Varun Mehta is vice president of legal and compliance solutions at Clutch Group.
Varun Mehta is vice president of legal and compliance solutions at Clutch Group.

Dramatic changes in the regulatory landscape have prompted a number of high-profile exits from the once lucrative and vibrant mortgage market. The Federal Reserve holds foreign banks to a higher regulatory standard than U.S. banks. Now Barclays, RBS and other major players in this space have announced plans to substantially reduce their mortgage-backed trading activities.

With the mortgage market significantly diminished in the aftermath of the financial crisis, only a small portion of the private mortgage-backed securities market remains. The fewer institutions there are in this small but critical sector, the more vulnerable it becomes. The U.K. institutions' exits also raise serious concerns about market competition. Are regulators creating a monopoly in the mortgage securities markets?

With financial institutions exiting more heavily regulated areas of the mortgage market, the future of certain products appears uncertain. The changes are most likely to affect mortgage debt products not backed by Fannie Mae or Freddie Mac. The majority of the non-agency mortgage debt currently being traded predates the 2008 financial crisis. JPMorgan Chase estimates that around $700 billion in pre-crisis mortgage debt is outstanding.

New U.S. regulations, namely the Federal Reserve's foreign bank rule under the Dodd-Frank Act, are prompting this exodus. The rule was finalized in February of this year and becomes effective in July 2016.

Under the rule, foreign banks with more than $50 billion in assets and a "significant U.S. presence" are required to establish an intermediate holding company over U.S. subsidiaries to "facilitate consistent supervision and regulation" by U.S. regulators. Foreign banks will also be held to the Federal Reserve's capital planning and stress testing requirements.

Intent on avoiding these burdensome requirements, banks are shedding billions of dollars in risk-weighted assets this year to come under the $50 billion mark. We may see even more foreign banks following suit in attempts to avoid these costly requirements. Unfortunately for the mortgage market, when making decisions about where to make cuts, many banks have landed on mortgage operations.

There's no doubt that the U.S. mortgage market, which the Fed is tasked with preserving and which already suffers from limited liquidity, will be hard hit by these exits.

The larger global financial system and individual households stand to suffer from this development too. As competition weakens, the availability of housing credit will be further strained as more banks refuse to securitize non-agency loans. Since the debate over housing finance reform remains stalled in a gridlocked Congress, this illiquidity is unlikely to be resolved by policy-makers in the short-term future. And it is equally unlikely that regulatory pressures will abate. Mortgage-backed securities retain their public perception problem from the financial crisis. If there is any one market that the general U.S. population wants heavily regulated, it is this one.

From a regulatory perspective, the trend among foreign banks illustrates the often-unforeseen consequences of overly burdensome U.S. regulations.

With regulators looking to tighten the reins, banks are left wondering if there are ways to comply with these regulations without being hamstrung by costs. However, as players exit the market, those who stick it out may be rewarded with surplus market share. If banks have the resources to weather the storm, there is certainly reason to do so.

Furthermore, while this rule is certainly a bitter pill to swallow, it could bestow some benefits. As banks are forced to design and adopt a nimbler response system to seemingly burdensome regulatory requests, they will strengthen their understanding of their own institutional data and sharpen their overall strategy. Avoiding regulatory fines and reporting increased levels of compliance can only help bank executives when it's time to face their shareholders.

Varun Mehta is vice president of legal and compliance solutions at Clutch Group.