The outlook for the lenders' mortgage insurance market in Australia is "problematic" unless there is capital relief or all lenders using LMI, according to Deloitte Access Economics.In a study accompanying Genworth's second round submission to the Financial System Inquiry, Deloitte argued that if the LMI market were to "atrophy" the cost would be felt in reduced access to home ownership for first-home buyers, the self employed relying on low doc loans and others who rely on high loan-to-valuation loans or higher risk loans.In its interim report, the FSI said it had received submissions arguing that under current policy settings the major banks would reduce or even stop using LMI altogether. QBE LMI's submission said an emerging trend was the selective charging of a low equity fee in lieu of LMI by some lenders.The issue is that lenders using the advanced (internal ratings based) approach for calculating capital receive no capital benefit for the use of LMI, despite the fact that the LMI providers are required to hold capital for the risk that is transferred.Five banks - the majors and Macquarie Bank - have approval to use the advanced modelling approach. They account for the bulk of mortgage lending.Under the old Basel I prudential guidelines, lenders were able to apply a lower risk weight to loans with a high loan-to-valuation ratio or to non-standard loans if they were covered by LMI. Smaller banks using the standard approach for calculating capital are still able to do this.The FSI said several submissions proposed changes to capital standards to reduce the risk weights for insured loans - in effect, a return to the Basel I situation. However, it was concerned that reducing risk weights for insured loans might affect the competitive situation between advanced banks and smaller lenders.Westpac's second round submission agreed that LMI faced a difficult future. It said: "Regulatory settings currently provide a disincentive for further take-up of loan insurance. "Westpac believes there is merit in the inquiry considering concessional capital treatment across residential lending, irrespective of IRB or standardised treatment for the use of LMI on residential mortgage lending."The big banks want to see LMI continue as a viable part of the system. Westpac said: " The long-standing practice of requiring LMI for lending over 80 per cent LVR overlays the insurer's underwriting standards and provides risk mitigation for bank portfolios."Westpac supports the use of LMI as an appropriate means to manage risk in certain types of residential mortgage lending."Commonwealth Bank's second round submission said: "Home loan products in Australia are prudently structured. Features include full recourse to the borrower, the predominance of variable rate mortgages with low prepayment penalties, minimal low-doc lending and mortgage insurance for high LVR loans."Genworth said the current prudential settings could lead to distortions in the markets. It said: "The non-recognition of LMI for advanced banks encourages them to adopt bank risk retention programs to cherry pick high LVR loans, waive LMI and charge a higher interest rate to the borrower."We believe that high LVR loans