APRA welcomes finalisation of Basel III bank capital framework

APRA has welcomed the Basel III announcement and expects to commence consultation on revisions to the ADI capital framework in early 2018.

Despite the 2022 date, APRA also reaffirmed that Australian banks should be following strategies to increase their capital strength to exceed the unquestionably strong benchmarks by 1 January 2020.

The Australian Prudential Regulation Authority (APRA) today welcomed the announcement that the Basel Committee on Banking Supervision had finalised the Basel III bank capital framework.

The announcement confirms the final set of measures designed to address deficiencies in the internationally-agreed capital framework following the global financial crisis and are primarily focused on addressing undue variability in risk-weighted assets, and therefore capital requirements, across banks.

Key elements of the final framework include changes to the standardised approach to credit risk capital for real estate, restrictions on modelled risk estimates by banks using the internal ratings-based (IRB) approach to credit risk capital, and the removal of provisions for banks to use internal models to determine their operational risk capital requirements. The Basel Committee has also agreed to introduce a ‘floor’ to limit the reduction in capital requirements available to banks using capital models relative to those using the standardised approaches.

APRA Chairman Wayne Byres said APRA’s ADI capital framework, including the adjustments made to IRB risk weights in 2016, is well-equipped to accommodate the final Basel III framework. APRA has been involved in the international work to agree the final Basel III reforms.

“We welcome the finalisation of these measures which represent the final stage of a decade’s financial reform work aimed at building resilience in the financial system following the global financial crisis.

“Importantly for Australian ADIs, these final Basel III reforms will be accommodated within the targets APRA set in July this year in our assessment of the quantum and timing of capital increases for Australian ADIs to achieve unquestionably strong capital ratios,” Mr Byres said.

The Basel Committee has agreed to an implementation timetable commencing in 2022 for the final Basel III reforms. APRA will consider the appropriate effective date for revisions to the ADI prudential standards in light of the Basel Committee’s announcement and expects to commence consultation on revisions to the ADI capital framework in early 2018. However, consistent with its July 2017 announcement, APRA reaffirms its expectation that ADIs should be following strategies to increase their capital strength to exceed the unquestionably strong benchmarks by 1 January 2020.

The 2018 consultation will be based on the final Basel III framework but with appropriate adjustments to reflect APRA’s approach and Australian conditions, most notably adjustments to capital requirements for higher risk residential mortgage lending, consistent with the achievement of unquestionably strong capital ratios.

Warnings over home loans not meeting serviceability requirements

We discussed Mortgage Lending Standards on 6PR Today.

Banking analysts have raised concerns after the number of home loans being approved despite not meeting serviceability requirements jumped to its highest point since before the global financial crisis.

Digital Finance Analytics Principal, Martin North told Mornings with Gareth Parker, we could be headed for some strife if rates go up.

Listen to the discussion.

Major Banks Are Still Highly Leveraged

The latest ADI performance data from APRA to September 2017 shows that profitability rose 29.5% on 2016 and the return on equity was  12.3% compared with 9.9% last year. Loans grew 4.1%, provisions were down although past due items were $14.3 billion as at 30 September 2017. This is an increase of $1.5 billion (11.8 per cent) on 30 September 2016.

On a consolidated group basis, there were 147 ADIs operating in Australia as at 30 September 2017, compared to 148 at 30 June 2017 and 153 at 30 September 2016.

  • Summerland Financial Services Limited changed its name from Summerland Credit Union Limited, with effect from 1 August 2017
  • The Royal Bank of Scotland plc had its authority to carry on banking business in Australia revoked, with effect from 31 August 2017.

The net profit after tax for all ADIs was $35.9 billion for the year ending 30 September 2017. This is an increase of $8.2 billion (29.5 per cent) on the year ending 30 September 2016. The cost-to-income ratio for all ADIs was 48.2 per cent for the year ending 30 September 2017, compared to 48.3 per cent for the year ending 30 September 2016. The return on equity for all ADIs was 12.3 per cent for the year ending 30 September 2017, compared to 9.9 per cent for the year ending 30 September 2016.

The total assets for all ADIs was $4.56 trillion at 30 September 2017. This is an increase of $41.9 billion (0.9 per cent) on 30 September 2016. The total gross loans and advances for all ADIs was $3.13 trillion as at 30 September 2017. This is an increase of $123.6 billion (4.1 per cent) on 30 September 2016.

Note: ‘Other ADIs’ are excluded from all figures other than population and total assets. Foreign branch banks are excluded from return on equity and capital adequacy figures.

The total capital ratio for all ADIs was 14.6 per cent at 30 September 2017, an increase from 13.7 per cent on 30 September 2016. The common equity tier 1 ratio for all ADIs was 10.6 per cent at 30 September 2017, an increase from 9.9 per cent on 30 September 2016. The risk-weighted assets (RWA) for all ADIs was $1.95 trillion at 30 September 2017, a decrease of $18.2 billion (0.9 per cent) on 30 September 2016.

For all ADIs Impaired facilities were $11.9 billion as at 30 September 2017. This is a decrease of $3.3 billion (21.7 per cent) on 30 September 2016. Past due items were $14.3 billion as at 30 September 2017. This is an increase of $1.5 billion (11.8 per cent) on 30 September 2016; Impaired facilities and past due items as a proportion of gross loans and advances was 0.84 per cent at 30 September 2017, a decrease from 0.93 per cent at 30 September 2016; Specific provisions were $6.1 billion at 30 September 2017. This is a decrease of $1.0 billion (14.2 per cent) on 30 September 2016; and Specific provisions as a proportion of gross loans and advances was 0.19 per cent at 30 September 2017, a decrease from 0.24 per cent at 30 September 2016.

As normal we chart the key ratios for the four major banks.  We see significant rises in gross loans, largely housing related. The capital ratios are higher, but the ratio of gross loans to shareholder funds still sits at 5%, which underscores how leveraged (and so profitable as the lending book grows).

Finally, it is worth reflecting on that fact that the big four comprise around 25% of the ASX 200 in terms of market capitalisation, and financial services overall comprises 35% of the capitalisation. In addition more than half of all dividends comes from the financial services sector, so we are economically very reliant on these players and their highly leveraged mortgage book.

 

APRA ADI Data Highlights Lending Tightening

Continuing our analysis of the APRA ADI data to September 2017, we will look across the various metrics for new loans, and by lender category.

APRA reports new flows by Major Banks, Other Banks, Foreign Banks and Mutuals (Credit Unions and Building Societies).

Looking first at third party origination, we see that origination from foreign banks is sitting at 70% of new loans, mutuals around 20% and other banks around the 50% mark.  Overall, volume through brokers is climbing.

New interest only loan approvals have fallen from, in the case of the major banks, around 40% to 20%, and we see the regulatory pressure has reduced the mix across the board.

Investment loan volumes have fallen, though major banks still have the largest relative share, above 30%.  Mutuals are sitting around 10%.

There has been a spike in loans being approved outside serviceability, with major banks reporting 5% or so in September. This may well reflect a tightening of standard serviceability criteria and the wish to continue to grow their loan books.

Finally, we look across the LVR bands for new loans. There has been a small rise in loans between 60% LVR, but around 30% of all new loans are in this range.

We see a small fall in the relative proportion of loans in the 60-80% range, but close to half of all loans written are still in this range.

Turning to the 80-90% LVR range, we see a rise in lending by foreign banks, with more than 20% of their loans falling in this range. Other lenders are averaging 10-15 %.

Finally, there is a rise in loans above 90% being written by mutuals, (as they they to grow share), while the banks are around 7% and foreign banks lower still.

So overall, we see the impact of regulatory intervention. The net impact is to slow lending momentum. As lenders tighten their lending standards, new borrowers will find their ability to access larger loans will diminish. But the loose standards we have had for several years will take up to a decade to work through, and with low income growth, high living costs and the risk of an interest rate rise, the risks in the system remain.

Interest Only Loans Decline Significantly To Sep 2017

The latest APRA Property Exposure Data to September 2017 has been released.  The most significant change is in the relative volume of interest only loans now held in the portfolio.

First, note that the average loan balance for interest only loans currently stands at $347,000 against the average balance of $264,000.  So further confirmation that interest only loans are on average larger. No surprise of course, as these loans do not contain any capital repayments (hence the inherent risks involved, especially in a falling market).

Then look at the relative share of interest only loans in the portfolio, as households switch to more expensive principal and repayment loans (meaning their monthly repayment just went up!). In addition, see the mix of loan value versus volume. Interest only loans have fallen from around 40% in total value to 35%, but this represents a fall from around 30% of the loan count, to 27%. This again reflecting the higher average loan values for IO borrowers.

We also see a fall in the volume of investment loans being held on book. As the lions share of interest only lending has been for investment purposes, this is of no surprise.

We will look at the data by individual type of lender in a separate post, together with the latest loan to value splits.

 

APRA releases changes to the capital framework for mutual ADIs

The Australian Prudential Regulation Authority (APRA) has released its final revisions to the capital framework for mutually owned authorised deposit-taking institutions (ADIs) in relation to changes that provide these ADIs with more flexibility in their capital management.

In 2014, APRA developed the Mutual Equity Interest (MEI) framework for mutually owned ADIs. The advent of MEIs enabled mutuals to issue capital instruments that met the criteria for Additional Tier 1 and Tier 2 capital under APRA’s capital adequacy framework. In July this year, APRA proposed extending the MEI framework to allow mutually owned ADIs to issue CET1-eligible capital instruments directly without jeopardising their mutual status.

APRA has today released its response paper on the consultation as well as the final Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111). APRA received a number of submissions in response to its proposals. While submissions sought clarification of, and raised issues with, particular aspects of the proposed framework, submissions were supportive of the direction of the proposed changes, which improve the capital management flexibility available to mutually owned ADIs.

Facilitating the ability of mutually owned ADIs to directly issue CET1 instruments was also the first recommendation of the recent Independent Facilitator Review (Hammond Review) into the mutual ADI sector1.

The revised prudential standard APS111 will come into effect from 1 January 2018.

Mortgage Lending Still On The Up

The latest banking statistics from APRA, to end October 2017 shows that banks continue to lend strongly to households. The overall value of their portfolios grew 0.5% in the month to $1.57 trillion, up $7.3 billion.

Owner occupied loans grew 0.6% to $1.03 trillion, up $6.4 billion and investment loans rose 0.15% of $816 million. The proportion of investment loans continues to drift lower, but is still at 34.8% of all lending (too high!!).

Looking at the monthly movement trends in more detail, we see the “dent” in the trends a couple of months back thanks to CBA’s reclassification of loans from their portfolio. Ignoring that blip, the current policy settings are still too generous. Household debt will continue to rise, despite low wage growth and the prospect of higher interest rates. Risks in the system are still rising.

Looking at the individual lenders, the portfolio movements are small, but Westpac has extended its lead over CBA on investor loans. There is clearly a difference in strategy here between the two.

That is even more obvious where we see the monthly portfolio movements by lender.  CBA reduced their investment portfolio this month, whilst Westpac grew theirs.

Finally, here is the investment portfolio growth by lenders, using the sum of the monthly movements. Market growth is sitting at around 3%. Some smaller lenders are well above the speed limit.

The RBA data out now will give us the read on market growth, and the amount of reclassification in play.

APRA calls for renewed focus on ‘realistic living expenses’

From The Adviser.

The chairman of the prudential regulator has called on the finance industry to “devote more effort to the collection of realistic living expense estimates from borrowers” and give “greater thought” to the appropriate use and construct of benchmarks.

Speaking at the Australian Securitisation Forum 2017 on Tuesday (21 November), the chairman of the Australian Prudential Regulation Authority said that the regulator had been “increasingly focused on actual lending practices” and “confirmed there is more to do… to improve serviceability measures, particularly in relation to the assessment of living expenses and the identification of a borrower’s existing debts” to ensure that borrowers can afford their mortgages.

Chairman Wayne Byres told delegates that it was “no secret” that the regulator had been “actively monitoring housing lending by the Australian banking sector over the past few years” in a bid to “reinforc[e] sound lending standards in the face of strong competition that… was producing an erosion in lending quality just at a time when standards should be going in the other direction”.

Noting that mortgages represent more than 60 per cent of total lending within the banking sector, My Byres said that APRA’s goal is to ensure that regulated lenders are “making sound credit decisions which are appropriate, individually and in aggregate, in the context of broader housing market and economic trends”.

The chairman said: “We have consistently called out a number of factors that are contributing to an environment of heightened risk, many of which have been with us for quite some time now. Household indebtedness is high; perhaps more importantly, the trajectory is clearly for it to rise further.”

Mr Byres pointed to figures that show that the housing debt-to-income ratio is near 200 per cent — an all-time high.

“This trend is underpinned by a sustained period of historically low interest rates, subdued income growth and high house prices,” Mr Byres warned. “Combined, they describe an environment in which lenders need to be vigilant to ensure that their policies and practices are both prudent and responsible.

“In short, heightened risk requires heightened vigilance: certainly by APRA, but also — and preferably — by lenders (and borrowers) themselves.”

The APRA chairman said that while APRA’s crackdown on interest-only loans has been helping moderate this type of lending, he warned that there were still metrics that continue to “track higher than [what] intuitively feels comfortable”.

Question of reliability of HEM as a ‘realistic’ benchmark

One such metric was non-performing loans, which Mr Byres said were growing at an overall rate that was “drifting up towards post-crisis highs, without any sign of crisis”.

As such, the regulator is paying “particular attention” to lending to those with a low net income surplus (NIS), those who are “vulnerable to shocks”. According to APRA, NIS lending relies on the lender’s assessment of the surplus income borrowers would likely have left over each month, after taking into account living expenses, debt repayments and adding in some buffers.

“Over recent years, we have been challenging lenders to ensure that their serviceability methodology is robust, and includes adequate conservatism to ensure that borrowers are not unduly exposed if their circumstances were to change,” the chairman said.

Mr Byres went on to state that while the upward trend in low NIS lending “appears to have moderated over the past few quarters”, there is still a “reasonable proportion of new borrowers [who] have limited surplus funds each month to cover unanticipated expenses or put aside as savings”.

He therefore highlighted that as measures of NIS are dependent on the quality of the lenders’ assessment of borrower living expenses, if those expenses are “understated”, then measures of NIS are “overstated”.

Touching on the fact that many banks use the Household Expenditure Measure (HEM) as a benchmark of living expenses, Mr Byres echoed thoughts from the broking industry that this benchmark actually paints a “modest level of weekly household expenditure”.

He called on lenders to do more to ascertain a borrower’s expenses, saying: “It is open to question whether, even if it is higher than a borrower’s own estimate, such a benchmark always provides a realistic assessment of a borrower’s genuine expenditure needs.

“From APRA’s perspective, we would like to see the industry devote more effort to the collection of realistic living expense estimates from borrowers and give greater thought to the appropriate use and construct of benchmarks in instances where those estimates are deemed insufficient.”

Several banks have already introduced tighter policies around expenditure, with AMP announcing that it would not progress loan applications if it did not include a new monthly living expenses form, which covers both basic living and discretionary living expenses.

The APRA chairman also called out the fact that there had only been a “slight moderation” in the proportion of borrowers being granted loans that represent more than six times their income (which would require borrowers to commit more than half of their net income to repayments if interest rates return to their long-term average of just over 7 per cent). He also warned that “high LTI lending is well north of what has been permitted in other jurisdictions grappling with high house prices and low interest rates, such as the UK and Ireland”.

Lastly, Mr Byres highlighted that while lenders utilise a loan-to-income ratio to understand the extent to which a borrower is leveraged, he said that this can be problematic as it does not capture a borrower’s total debt level.

He therefore outlined his belief that the introduction of mandatory comprehensive credit reporting (CCR) from next year will help “strengthen credit assessment and risk management” as it will enable lenders to see a borrower’s full financial commitments, including those from others financial institutions (which has previously been “something of a blind spot” for lenders).

The APRA chairman said: “[T]he government’s recent announcement of mandatory comprehensive credit reporting beginning from next year will facilitate a switch from LTI to debt-to-income (DTI) metrics and strengthen credit assessments and risk management. This will undoubtedly be a positive development for the quality of credit decisions.”

APRA will ‘devote a large portion of supervisory resources to housing’ in 2018

Mr Byres conceded that APRA has “certainly been more interventionist than [it]would normally wish to be”, but added that as risk within the lending environment has increased, he believed the regulator’s actions have “helped to strengthen lending standards to compensate”.

He said: “We will need to continue to devote a large portion of our supervisory resources to housing in 2018. The broader environment of high and rising leverage, encouraged by historically low interest rates, requires ongoing prudence. It is easy to run up debt, but far harder to pay it back down when circumstances change.

“It is in everyone’s long-term interest to maintain sound standards when times are good – that is, after all, when most bad loans are made. Moreover, sound lending standards are an essential foundation on which the health of the Australian financial system is built, regardless of whether the loans are held on balance sheet, or securitised and sold.”

APRA On Housing – Risks Lurking Beneath

Wayne Byers, APRA Chairman spoke at the Australian Securitisation Forum 2017.  Household debt is high, and continues to rise. There are a three interesting observations within his speech about the risks in the mortgage system, despite their recent interventions.

First, the trend in non-performing housing loans is upward, despite a relatively benign environment for lenders. The overall rate of non performing housing loans is drifting up towards post-crisis highs, without any sign of crisis.

Second, while the upward trend in low Net Income Surplus (NIS) lending appears to have moderated over the past few quarters, a reasonable proportion of new borrowers have limited surplus funds each month to cover unanticipated expenses, or put aside as savings.

Third, there is only a slight moderation in the proportion of borrowers being granted loans that represent more than six times their income. As a rule of thumb, an LTI of six times will require a borrower to commit 50 per cent of their net income to repayments if interest rates returned to their long term average of a little more than 7 per cent. High LTI lending in Australia is well north of what has been permitted in other jurisdictions grappling with high house prices and low interest rates, such as the UK and Ireland.

So, APRA is finally looking at LTI and they acknowledge there are risks in the system. Better late than never…! LVR is not enough.  He also discussed the non-bank sector.

Here is the speech:

It is no secret we have been actively monitoring housing lending by the Australian banking sector over the past few years. Throughout this period, our efforts have been directed at reinforcing sound lending standards in the face of strong competition that, in our view, was producing an erosion in lending quality just at a time when standards should be going in the other direction.

Housing loans represent over 60 per cent of total lending within the banking sector. Our goal has been to ensure APRA-regulated lenders are making sound credit decisions which are appropriate, individually and in aggregate, in the context of broader housing market and economic trends. We have consistently called out a number of factors that are contributing to an environment of heightened risk, many of which have been with us for quite some time now. Household indebtedness is high: perhaps more importantly, the trajectory is clearly for it to rise further (Chart 1).

Chart 1 shows increasing percentage of household debt to income over time from June 1997 to June 2017

This trend is underpinned by a sustained period of historically low interest rates, subdued income growth, and high house prices. Combined, they describe an environment in which lenders need to be vigilant to ensure their policies and practices are both prudent and responsible. In short, heightened risk requires heightened vigilance: certainly by APRA, but also – and preferably – by lenders (and borrowers) themselves.

Our activities in relation to housing broadly fit into three categories:

  1. Industry-wide portfolio benchmarks: perhaps the most-publicised of our actions have occurred at the industry level through the temporary benchmarks in place in respect of both investor lending growth and new interest-only lending. These benchmarks have served to constrain higher risk lending, and discouraged lenders from competing aggressively for these types of loans. Standards and pricing have increased as a result, tempering the growth of new credit in these areas. I’ll come back to these impacts shortly.
  2. Lending standards: we increased our activities in this area as far back as 2011, when we wrote to the boards of the larger authorised deposit-taking institutions (ADIs) to seek assurance they were actively monitoring their housing portfolios and standards. In more recent years, we have also used measures such as hypothetical borrower exercises to test lending policies.2  This led to new, and in a few cases more prescriptive, regulatory guidance on appropriate lending standards and risk management in residential mortgage lending: this was first issued in 2014 and refined last year.
  3. Lending practices: as we have dived deeper into housing lending, we have increasingly focussed on actual lending practices – in other words, are lending policies reflected in the everyday conversations that lenders are having with borrowers? Sound policies only provide comfort if they are actually followed. Aided by file reviews conducted by external auditors, we have confirmed there is more to do in this area to improve serviceability measures, particularly in relation to the assessment of living expenses and the identification of a borrower’s existing debts.

Impact on lending activity

In thinking about the impact of our interventions on housing credit, it’s important to note that APRA can only influence the terms and price at which credit is supplied. We cannot influence the underlying demand. Actual lending outcomes will be a product of both, so I do not want to be seen to suggest that all of the trends that I am about to discuss are solely attributable to APRA – there are many forces at play. That said, there’s no doubt many of trends are ones we hoped to see.

Aggregate housing credit is now growing a little over 6 per cent: not that different from its growth rate before we introduced our industry-wide investor growth benchmark in 2014 (Chart 2).

Chart 2 shows housing credit growth percentage per annum

But it is clear that the strong growth in lending to investors has been curtailed. The emerging imbalance called out by the Reserve Bank in its September 2014 Financial Stability Review has been halted (although not reversed), and overall growth in credit to investors is now more in line with that to owner-occupiers. We have also had the added benefit that lenders have been forced to improve their management information systems, which in the absence of any regulatory requirements had grown lax in identifying the purpose for which money was being borrowed.

More recently, we introduced an additional benchmark with respect to new interest-only lending. The proportion of interest-only lending had been gradually building in Australia (Chart 3).

Chart 3 shows ADIs' interest only loans

In an environment of seemingly ever-rising house prices and low interest rates, an increasing number of borrowers had become comfortable maintaining high debt levels. To exacerbate this, lenders’ practices made it easy to refinance or extend interest-only terms, making it relatively simple for a borrower to avoid paying down their principal debt over an extended period of time.

Our announcement in March this year that APRA-regulated lenders should limit their new interest-only lending to no more than 30 per cent of new lending funded during a given quarter has had an immediate and notable impact (Chart 4).

Chart 4 shows ADIs' new interest only loans

Over the past couple of years, the share of interest-only lending has moderated in response to the more modest rate of growth in lending to investors (who typically make greater use of interest-only products). Nevertheless, having run at between 40-50 per cent of new lending for some time, interest-only lending accounted for about 23 per cent of total new lending for the quarter ended September.  Forecasts for the December quarter suggest something similar again.

While our focus was on new interest-only lending, the emergence of stronger price signals through differential pricing also motivated many existing interest-only borrowers to switch to principal and interest (P&I) repayments. This has resulted in a reduction in ADIs’ interest-only loans outstanding by around $36 billion, or close to 7 per cent, over the last six months. We see this switching as positive for the risk profile of loan portfolios, as it has increased the proportion of borrowers that are paying down principal on their loan and therefore working to reduce overall indebtedness.

In March, we also asked ADIs to increase their scrutiny of interest-only lending with high loan-to-value ratios (LVRs). As a result, many APRA-regulated lenders reduced their maximum LVRs for interest-only loans. Over the subsequent months, we have seen a continuation in the decline of high LVR lending, both in terms of interest-only and, to a lesser extent, P&I loans (Charts 5a and 5b).

Chart 5 High LVR and interest only
Chart 5b shows share of new lending by LVR

Within this broadly positive picture, however, there are a few other metrics that are continuing to track higher than intuitively feels comfortable.

First, the trend in non-performing housing loans is upward, despite a relatively benign environment for lenders (Chart 6).

Chart 6 shows ADIs non-performing housing loans

With historically low interest rates and an unemployment rate that for the past few years has drifted lower, an a priori expectation might have been for non performing housing loans to return to lower levels. Certainly, the current trend is influenced by geographic factors – in particular, the softening of activity and house prices Western Australia is a significant part of the increase. But nonetheless the overall rate of non performing housing loans is drifting up towards post-crisis highs, without any sign of crisis. Given metrics of non-performing loans are a product of historical lending practices, they do not tell us anything much about lending quality today. But it does support the proposition that the need to reinforce lending standards was warranted.

With this in mind, we are paying particular attention to lending with a low net income surplus (NIS). This measure represents the lender’s assessment of the surplus income borrowers would likely have left over each month, after taking into account living expenses, debt repayments and adding in some buffers. Low NIS borrowers are obviously vulnerable to shocks. Over recent years we have been challenging lenders to ensure that their serviceability methodology is robust, and includes adequate conservatism to ensure that borrowers are not unduly exposed if their circumstances were to change. While the upward trend in low NIS lending appears to have moderated over the past few quarters (Chart 7), this chart still shows a reasonable proportion of new borrowers have limited surplus funds each month to cover unanticipated expenses, or put aside as savings.

Chart 7 shows share of new lending by net income surplus

To add to this picture, we have also observed only a slight moderation in the proportion of borrowers being granted loans that represent more than six times their income (Chart 8).

Chart 8 shows share of new lending by loan-to-income ratio
As a rule of thumb, an LTI of six times will require a borrower to commit 50 per cent of their net income to repayments if interest rates returned to their long term average of a little more than 7 per cent. High LTI lending in Australia is well north of what has been permitted in other jurisdictions grappling with high house prices and low interest rates, such as the UK and Ireland.5

Current areas of focus

These last two charts are a useful segue into two key areas on which we are currently focussing.

The first is estimates of living expenses. Measures of NIS are dependent, amongst other things, on the quality of the lender’s assessments of borrower living expenses. Put simply, if living expenses are underestimated then measures of NIS are overstated. Lenders know that borrowers have difficulty estimating their expenses (and have an incentive to understate them), and so as a safeguard will typically use the higher of the borrower’s estimate and their own benchmarks of what a minimum level of living expenses is likely to be. These benchmarks are often based on the Household Expenditure Measure (HEM), with a degree of scaling for different income levels. Indeed, our recent review of lending files at some of the largest lenders provided interesting insights into the high proportion of loans that are being assessed for serviceability based on the lenders’ living expense benchmarks (Chart 9).

Chart 9 shows use of living expenses benchmarks

The use of benchmarks as the primary means of measuring living expenses operates to protect against instances of borrowers underestimating their expenditure. However, the prominent use of any type of benchmark within credit assessments only emphasises the importance of that benchmark being realistic. The HEM, for example, is a measure that reflects a modest level of weekly household expenditure for various types of families. It is open to question whether – even if it is higher than a borrower’s own estimate – such a benchmark always provides a realistic assessment of a borrower’s genuine expenditure needs. From APRA’s perspective, we would like to see the industry devote more effort to the collection of realistic living expense estimates from borrowers and give greater thought to the appropriate use and construct of benchmarks in instances where those estimates are deemed insufficient.

The second key area is lenders’ knowledge of a borrower’s financial commitments and total indebtedness. Loan-to-income ratios (LTI) provides a measure of the extent to which borrowers are leveraged, but are obviously limited because they do not capture the borrower’s total debt level. Many other countries have used credit scores and positive credit reporting for some time as a means of sharing information and conducting comprehensive credit assessments. In Australia, other financial commitments remain something of a blind spot for lenders. However, the Government’s recent announcement of mandatory comprehensive credit reporting beginning from next year will facilitate a switch from LTI to debt-to-income (DTI) metrics, and strengthen credit assessments and risk management. This will undoubtedly be a positive development for the quality of credit decisions.

New non-ADI lender rules

We are working within a system in which well north of 90 per cent of housing finance is currently provided by APRA-regulated lenders. So the measures that we have taken impact the vast majority of mortgage lending in Australia. But when the flow of credit encounters regulation, it’s like flowing water encountering a barrier: one tries to find a way around the other. We therefore haven’t been blind to the fact that the more we lift the quality and/or reduce the quantity of lending in the regulated sector, the more that it provides opportunity for non-APRA regulated lenders to fill any unsated demand. We need to be mindful that, while from a financial safety (microprudential) perspective credit portfolios of individual regulated lenders will be improving, from a financial stability (macroprudential) perspective the risk may just be moving elsewhere. Moreover, it could be concentrating risk in the parts of the system that are less transparent or receive less regulatory scrutiny – often short-handed as the ‘shadow banking’ sector.

There have been two main responses to this risk in recent times:

  • First, we have been looking at whether bank funding of housing loans via warehousing facilities is facilitating risks that would be materially higher than banks would naturally want to write for themselves. In other words, we want to make sure lenders have not been pushing risk out the front door, only to bring it in again via the back. Warehouse exposures are relatively small, but we have observed that there is quite a high tolerance for investor and interest-only loans within warehouses – in some cases, documented eligibility criteria allow for as high as 60 per cent of the pool in each of these categories. Across the industry, non-ADI lenders utilising ADI warehouses would seem to have, on average, slightly higher risk profiles in their portfolios, but there are clearly some individual non ADIs lenders with lending portfolios that are dominated by the sorts of lending that we have been disincentivising ADIs from taking on.
  • Secondly, the Government has introduced legislation into Parliament that would provide us with a new power to use should we think the aggregate impact of non-ADI lenders is materially contributing to risks of instability in the Australian financial system.

I would like to say a few words about this power, since I know it has generated quite a bit of interest amongst many in this room. The first point I would make is to stress that we see it very much as a reserve power. There is a clear threshold to be met before any rules could be applied to non-ADI lenders: that (i) APRA considers that the lending by non-ADI lenders contributes to risks of instability in the Australian financial system and, (ii) APRA considers that it is necessary, in order to address those risks, to make rules covering the lending of non-ADI lenders.

That means that, most of the time, the power to impose rules will lie dormant: non-ADI lenders will go about their business as they have always done, unconstrained by any APRA rules. Importantly, non-ADI lenders will not be subject to any day-to-day prudential oversight by APRA. For those of you uncomfortable at the thought of APRA supervising non-ADIs, let me assure you the feeling is mutual. We are not seeking to expand our supervisory remit and, beyond collecting information that allows us to track aggregate trends in lending activity, we will not be undertaking any supervision of individual lenders. Indeed, we are keen to distance ourselves from any perception we are responsible for the activities of any individual non-ADI lender, or for protecting their investors. To be absolutely clear, we have no intention of taking on that role. For investors in non-ADI lenders, market discipline and caveat emptor remain the primary regulating influences. Our focus is very much on the aggregate.

The ASF’s submission on the proposed legislation noted that any judgement on the extent of material risks to financial stability is fraught with difficulty. I wholeheartedly agree. There is no single measure of financial stability: it is necessarily a matter of judgement, taking into account a wide range of factors. But we will undoubtedly be better placed to make good judgements if we have good data. So the new legislation does impose a new set of ongoing requirements for those businesses that exceed the size threshold to be registered under the Financial Sector (Collection of Data) Act 2001 (FSCODA), and hence provide data to APRA to help us track overall lending trends. We are giving thought to what that data might entail, and will consult with the industry before any new requirements are introduced. But as per the ASF’s submission, we will mainly be seeking to observe the volume and nature of lending that is occurring, and not the traditional prudential metrics that we collect from ADIs.

The ASF’s submission also noted that the new legislation might create some uncertainty in the minds of investors as to the regulatory framework applying to non-ADI lenders. I cannot dispute that might be the case, although clarifying that non-ADIs will not be prudentially supervised and that APRA’s rule-making is a reserve power should alleviate some of those concerns. But equally, given international perceptions of Australia’s housing market, reinforcing the understanding of international investors that the Australian authorities have a wide range of tools at their disposal to support financial stability, should the need arise, certainly offers benefits as well.

As to what would happen if we got to a point where we thought the introduction of non-ADI rules might be needed, it is important to note that, as with data collections, we would need to undertake a consultation process, engaging with affected lenders on what we proposed to do in response to the risks we perceived to exist.

Let me finish on this issue by noting that, as things stand today, we do not foresee the need for any new non-ADI lender rules to be introduced the moment the legislation is passed. Our immediate priority will be to consider how to identify the right entities to collect data from, and the data we want to collect. We look forward to a constructive engagement with the industry on those matters

ADI’s Still Doubling Down On Mortgages

The APRA ADI data released today to September 2017 shows that owner occupied loan portfolio grew 0.48% to $1.03 trillion, after last months fall thanks to the CBA loan re classifications. Investment lending grew just a little to $550 billion, and comprise 34.8% of all loans. Overall the loan books grew by 0.3% in the month.

This confirms our view that last months results were more to do with CBA’s changing their loan classification, rather than macroprudential biting.  The relative mix of investment loans did fall a little, so you could argue the tightening of interest only loans did help.

Overall market shares were pretty static with CBA still the largest owner occupied loan lender and Westpac the largest investment property lender.

The 12 month loan growth for investor loans is well below the 10% speed limit imposed by APRA, and all the majors are below the threshold.

We see some significant variations in portfolio flows, with CBA, Suncorp, Macquarie and Members Equity bank all reducing their investment loan balances, either from reclassification or refinanced away. The majors focussed on owner occupied lending – which explains all the attractor rates for new business. Westpac continues to drive investor loans hard.

Comparing the RBA and APRA figures, it does appear the non-banks are lifting their share of business, as the banks are forced to lift their lending standards. But they are still fighting hard to gain market share, which is not surprising seeing it is the only game in town!