By the time today's traditional mortgages are repaid, the process that created them will almost certainly no longer exist. Few will miss the paperwork, the waiting, or the potentially fraught visits with the bank manager. In their place will be digital services and digital mortgages, which S&P Global Ratings expects will reshape house lending and retail banking to the benefit of borrowers.

This revolution was considered unlikely until recently. Mortgages were judged too complex to be digitized and marketed remotely, while the approval process seemed too complex for automation. Yet technology-led financial service providers (fintech), digital-native banks, and some early adopters among traditional banks have proven that property lending can be conducted remotely and are reaping the benefits of strong demand for end-to-end digital mortgages.

The digital shift promises to roil banks' decades-old model of retail lending, which uses mortgages as an anchor for customer relationships and a key contributor to net interest and fee income. Mortgage lending accounted for about $635 billion, or 10% of global bank revenues in 2021, according to research by management consulting firm McKinsey & Co. That figure is expected to increase by about $90 billion, to $725 billion, by the end of 2025, driven by new lending in China, emerging Asia, and the United States, said McKinsey. The importance of mortgages to retail banks is clear from their share of total lending, which is about 60% in Australia, and 40%-50% in Canada and Western Europe (see chart 1). The U.S. market saw a record $4.4 trillion of mortgage origination in 2021, but its dominant originate-to-distribute model means mortgages accounted for only 20% of bank lending books.

Chart 1

Digital mortgages will be more homogenous, easier to apply for, easier to switch between, and quicker to secure. They will also smooth the way to greater competition and thus introduce uncertainty to banking sector revenue, margins, and spending, which could ultimately weigh on issuers' creditworthiness. The digital transition will create winners and losers among established banks (depending on how well they adapt to the new paradigm) and open the door to new entrants. At the same time, digitization and standardization of mortgages should enable mortgage market participants to better manage loan-portfolio risk, which may also have positive credit quality implications.

Chart 2

The End Of Business As Usual

Digital mortgage lending is both an opportunity and a threat to traditional banks. Which side of the ledger today's dominant mortgage providers find themselves on will depend to a large degree on the skill with which they manage the transition away from branch-based operations, and the quality of the digital platforms and products they offer.

We believe banks will have little choice but to make that transition. Digitization of the lending process will unpick mortgage lending's central role in retail banking and therefore banks' traditional operating model, which used home loans both to attract customers and tie them into a relationship from which they could be plied with banking and ancillary services (credit cards, savings products and insurance).

A bank's local branch network, and its branch-based sales people, sat at the heart of that model. Neither will have much role to play in a digital mortgage-based future. That means there will be fewer opportunities to cross-sell and up-sell clients. Easier application processes will also mean easier switching for existing borrowers, further loosening the bonds created by mortgage products.

Banks should retain, at least initially, an advantage in the new digital marketplace. The financing of a property purchase is the single most important financial commitment in most peoples' lives and many borrowers will continue to prefer to deal with trusted, and established financial brands. That advantage shouldn't be overstated though. The experience in the U.S. market, where the upstart Rocket Mortgage LLC (BB/Stable/--) has quickly grown to account for the majority of new mortgage origination suggests that a capable platform and competitive pricing are more than a match for an established brand (see "The U.S. Experience").

Traditional banks also have some inherent disadvantages. Recalibrating operations to digital platforms from branches promises to be challenging, expensive (requiring upfront investment in technology and the dismantling of legacy operations), and time consuming.

As a first step on that journey, established banks have often unveiled digital mortgage platforms that operate under the same brand, and alongside their branch-based businesses. These parallel services obviously come at a cost, which banks are unlikely to be willing to bear over the long term. Moreover, many of the services appear only quasi-automated, offering customers an online application process that leads to contact with a bank representative, and often a branch visit.

Some banks have launched specialized digital lending subsidiaries or divisions, possibly in a bid to free new operations from legacy systems and accelerate true digitalization. In May 2022, Commonwealth Bank of Australia (AA-/Stable/A-1+) unveiled its Unloan unit, which operates separately from both CBA branches and the parent banks' digital platforms.

Digital Gains For Originators

Digital mortgages' promise of disruption comes with the potential for significant gains for originators. Chief among them will be cost savings from automation of the application process. According to the U.S. Mortgage Bankers Association personnel expenses account for over 60% of loan origination costs. Almost all of those personnel expenses could be eliminated from the mortgage process by automation--though competition (including from new entrants) could ensure that much of those savings accrue to customers rather than banks.

Digitalization should also offer lenders greater security, largely due to more robust and transparent document handling that is inherent to automation. Documents that have typically been provided by applicants and then required manual verification will be sourced in electronic form directly from government bureaus and third party companies, such as credit verification providers. This reduces the scope for fraud (by customers) and errors (by customers and bank staff).

Faster application process, and the prospect of 24/7 operations, should enable banks to originate more loans, while scalability offered by automation means that increased volume will come at minimal additional cost. That will provide banks with scope to expand their loan books, so long as funding permits, while a less onerous applications process could also foster increased demand.

We also expect that digital mortgages will lead to improved credit risk management, both for individual originators and across the entire sector. By their nature, the new mortgage services will require greater standardization, increased transparency regarding customer creditworthiness, and offer a shift toward greater pricing transparency. Automation should ensure that lending standards are rigidly enforced and quickly adjustable. Credit quality assessment by algorithms will lead to standardized quantification of risk, based on preestablished credit scoring parameters. Automation should also minimize the scope for input errors and exceptions to underwriting rules created by human error or whim. Each of these stands to improve risk assessment, both for individual loans and lending portfolios, while also enabling for tailoring of prices to match individual profiles and the prevailing risk profiles of banks' lending books.

There are also risks that could arise with the growth of digital mortgages. Diverse and potentially little-tested business models (including those of new entrants with limited credit risk management experience) might prove fragile and could, in rare instances, threaten systematic financial stability. This places new onus on regulators to monitor markets and their participants, particularly given the potential for significant social impacts due to housing market issues.

As with many automated and scalable digital products, there is likely to be an element of winner-takes-all (or winner-takes-most) in the digital mortgage market. That will mean that the benefits of digitalization will not accrue evenly, leaving costs to weigh more heavily on mortgage providers that fail to rise to best in class, either at the platform or product level. Nonetheless, for those that manage the transition competently, we believe that efficiency gains should outweigh the pain of lower fees, providing a net benefit to their creditworthiness.

Benefits For Customers And The Market

Digital mortgages' promise of convenience and efficiency will complement the wider trend toward seamless and remote banking. Customers should benefit from a faster loan application process, quicker decision making and origination, and an expedited release of funds, all of which should shorten the home buying processes.

Ultimately that will contribute to housing market liquidity by encouraging faster and more regular buying and selling. That could have knock-on effects for the creditworthiness of issuers in related sectors, ranging from Real Estate Investment Trusts (REITS) and property investment firms to developers and builders, and of course banks.

Not everyone stands to benefit though, and there could be significant societal impacts to reckon with. Digital mortgages' homogenization brings with it the risk of structural exclusion for market segments that don't tick the boxes required by automated systems, for example. Would-be borrowers with irregular income streams, high debt levels, or past credit issues could struggle to access home lending. That creates a business case for specialized lenders targeting non-standard, non-prime customers. The potential for social issues created by exclusion also provides good reason for regulators, or other state agencies, to support mortgage provision to underserved markets.

A Digital Ecosystem

New digital-first banks and non-bank challengers will inevitably attract much of the attention as digital mortgages become mainstream. But these challengers to established banks will be only part, and perhaps not the most important part, of a wider ecosystem that will grow around digital mortgages.

Brokerage and comparison platforms will be the shop window for many potential customers, and a principal route to the market place for many providers. We expect the sites will play an increasing role both as intermediaries and distributors (including via embedded finance promotions). In both cases, these platforms will act as a conduit through which borrowers begin an application. Then, depending on the distribution model chosen by the originator, the borrower could be transferred (ideally seamlessly) to an originator to complete the process, or complete the process in the third-party platform. The latter option will likely utilize open banking API-technology that enables an end-to-end banking-as-a-service experience (see" The Future of Banking: Adding A Banking License to Companies' Menus Might Be A Recipe For Success," Oct. 11, 2022). Brokerage and comparison platforms are unlikely to distinguish between bank and nonbank lenders, while providing customers with the option to filter offers based on rates, loan-to-collateral (LTC) value, and processing time.

New originators are likely to rely on third-party platforms to provide a pathway to potential clients and for credibility. Established banks, meanwhile, are likely to use them to secure distribution beyond their own networks. These trends are already notable in other markets, such as energy and insurance, where comparison platforms are well established.

We also believe that digital mortgage brokers, price comparison sites, and credit bureaus might increasingly cooperate to insert themselves between banks and their customers. That would further loosen the bonds created by mortgage products. Banks are unlikely to passively accept that. We expect they will seek partnerships with the new service providers and could potentially be buyers, not least in order to gain access to software and systems that could optimize and speed development of their digital offerings.

Chart 3

The Journey Ahead For Banks

The speed of banks' voyage toward mortgage digitalization will vary significantly, both from bank to bank and across different countries and regional markets. Yet most large and sophisticated banks have, at least to some degree, already begun the journey.

For the bulk of them the first steps have been partial digitalization and automation of in-house lending processes, many of which are not client facing. Those further down the path may be offering digital mortgage application platforms, operated through websites and mobile applications. The extent to which these services are truly digital varies. At the leading-edge some banks offer automatic document processing aligned with data gathering from tax authorities, credit registries, and other third-party sources. Many now offer e-signatures, having first adopted the practice during the COVID-19 pandemic, when social distancing rules closed branches at the same moment that clients were seeking repayment holidays.

Progress toward digital mortgages has, at least in part, been dictated by country norms. Norway-based DNB Bank ASA (AA-/Stable/A-1+) claims about 70% of its mortgage applications are digital and that its processing time per mortgage has, on average, halved. That has been facilitated by Norway's advanced digital infrastructure, and notably the state-backed initiative to create APIs, which enables DNB to digitally retrieve data on property ownership, property values, and customer tax returns.

Fintechs Are Targeting Refinancing, For Now

Fintech companies specialized in mortgage refinancing have already made inroads into markets traditionally dominated by banks. These challengers typically employ an asset-light, "originate-to-distribute" model that involves reselling mortgages on the secondary market or refinancing mortgage loans through alternative investment funds, such as Sweden's Stabelo, which invests in residential mortgages. By focusing on refinancing, these lenders can piggyback on existing documentation to conduct mandatory checks and credit risk assessment. Generally, refinancing also benefits from lower LTC value ratios, which reduces default risk.

It seems only a matter of time until fintechs begin to expand more aggressively into the new mortgage market. We expect that will be facilitated by regulatory initiatives, such as the EU's second payment service directive (known as PSD2), which provides greater scope for third parties to access and analyze customer data at incumbent banks.

Banks will retain some advantages in the coming contest. Established mortgage lenders brands, which encompass familiarity, and reputations for solidity and lending expertise, afford them a legacy "go-to status" that could prove tenacious. We expect established banks will also, generally, benefit from more stable funding profiles, not least due to customer deposits. This will insulate them against volatility in market funding that could bedevil fintech providers.

Fluctuations in demand for mortgages could also test smaller and undiversified digital players, whose likely slim margins will make them reliant on maintaining a high volume of transactions. Banks' wider range of lending and saving products should provide a buffer against swings in mortgage demand.

Beyond Digital Mortgages

Digital mortgages' key societal benefit will be their facilitation of faster housing transactions, which promises a more liquid and efficient real estate market. New technologies, many of which are currently little or not at all in use, could magnify that benefit.

Land registries, for example, are exploring the use of blockchain technology, particularly non-fungible tokens (NFTs), to decentralize property deals. Tokenization and smart contracts could provide proof of ownership that would enable buyers and sellers to securely and directly transact, eliminating the need for slow and expensive intermediaries.

Nordic land registries, which have been experimenting with blockchain-powered solutions for property transactions over the past five years, are leading this revolution. In Finland, the DIAS digital trading platform uses permissioned blockchain technology to enable the transfer of information between real estate developers, real estate agents, tax administration, the national land registry, customers, and banks. This has facilitated the creation and transfer of digital contracts as well as payment in real time, underpinning so-called "stage-by-stage bank approval" that is conducted directly and digitally on a platform.

Similar initiatives are being studied by authorities in the U.S., the U.K., Netherlands and Australia, each of which is considering how blockchain technology might be applied to management of land registries. We believe that blockchain-based solutions will continue to be adopted across the financial sector--not least via work on central bank digital currencies (CBDCs). A future characterized by decentralized finance seems inevitable, and will likely include tokenized mortgage products, such as tokenized real estate loans and real estate investments in digitized form.

Obstacles To The Digital Future

Regardless of mortgage providers willingness to automate their processes, digital mortgages will face varying obstacles across different regions. First and foremost, market development will remain dependent on national digital infrastructure. Without access to digitized data from income tax authorities, credit bureaus and property registers, an end-to-end digital mortgage (and the savings and benefits it offers) cannot exist. Cultural habits will also weigh on adoption rates, particularly in markets where branch-based banking remains popular. And regulatory concerns, notably surrounding financial stability risks, could introduce legal barriers to digital mortgages.

Beyond those factors there are also a host of potential roadblocks that could affect specific markets. They include:

• Complex land registries: It will take time to transform and store physical deeds as digital certificates, particularly where there is no centralized system, such as in Germany. Furthermore, only a few state agencies are working on open-access blockchain solutions to facilitate access to property-related public records.
• External property valuation: Some jurisdictions, such as Spain, require banks to provide an independent property valuation as part of a loan assessment. This involves an on-site inspection, which can't be digitalized.
• Digitally incompatible processes: Spain and Germany, among other countries, both require buyers and sellers to sign sales contracts in front of a notary.
• Regulatory impediments: Rules protecting customers from incorrect advice and miss-selling, regulatory requirements relating to creditworthiness assessments, and capital requirements for lenders may be incompatible with digital mortgage business models.
• Security risks: Interfaces between legacy systems and new technologies are a notoriously vulnerable to cyber-attacks. The temptation for banks to add blockchain technologies onto older information technology systems makes this risk particularly pertinent.

Such barriers are not inconsequential, but we believe they will be overcome and that the days of branch-based mortgage writing are numbered. There are likely to be intermediate stages along the way. Basic mortgage products will evolve to become more automated, more flexible, and increasingly portable.

That could ultimately mean that the adoption of fully digitalized mortgages will barely be noticed, though the U.S. experience also suggests the shift could be abrupt. Either way the impact of the digitalization of mortgage lending will be far reaching, and is somewhat uncertain, for the credit quality of established banks and their challengers.

Related Research

• European Banks’ Residential Mortgage Losses Should Remain Contained Even As Economies Slow, Nov. 15, 2022
• The Future Of Banking: Adding A Banking License To Companies' Menus Might Be A Recipe For Success, Oct. 11, 2022
• Digitalization of Markets: Framing The Emerging Ecosystem, Sept. 16, 2021
• Nonfungible Tokens: Creating New Asset Classes, Disrupting Others, Sept. 16, 2021
• European Banks Face Risks In Race To Implement PSD2, May 16, 2019
• The Future of Banking: Will Retail Banks Trip Over Tech Disruption?, May 14, 2019

Writer: Paul Whitfield