To a large extent, such competition has been the outgrowth of a fundamental change in the general approach to mortgage lending. Traditionally, mortgage financing was approached as a credit rationing process. In contrast, today banks compete aggressively for borrowers by packaging highly competitive spread of home loan products to meet different needs of borrowers. In the more developed markets, this has manifested in more prevalent sales of non-traditional mortgage products to sub-prime borrowers as competition for borrowers has intensified. The rise of investment property has also been striking, with significant growth in this loan class observed in Malaysia relative to owner occupiers. In this environment, it is important that banks develop a more complete understanding of the full spectrum of risks presented in this business. The dangers of complacency have been  BIS Review 3/2010  1  clearly demonstrated in the devastating consequences of this global financial crisis. Basic failures in risk management and oversight have been cited as a key characteristic of financial institutions that suffered large losses during the crisis. In many instances, boards and senior management of these institutions neglected to understand and control their institutions’ balance sheet growth and the risks that they were exposed to. Some institutions in fact made deliberate strategic decisions to retain large exposures to financial instruments linked to subprime assets but failed to take appropriate measures to control or mitigate those risks.
In many financial institutions, the rigor of board scrutiny and due diligence was replaced with an over-reliance on external ratings or complex internal models for credit evaluations. This was compounded by incentive structures that were not adequately risk-aligned and inconsistent with long-term value creation, eventually undermining the soundness of banks. These failures have extracted a high price on affected financial institutions, investors and national economies at large. Some of the large financial institutions that entered aggressively into the sub-prime market are now no longer around, while losses from the write-downs of loans and provisions have been staggering. Between the second quarters of 2007 and 2009, the global write-down of loan provisions had amounted to USD1.3 trillion. In October 2009, the International Monetary Fund indicated that the estimates could rise further to as much as USD2.8 trillion 1. The events which have since unfolded underscore the fact that effectively managing risks associated with mortgage financing encompasses a much broader set of considerations – including the consequences of an adverse and broad downturn in the housing market. The crisis has reinforced the need for banks to consider the cyclical developments in the mortgage financing market more explicitly in their risk assessments. Factors such as a sustained growth in house prices, low interest rates and modest equity commitment should inform banks of the risk outlook for the mortgage segment and corresponding risk mitigation actions that are needed to avert potential losses.