Since the Great Financial Crisis (GFC), bank participation in mortgage lending has declined, with less-regulated nonbanks rising to take their place. Bringing banks back is important for maintaining market stability, but loosening capital rules, which were tightened in the wake of the GFC, is unlikely to achieve this. The truth is that banks had already begun exiting the market several years before post-GFC capital regulations took effect. This suggests that without also addressing the legal, reputational, and profitability constraints facing banks today, their activity is likely to remain subdued.
At the forefront of the proposals to loosen bank capital rules is the Federal Reserve, led by Vice Chair for Supervision Michelle Bowman. She argues that these overly burdensome regulations drove a significant share of home lending away from traditional banks. The idea has also gained traction in Congress and the White House.
The pillar of these regulations is Basel III, which determines how much capital banks must hold against different types of exposures. These rules helped strengthen the financial system: today, large banks hold capital reserves that are twice their pre-GFC levels.
However, if capital rules were the primary driver of this shift, we would expect the bank retreat to begin after their implementation, but the timing suggests otherwise. Research from ResiClub shows the bank shares of mortgage originations and MSR ownership fell from roughly 60 percent and 95 percent in 2008 to about 35 percent and 45 percent by 2023, respectively. Basel III took effect in 2014, with a gradual phase-in through 2018, yet bank market shares in mortgage lending began declining well before its enforcement. MSR sales and servicing transfers also accelerated between 2012 and 2014 in anticipation of Basel III, but the broader retreat was already underway.
This timing points to deeper structural forces behind the bank retreat than capital rules alone. One of the most important yet often overlooked is the Obama administration’s enforcement of the Civil War era False Claims Act (FCA) in the early 2010s. Large banks faced substantial financial penalties and reputational damage for mortgage-related misconduct tied to federally insured lending programs. Unlike capital rules, which are transparent and predictable, FCA enforcement in the financial sector introduced the risk of uncertain, retroactive liability. For banks, particularly in FHA lending, this created a fundamentally different risk calculus.
That legacy persists today: Large banks remain wary of activities that could expose them to public enforcement and politically sensitive, headline-driven outcomes such as foreclosures. This reputational risk represents a significant barrier to the banks’ re-entry, and one left unaddressed by capital relief.
While regulators intended these rules to limit excessive bank concentration in volatile, high-risk, and less liquid mortgage servicing rights (MSRs), they ironically may have made the system less safe: the bank’s retreat was offset by an increase in nonbank lending.
These firms operate with lighter capital requirements and are overseen through a more fragmented and often less stringent regulatory framework. They also appear to take on greater risk as evidenced by lower credit scores, higher combined loan to value ratios, and higher debt-to-income ratios. This exposes the system to greater liquidity risks; as nonbanks account for a growing share of government-backed loans, pressure will build for a government backstop in the event of an adverse shock.
The economics of mortgage lending have also shifted in ways that disadvantage banks relative to nonbanks. Large banks face higher fixed costs, more intensive compliance requirements, and, after years of reduced activity, less specialized infrastructure and technology in mortgage origination and servicing. Nonbanks, by contrast, are more specialized, flexible, and better positioned to operate in today’s lower-margin, high-volatility environment. Since they are not bound by the same capital requirements as banks, they can originate and service mortgages at lower cost. The result is a playing field that is severely tilted against banks.
At most, capital rule changes affect decisions at the margin. Even if capital requirements are eased, the combination of legal risk, reputational concerns, and weaker relative economics is likely to continue limiting bank activity. Moreover, loosening capital requirements is not without risk. With mortgage delinquencies on the rise, easing standards or encouraging additional risk-taking could prove poorly timed.
The Federal Reserve’s proposal reflects a misdiagnosis of why banks stepped back from mortgage lending in the first place. Capital rules may have reinforced that shift, but they did not drive it. Without confronting the legal, reputational, and structural factors that continue to shape bank incentives, easing capital requirements alone is unlikely to bring banks back into the mortgage market in a meaningful way.
The post Loosening Bank Capital Rules Won’t Bring Banks Back to Mortgage Lending appeared first on American Enterprise Institute – AEI.
