Could a return of banks to the mortgage market help lower interest rates? According to the Fed, it might.

The Changing Landscape of Mortgage Lending

Traditionally, individuals seeking a mortgage would turn to banks or local credit unions. However, in recent years, specialized mortgage companies such as CrossCountry Mortgage, Rocket, and loanDepot—none of which are traditional banks—have become the primary sources for home loans.

The Federal Reserve is now considering adjustments to regulations to encourage banks to play a larger role in mortgage lending and servicing, which involves managing payments over the life of a loan. The aim is to boost competition in the housing market and potentially drive mortgage rates down.

Why Banks Have Pulled Back

Michelle Bowman, Vice Chair for Supervision at the Federal Reserve, explained to the Senate Banking Committee that current capital requirements have led banks to scale back their involvement in mortgage lending, making it harder for consumers to access home loans.

She noted, "We are exploring ways to better assess mortgage risk, which would benefit banks of all sizes, not just the largest institutions."

Banks’ Declining Role in Mortgages

Back in 2008, banks were responsible for originating at least 60% of U.S. mortgages and handled nearly all servicing. Today, the situation has reversed: by 2023, banks originated only about 35% of mortgages and serviced less than half, according to Treasury figures.

Several factors have contributed to this shift. Mortgage lending tends to yield lower profits than other banking activities, and higher interest rates have further reduced business. Additionally, post-financial crisis regulations require banks to hold more capital against risky assets, making it less attractive to keep mortgage loans and servicing rights on their books.

Meanwhile, nonbank lenders, which are subject to different (often state-level) regulations, have expanded their presence as banks have stepped back. This increased competition has made the mortgage market even less appealing for traditional banks.

For example, Willamette Valley Bank in Oregon recently announced its exit from mortgage lending, citing rising rates and the growing dominance of nonbank lenders. Last year, other banks such as Popular, Ally Financial, and WaFd Bank also withdrew from the mortgage business.

Competitive Pressures and Regulatory Proposals

Mario Ichaso, a senior strategist at Wells Fargo, noted that fierce competition from nonbank servicers—many of which have invested heavily in technology—has significantly reduced profit margins for banks.

To address this, Bowman has proposed easing certain regulations by tying capital requirements more closely to factors like loan size and down payment, and by revising how mortgage servicing rights are valued for banks.

Will Mortgage Rates Fall?

These regulatory changes could free up more capital for banks to lend, potentially drawing them back into the mortgage market. Increased competition may help lower mortgage rates for borrowers.

Eric Orenstein, a senior director at Fitch Ratings, believes that if banks regain market share from nonbank lenders, consumers could benefit from lower rates. "With more competition, lenders are likely to offer better rates, which means borrowers could see savings," he said.

However, mortgage rates are also influenced by broader economic factors, such as Treasury yields and demand for mortgage-backed securities. While more competition may not bring rates down from current levels of around 6% to the 4% range, it could lead to modest reductions or lower fees.

Michael Fratantoni, chief economist at the Mortgage Bankers Association, added that increased bank activity in buying and selling mortgage servicing rights could also help reduce rates. He explained, "The value of mortgage servicing assets plays a role in determining rates. If these assets become more valuable, consumers could see better mortgage offers."

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Bowman also highlighted that during the pandemic, borrowers with bank-serviced mortgages were more likely to receive payment relief compared to those with nonbank servicers.

On the other hand, research shows that nonbank lenders have improved their servicing, especially in communities with more low-income or minority borrowers, as they have invested in technology and expanded their operations.

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Claire Boston is a Senior Reporter for Yahoo Finance covering housing, mortgages, and home insurance.