Banks tilt their balance sheets to align with movements in interest rates. They don't get screwed over when somebody refinances at a lower rate and the system doesn't asymmetrically favor borrowers as assumed above. Refinancing a mortgage isn't free. Costs are set accordingly.
Okay - so there is an interest payment despite what everyone above has said. That makes sense. If there isn't an interest adjustment it doesn't make sense.
No, there isn't. There is costs involved in taking out a mortgage (origination cost, for example). The banks get paid to loan the money out. When you refi, they get paid again. That's where they're mostly making their money.
Your view is incorrect. There doesn't have to be and there isn't a cost or risk being hidden via following the US approach.
Can you logically explain how you can fix rates and hedge yourself if the rates go up but if rates go down you simply refinance with no cost. Who is wearing the risk to rates going down ? What happens if banks cannot finance this ? What is the downside not to hedge your loan if this is the way this policy is implemented ?
marty998 already explained it:
They are doing it because they are able to raise 5 year funding at a rate that allows them to make a 5 year loan that is profitable at 5%.
They're already profitable when they make the loan, and when you refi they'll be profitable too.
Allow me to make up some numbers to illustrate a point.
Bank borrows money from the fed at 4%, loans it to you at 5%. They make money originating it, and make money on the spread.
Rates go up 1%. You obviously don't refi (unless you're getting cash out), but they don't care, they've already made money. They borrow new money at 5%, and loan it out at 6% to new borrowers.
Rates go down 1%. You refi. They now borrow money from the fed at 3%, and loan it to you at 4%. They make money originating it, and make money on the spread.
Their profit is not at risk from you refinancing, and requiring a prepayment penalty doesn't suddenly make the system work. It's fine, or not, but it's not the lynchpin, because you're assuming they hold all the loans to maturity, which isn't even the case.
In any case, all of this is separate from the GFC (and when the GFC occurred, many banks still were doing the prepayment penalty thing - shouldn't that have stopped it, if it was so helpful?). Subprime borrowing, no doc loans, and especially CDOs caused the issues. Not having a prepayment penalty or not.
Trust me, when the GFC happened, and rates dropped, most people couldn't refi to lower rates due to being underwater. ;) So a bunch of borrowers suddenly refing to lower their rates was the least of the banks' worries. Borrowers not paying because they couldn't afford the mortgage they were given was a lot bigger issue.
tl;dr:
1) GFC and prepayment penalties - totally different issues.
2) Prepayment penalties is not how the bank makes money, they make it on origination and the spread they're borrowing at. If rates drop, and borrowers refi to lower, well, the banks are borrowing it at lower, so it doesn't hurt them. Prepayment at that point just gives them extra profit.