money market rate of interest, perhapsbecause this could be regarded as the ‘true’ competitive market rate, sinceit represents an option-neutral form of borrowing. Diamond and Lea use ‘thecost to the government of issuing sovereign debt’ representing the ‘minimumpossible cost’ of funds, that is, government bonds of the same durationas the mortgage product being analysed (Diamond and Lea, 1992, p. 7).These represent the risk and options-free cost of borrowing. One justificationfor using hypothetical benchmark rates is that they provide a similar basisfor comparison between countries (or indeed institutions within countries).Nevertheless, by using hypothetical benchmarks, the CEC and Diamond andLea are treating the cost of funds as being at least partly an endogenousvariable: that is, endogenous to (or determined by) the lenders in the CEC’sreport, endogenous to the mortgage delivery system in Diamond and Lea’s.

Before this use of a hypothetical benchmark is contrasted to MerrillLynch’s use of the actual cost of funds, an important point of differencebetween Diamond and Lea’s choice of benchmark rate and the CEC’s shouldbe highlighted. Because the relationship between the money market rateand the government bond rate is uneven, both within countries over timeand between them, quite different results can be produced, as is demon-strated by the crude illustrative calculations in Table 3. This table presentsinterest spreads using the non-standard mortgage products between sevenEU countries over the period 1989–1997. The mortgage products chosen arewhere possible those that are most common in each country and therebyreflect different terms, such as loan-to-value ratios, repayment periods andinterest adjustment arrangements. Thus ‘like-with-like’ products are notbeing compared between countries. The notes to the table indicate that theproducts are, however, generally standard within countries over time.4 It isthis continuity which is important for illustrating the effect of the choice ofbenchmark rate over time.5

Table 3 shows that while, for example, Belgium exhibited the smallestmargins in 1989 according to the long-term government bond (LTGB) bench-mark, it shared the sixth place according to the money market rate (MMR).In 1989 the UK had the narrowest margins according to the MMR, but thewidest according to the LTGB. In 1993, the UK’s ranking according to theMMR and LTGB was almost the exact opposite of 1989. The results appearto be pretty much random, depending on the benchmark used.

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Table 3. Interest rate spreads (percentage points) using day-to-day money marketrates and long-term government bond rates

Country 1989 1990 1991 1992 1993 1994 1995 1996 1997

Belgium

(a) MMR 2.1 −1.1 2.5 1.6 1.5 3.9 4.1 3.8 3.1

(b) LTGB 0.4 −2.0 1.8 1.6 1.6 1.7 1.3 0.7 0.9

France

(a) MMR 1.3 0.8 1.7 0.6 0.7 2.8 2.5 3.9 3.7

(b) LTGB 1.2 0.3 1.7 2.0 2.4 −1.2 −2.2 −0.5 1.1

Germany

(a) MMR 1.4 1.8 0.7 −0.4 0.2 3.1 3.5 4.2 3.6

(b) LTGB 0.9 0.9 0.9 1.0 1.4 1.7 1.5 1.9 1.7

Italy

(a) MMR 2.1 2.7 2.8 0.1 3.1 2.4 3.2 1.3 0.9

(b) LTGB 2.7 2.6 3.1 2.1 2.7 0.0 1.1 1.0 1.0

Netherlands

(a) MMR 0.9 1.0 0.5 −0.3 0.1 2.5 2.7 3.4 2.9

(b) LTGB 0.7 0.2 0.6 0.8 0.9 0.9 0.4 0.5 0.8

Spain

(a) MMR 0.4 1.2 2.7 1.9 1.5 1.5 0.4 −0.1 0.0

(b) LTGB 1.0 1.3 3.5 2.8 3.5 −0.4 −1.7 −0.6 0.0

UK

(a) MMR −0.1 0.1 0.7 0.7 1.9 2.7 1.6 0.8 0.7

(a) LTGB 4.1 3.9 2.6 1.2 0.1 −0.4 −0.4 −1.4 0.1

MMR: money market rate; LTGB: long-term government bond.Mortgages. All rates specified as rates on new loans. Belgium: 20-year mortgage withinterest rate revisable every 5 years. Market share = 87% (1993) falling to 8% (1997).France: prêtseligibles: loans qualifying for refinancing on mortgage market, 15-yearfixed rate, market share fluctuates 13–23%. Germany: 10-year fixed rate mortgage.Italy: Fixed rate mortgages. Market share grown to 50%. Netherlands: loans guar-anteed by municipalities or National Mortgage Guarantee Foundation; interest raterevised every 5 years. Spain: 1989–1990: loans from retail banks (= c. 50% marketshare); 1991–1993: all loans; 1994–1997: loans adjusted by reference rate. UK:weighted average mortgage rate on largest building society loans.Source: mortgage rates: EC Mortgage Federation and European Mortgage FederationAnnual Reports. Interest rates: Eurostat:Money and Finance.

By using the actual cost of funds to lenders, Merrill Lynch takes the costof funds to be at least partly an exogenous variable for the lenders, i.e. deter-mined by factors outside their control. There is a case for Merrill Lynch’streatment of funds in this way. If wholesale funds are cheaper than retailfunds, then a savings bank or a building society with no or limited access tothis funding source is not wholly in control of the benchmark rate. So in thissense the cost of funds is an exogenous variable. This is why it is important to

44 M. STEPHENS

be careful in interpreting Diamond and Lea. In their report, the cost of fundsis treated as being partly exogenous to the lender, but it is endogenous to themortgage delivery system.

If one is to treat the cost of funds as being endogenous to what is beingassessed (either the lenders or the mortgage delivery system) then it is neces-sary to use a hypothetical benchmark; if they are treated as being exogenousthen it is appropriate to use the actual cost of funds. This distinction providesjustification for Diamond and Lea’s selection of a benchmark. However,Merrill Lynch’s assumption of complete exogeneity is mistaken because thecost of funds is not solely fixed by factors outside lenders’ control. Emphati-cally, the CEC has used an inappropriate benchmark since it treats the costof funds as being endogenous to the lender, when in fact differential accessto subsidies or regulatory privileges mean that they are often influenced byexogenous factors. The German mortgage banks’ monopoly over the issueof mortgage bonds is a case in point. The only defence of the CEC on thispoint is that the report pre-dated the European banking and related direc-tives of 1989. These do not require the German government to dismantle theregulations relating to the issue of mortgage bonds, provided that they arenot applied in a discriminatory way (e.g. a French bank must be allowed toestablish a mortgage bank in Germany).

5.4. The problem of time

Efficiency measures are very sensitive to the treatment of time, and thiscreates acute problems of legitimate comparison. The CEC and (generally)Merrill Lynch present results for a particular point in time. In the case ofMerrill Lynch this is justified since their objective is merely to show thatbuilding society interest spreads in the UK were high by international stan-dards at that time and that financial institutions can sustain lower spreads.The CEC has a greater problem, since the results are presented without anyreference to a particular year or time period. This leaves the report open tomisinterpretation because the results imply a relatively static state of affairs.This interpretation is encouraged by the way the figures are fed into a widercalculation estimating the ‘price falls’ in the three sectors of financial services(banking, of which mortgages are a part, insurance and securities) that onemight expect to see as a result of cross-border competition facilitated by theEuropean Single Market.

Fortunately, the basis for the CEC results was published in an appendixof the Price Waterhouse (1988) background report. The figures used were for1986, but data had been collected for the period 1982–1986. Taken over thefive-year period as a whole there is much year-on-year volatility in the results(Table 4). For example, both the UK and France had the narrowest spreads

CONVERGENCE IN EUROPEAN MORTGAGE SYSTEMS 45

Table 4. Year-on-year fluctuations in interest spreads (percentagepoints)

Country 1982 1983 1984 1985 1986

Belgium 3.36 4.69 3.41 3.23 1.92

France 0.11 1.83 1.94 2.09 2.61

Germany 1.43 3.09 2.75 2.61 2.30

Italy 2.12 2.06 1.68 2.00 1.40

Netherlands 2.97 3.85 2.57 1.50 1.37

Spain 2.31 1.59 4.69 6.35 3.20

UK 1.60 1.53 4.17 2.61 1.16

Source: Price Waterhouse (1998), Table 5.2.2.

in one year and the second widest in another. Indeed, the UK moved frombeing the second most ‘efficient’ to the second least ‘efficient’ in a singleyear. Table 3 shows that such year-on-year changes were a continuing featurein the 1990s. Clearly, the attempt to calculate the potential for price falls onthe basis of one year’s data when the consultants’ data showed that it was byno means typical was heroic in the extreme.

Diamond and Lea present results averaged over a number of years. Thesevary from four years (1988–1991) to eleven years (1982–1991) (see Table5). Averaging results can of course disguise year-on-year variations, whichDiamond and Lea identify under three principal conditions: (i) lags betweenthe adjustment of the mortgage rate and the cost of funds, especially wherethe dominant product is a variable rate mortgage funded from deposits, (ii)structural changes in the mortgage market, and (iii) relative competitive pres-sures. They estimate the adjusted spread using the entire yield curve wheremortgages are variable rate and predominantly retail-funded. This is becausesuch mortgages are generally priced according to the average cost of fundswhich are made up of savings accounts with different liquidities (and theentire stock of mortgages is re-priced when interest rates are revised). Hence,one source of year-on-year fluctuations (lags between changes in the marginalcost of funds and changes in the mortgage interest rate) is tackled. However,the problem of time creates a problem in interpreting the relative competitivepositions of lenders. It may not be obvious to a consumer taking out a long-term product whether the current competitiveness of a particular lender willbe maintained, or whether the lender is merely flattered by the interest ratecycle.

46 M. STEPHENS

Table 5. Gross and adjusted spreads

Country Lender Period Gross spread Adjusted spread

(basis points) (basis points)

Denmark Mortgage banks 1986–1991 128 129

France Depositories 1987–1991 232 265

Specialized 1986–1990 234 200

Germany Mortgage banks (1st mortgage) 1982–1991 147 146

Depositories (1st mortgage) 1982–1991 215 207

Bausparkassen (2nd mortgage) 1982–1991−221 165

Depositories (top-up loan) 1982–1991 276 276

Packaged loan 1987–1991 n.a. 165

UK Building societies 1988–1991 165 120

Centralized lenders 1987–1991 151 135

USA Securities market 1988–1991 207 123

Depositories 1988–1991 n.a. 182

Source: adapted from Diamond and Lea (1992), Table 7.10.

5.5. Assessment

This study of the three reports, each aiming to measure some form of inter-mediation efficiency, reveals several methodological traps. The choice ofa benchmark rate implies that the cost of funds is being treated as eitherendogenous or exogenous to the subject (intermediary or mortgage deliverysystem) that is being assessed. Particular difficulties arise from the problemof time, although techniques can be adopted to reduce this. Importantly, itappears that even sophisticated approaches to measuring efficiency are unableto quantify the impact of risks on spreads.

The significance of these difficulties is not only of methodological interestto academics. The difficulties are also important in illustrating that a chronicinformation problem exists concerning the transparency of mortgage pricingin Europe. This market failure in itself is likely to be a significant barrier toconvergence between mortgage finance systems.

6. Convergence: From Single Market to the Euro

The evidence presented in Section 3 indicated that the single market legisla-tion has had little impact on mortgage system convergence. As was outlined

CONVERGENCE IN EUROPEAN MORTGAGE SYSTEMS 47

earlier, the failure of systems to converge is usually attributed to country-specific non-financial features of mortgage systems. This would explainwhy European mortgage markets have not moved from the first (‘diverse’)category to the fully convergent category, but not why they have failed tomove to the intermediate category of ‘financially competitive convergence’.It is suggested here that the most likely explanation lies in three areas: (i) thechronic price information problem illustrated in Section 5, (ii) the deterrentarising from exchange risk in both savings and mortgage markets, and (iii)the privileged access of cheap finance to some intermediaries.

In this section the impact of the Euro on these barriers to convergence willbe considered.

6.1. From opaque to transparent pricing

The single currency will create much greater transparency when comparingthe prices of mortgages between lenders based in different countries. Thisoccurs through the complete convergence of central bank interest rates.Convergence will remove many of the problems identified in the precedingsection, thus allowing interest rates on mortgage products to be compareddirectly without reference to a benchmark rate. The continued reliance ondomestic notes and coins until 2002 is immaterial, since loans are pricedin interest rates, in contrast to physical products and services. The creationof a single set of central bank interest rates also removes a large part ofthe ‘problem of time’ which arises (in large part) from differential interestrate cycles between currencies. Differences arising from wholesale and retailcycles will persist but will diminish if these markets become more integratedas a result of greater competition in retail savings markets.

Differences in product prices derived from the terms offered will remain,but greater transparency will lead to pressure for at least the financial effi-ciency aspect of price differences to be eroded through competition. Whileit may not be possible for risk to be quantified, two factors suggest thatthis may not be so important. First, the price of mortgages will be estab-lished according to risk derived from nation-specific factors, such as therelative security offered by foreclosure rules. Consequently, even if financeis cross-border, non-financial pricing will still reflect national institutionalarrangements in the wider housing finance system. Further, consumers makequalitative judgements concerning risk between mortgage products withintheir own countries now, and this is not seen as being a significant problem interms of competition.

48 M. STEPHENS

6.2. The cost of funds and savings markets

It is important to recognize that the mostcompetitivelenders in the Euro-zone may not be the mostefficient. The error of conflating efficiency withcompetition is a common one. For example, Diamond and Lea comment that“[p]resumably, more efficient systems of financing the home purchase will beable to penetrate new markets” (Diamond and Lea, 1992, p. 1). The analysisin Section 3 indicates that this is not quite right. ‘Systems’, as defined byDiamond and Lea, cannot penetrate new markets, because they contain non-transferable elements (like valuation, foreclosure and subsidy systems). Itis the transferable elements that are important, and these include elementsboth within a lender’s control (intermediation efficiency) and some that arenot, notably privileged access to cheap funds. If country B’s institutions haveaccess to subsidized or otherwise privileged sources of funds which allow theabsolute mortgage rate to be kept down, then an incoming institution will haveto compete against the ‘inefficient’ mortgage rate, not the one adjusted to takeaccount of the subsidy. Diamond and Lea themselves recognize this whenthey observe that “. . . deregulation and removal of subsidies in thesector maycause an increase in the direct cost of mortgage funds to the borrower” (1992,p. 1).

The existence of privileged sources of funds presents a barrier to conver-gence in mortgage markets. There are three principal sources, notably govern-ment regulation, government subsidy and cross-subsidization by institutionsthemselves. In countries such as France, where interest rates on savingshave been regulated to the disadvantage of savers, the Euro should have apowerful impact. The Single Market framework proved unable to removethe French prohibition of the payment of interest on current and short-termsavings accounts. An attempt by a British bank to overturn the restrictionfailed in the French courts. While French savers would be free to move theirfunds into other currencies this would, of course, carry an unacceptably largerisk of losses arising from currency fluctuations for the majority of savers.It is precisely this risk that the Euro removes, and one would expect to seea removal of competitive advantage arising from regulation. In turn, suchregulations would place previously privileged institutions at a disadvantagein the savings market, and governments would be likely to remove them.

Competition in the savings market may well be the key that unlocks thedoor to convergence in mortgage markets. This would ensure a level playingfield between intermediaries dependent on retail funds, but also betweenretail- and wholesale-dependent intermediaries. The increased viability ofwholesale funds is key to the success of cross-border operations (by removingthe need to establish or acquire a branch network) and would facilitatesecondary market activities, including securitization.6

CONVERGENCE IN EUROPEAN MORTGAGE SYSTEMS 49

Funds subsidized by governments represent a significant barrier to theintegration of savings markets. The PEL (plans d’épargne logement) systemin France, under which customers receive tax-free interest on their savingsand a low-cost mortgage, also provides cheap funds that lenders use to‘subsidize’ other mortgages. This arrangement is not challenged directly bythe single currency. Nevertheless, the policy framework introduced by theEconomic and Monetary Union may also aid financial convergence. The oper-ation of the Stability and Growth Pact is likely to continue to exert downwardpressure on government spending plans at a time when pressures arising fromdemographic ageing are exerting an upward pressure. In this climate, govern-mental indulgence towards financial institutions is more likely to diminishthan to thrive. Thus the distorting impacts of subsidies may be reduced overtime.

Much the same argument applies to the German and AustrianBauspar-kassen, although this system is a ‘closed’ circuit, so it cannot be used forcross-subsidization. Both the French PEL system and theBausparkassensystem are allowable under the Treaty of Rome, since no discriminationis involved. Foreign banks are allowed to establish eligible institutions,although they must be registered in the host state and registration require-ments can be onerous. A form of cross-subsidization, from one part of abusiness to another, is a commonplace feature of many commercial activities,including competitive mortgage markets such as the UK. The main threat tothe continued privileged position of some deposit-taking institutions arisesfrom the cost of conversion to the single currency when notes and coins areintroduced. As Lea et al. (1997) observe, the transition will clearly cost morefor savings institutions than for wholesale-funded enterprises.

6.3. Assessment: What kind of convergence?

This discussion suggests that there may be movement of European mort-gage finance systems from the ‘diverse’ category in our typology towards‘financially competitive’ convergence. To make the full transition into thiscategory, the cost of funds and the price of mortgages (adjusted for contrac-tual differences and risk allocation) should be equalized. The Euro shouldgive a powerful push in this direction through the introduction of much moretransparent pricing and greater competition in the savings market. In turn,this should lead to increased viability of wholesale funds and enhance theprospects of both cross-border and secondary market activity. However, clearbarriers still exist, arising from the continued access of some deposit-takinginstitutions to privileged funds. So long as these privileges exist, the fulltransition to ‘financially competitive convergence’ cannot take place. Withinour typology, ‘full convergence’ remains a long way away, due to the persist-

50 M. STEPHENS

ence of other institutional arrangements, such as consumer protection law,valuation systems and foreclosure rules.

7. Conclusions

This article has shown that the introduction of the single currency shouldhelp to encourage convergence between European mortgage systems. TheEuro will remove chronic information problems relating to pricing and shouldhelp to integrate savings markets. However, the privileged access to cheapfunds enjoyed by some institutions stands out as a barrier to convergence insavings and mortgage markets. The concerns arising from diversity in mort-gage finance systems summarized in Section 2 are therefore likely to persistfor the foreseeable future.

This situation reinforces the views expressed in previous studies thatindicated that the Single Market approach, centred on the harmonization ofminimum prudential standards between credit institutions, would be an inade-quate tool to bring about convergence in mortgage finance systems. Even iffinancial aspects of mortgage finance systems were to converge, many non-financial barriers would continue to exist. The market may itself find solutionsto some of these institutional differences. For example, it is conceivable thatvaluation techniques might be transferable. Other differences may be erodedby consumer protection legislation introduced at the EU level. The consid-eration given to the treatment of prepayment by the European Commissionis a case in point. However, other issues that maintain differences betweenmortgage products will be eroded less easily. For example, some countriescontinue to forbid the use of mortgages whose interest rate is adjusted at thediscretion of the lender. Further, issues of land law and security will remainunder the jurisdiction of country-specific legislatures. These non-financialfactors will prevent the development of a standard pan-European mortgageproduct, which will, in turn, inhibit full financial integration.

Notes

1 Lenders’ annual reports and accounts reveal that the performance of UK lenders in contin-ental mortgage markets continues to be far from impressive. Over the 1994–1997 periodAbbey National’s European operations averaged annual pre-tax losses of{=38.2 million.Abbey National withdrew from Spain in 1998. Bradford and Bingley, which in 1993 wasthe first foreign lender to establish aBausparkassein Germany, sold its German operationsin 1996, with a loss of{=6.5 million. Woolwich is performing better, although its operationsare small-scale. The Halifax has a 0.02% share of the Spanish mortgage market (author’scalculation).

CONVERGENCE IN EUROPEAN MORTGAGE SYSTEMS 51

2 The original objective of Diamond and Lea’s project was to make such an assessment, butthis was narrowed because of conceptual and empirical difficulties (Diamond and Lea, 1992,Editor’s Note, p. v).3 The first report is that published by the European Commission to advance the economiccase for the European Single Market (CEC, 1988). It is based on an extensive study conductedby Price Waterhouse (1988). The second is that conducted by Diamond and Lea for FannieMae (Diamond and Lea, 1992). The report conducted by the Merrill Lynch Global SecuritiesResearch and Economics Group (Merrill Lynch, 1994) is very short, but it is included here asit illustrates some important conceptual points. It should be noted that neither the CEC nor theMerrill Lynch report aimed to be as rigorous as Diamond and Lea’s. Merrill Lynch describetheir exercise as “a quick and dirty survey” (Merrill Lynch, 1994, p. 3) and the CEC its resultsas “illustrative and hypothetical” (CEC, 1988, p. 89).4 Spain provides the worst case of discontinuity. See the note to Table 2.5 This is not to say that relative movements in benchmark rates are the sole explanation forchanges in margins over time.6 Driver (1998) observes that there has been some recent growth in securitization in Europe,and some regulators, notably in France and Italy, are reviewing their rules relating to it. Never-theless, governments may be reluctant to harmonize their tax and regulatory regimes that helpto prevent the development of an integrated market. Securitization may also be hindered sincemortgages will still contain heterogeneous features derived from nation-specific institutionalarrangements that will affect a series of risks.

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