APRA approves ING Bank (Australia) Limited to use internal models to calculate regulatory capital

The Australian Prudential Regulation Authority (APRA) today announced that it has granted approval to ING Bank (Australia) Limited to begin using its internal models to determine its regulatory capital requirements for credit and market risk, commencing from the quarter ended 30 June 2018.

ING is the first authorised deposit-taking institution (ADI) to be accredited since APRA revised the accreditation process in 2015. Consistent with suggestions from the 2014 Financial System Inquiry, APRA’s changes were intended to make the process more accessible for ADIs to achieve accreditation, without weakening the overall standards that advanced accreditation requires.

APRA continues to engage with other ADIs seeking accreditation to use internal models for calculating regulatory capital requirements.

APRA Introduces First Anti-Cyber Attacks Prudential Standard

The Australian Prudential Regulation Authority (APRA) has responded to the growing threat of cyber attacks by proposing its first prudential standard on information security.

APRA today released a package of measures, titled Information Security Management: A new cross-industry prudential standard, for industry consultation. The package is aimed at shoring up the ability of APRA-regulated entities to repel cyber adversaries, or respond swiftly and effectively in the event of a breach.

The proposed new standard, CPS 234, would require regulated entities to:

  • clearly define the information security-related roles and responsibilities of the board, senior management, governing bodies and individuals;
  • maintain information security capability commensurate with the size and extent of threats to information assets, and which enables the continued sound operation of the entity;
  • implement information security controls to protect its information assets, and undertake systematic testing and assurance regarding the effectiveness of those controls;
  • have robust mechanisms in place to detect and respond to information security incidents in a timely manner; and
  • notify APRA of material information security incidents.

Executive Board Member Geoff Summerhayes said the draft standard built on prudential guidance first released by APRA in 2010 and backed it with the force of law.

“Australian financial institutions are among the top targets of cyber criminals seeking money or customer data, and the threat is accelerating,” Mr Summerhayes said.

“No APRA-regulated entity has experienced a material loss due to a cyber incident, but a significant breach is probably inevitable. In a worst-case scenario, a cyber attack could even force a company out of business.”

Key areas where APRA is hoping to lift standards include assurance over the cyber capabilities of third parties such as service providers, and enhancing entities’ ability to respond to and recover from cyber incidents.

“Cyber security is generally well-handled across the financial sector, but with criminals constantly refining and expanding their tools and capabilities, complacency is not an option,” Mr Summerhayes said.

“Implementing legally binding minimum standards on information security is aimed at increasing the safety of the data Australians entrust to their financial institutions and enhance overall system stability.”

Submissions on the package are open until 7 June. APRA intends to finalise the proposed standard towards the end of the year, with a view to implementing CPS 234 from 1 July next year.

Copies of the consultation package are available on APRA’s website at: http://www.apra.gov.au/CrossIndustry/Consultations/Pages/Information-security-requirements-Mar18.aspx

The findings of APRA’s latest cybersecurity survey can be found in the December 2017 issue of Insight.

Sold A Pup – The Bank Deposit Bail-In

Let’s talk about the bank bail-in conundrum.  A couple of weeks back I discussed whether bank deposits in Australia would be safe in a crisis. The video received more than 1,400 views so far, and has prompted a number of important questions from viewers. So today I update the story, and addresses some of the questions raised.  The bottom line though is I think we are being sold a pup, which by the way refers to a confidence trick originating in the Late Middle Ages!

Watch the video, or read the transcript.

First, a quick recap, for those who missed the first video. Officially, in Australia currently bank deposits are protected up to $250,000 per person by a Government Guarantee – The Financial Claims Scheme.  For banks, building societies and credit unions incorporated in Australia, the FCS provides protection to depositors up to $250,000 per account-holder per ADI according to APRA. Only deposit products provided by ADIs supervised by APRA were eligible to be covered. Amounts between $250,000 and $1 million are not be covered under the Guarantee Scheme. Above $1m banks can elect to pay a fee to the Government for this for protection, but none do. However, as we will see there are even questions about the sub $250k.  But note this, the FCS can only be activated by the Australian Government, whilst APRA is responsible for administering the Scheme.

The RBA says upon its activation, APRA aims to make payments to account-holders up to the level of the cap as quickly as possible – generally within seven days of the date on which the FCS is activated. The method of payout to depositors will depend on the circumstances of the failed ADI and APRA’s assessment of the cost-effectiveness of each option. Payment options include cheques drawn on the RBA, electronic transfer to a nominated account at another ADI, transfer of funds into a new account created by APRA at another ADI, and various modes of cash payments.

The amount paid out under the FCS, and expenses incurred by APRA in connection with the FCS, would then be recovered via a priority claim of the Government against the assets of the ADI in the liquidation process.  If the amount realised is   insufficient, the   Government   can   recover   the shortfall through a levy on the ADI industry. Ok, maybe in the case of a single failure

Now, since the Global Financial Crisis, regulators have been working on ways to avoid a tax payer based rescue in a crash, because for example, the UK’s Royal Bank of Scotland was nationalised in 2007. This cost tax payers dear, so regulators want measures put in place to try to manage a more orderly transition when a bank gets into difficulty.

The New Zealand the Open Bank Resolution (not to be confused with Open Banking) is the clearest example of a so called bail-in arrangement. Customer’s money, held as savings in a distressed bank can be grabbed to assist in a resolution in a time of crisis. The thinking behind it is simple. Banks need an exit strategy in case of a problem, and Government bail-outs should not be an option. So a manager can be appointed to manage through the crisis. They can use bank capital, other instruments, like hybrid bonds and deposits to create a bail-in. This approach to rescuing a financial institution on the brink of failure makes its creditors and depositors take a loss on their holdings. This is the opposite of a bail-out, which involves the rescue of a financial institution by external parties, typically governments using taxpayer’s money.

So what about Australia? Well, the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Bill 2017 is now law, having been through a Senate Inquiry. It all centers on the powers which were to be given to APRA to deal with a banking collapse.

In the bill, there is a phrase “any other instrument” in the list of bail-in items. Treasury said, “the use of the word ‘instrument’ is intended to be wide enough to capture any type of security or debt instrument that could be included within the capital framework in the future. It is not the intention that a bank deposit would be an ‘instrument’ for these purposes”. Yet, deposits were not expressly excluded.

In fact, when the Bill came back to Parliament it went through both houses with minimal discussion (and members on the floor, the chambers were all but empty). And despite a proposal being drafted and with Government Lawyers in parallel to exclude deposits, it was passed on 14th February without this change, leaving the door wide open under “any other instrument”. All the verbal assurances are meaningless.

So, the result appears to be APRA has wider powers now to handle a bank in crisis, and deposits are potentially accessible.  They are not expressly excluded, and in a time of crisis, could be bailed-in.

But this is not the end of the story. Treasurer Morrison issued a letter to Liberal government members with some talking points to justify this actions, in response to a wave of protests. But in so doing, he raises more questions.

The first point is that the Deposit Guarantee scheme (the one up to $250k) is not currently active. The Government would need to activate it, and can only do so when an institution fails.  This is important because it means that in theory at least, APRA could mount a deposit bail-in before the Government activates the deposit protection scheme. Consider what would happen if many banks all got into difficulty at the same time, as could be the case in a wider banking crisis – after all, they all have similar banking models.

The second point is that the Treasurer makes reference to the 1959 Banking Act, and says that depositors have a claim above other creditors in a bank failure. But in fact the 1959 Act says depositors do indeed rank ahead of other unsecured creditors, but that means the secured creditors come first. So would anything be left in case of a bank failure given the massive exposure to property?

Next, the letter says APRA has now enhanced powers to protect the interests of depositors – not deposits. And looking at the New Zealand situation the bail-in provisions there are framed to do just this, by utilising deposits to help keep the bank afloat, thus protecting depositors. The Reserve Bank of New Zealand says this is IN THE INTERESTS OF DEPOSITORS.

Oh, and finally, Morrison says the way the Bill went into Law was quite normal by being listed in the Senate Order of Business, meaning members had the opportunity to debate the bill if they had wanted to.  In fact, only seven Senators were there despite really needing a quorum of 19, but there is a get out in that a quorum is only needed if a division was called, and in this case it was simply nodded through. Democracy in action.

So there you have it. No Deposit Protection currently exists. Its limited to $250k per person if activated by the Government, at their discretion, and the legalisation leaves the door wide open for a New Zealand style of Bail-In. Not a good look.

So what should Savers do? Well, this is not financial advice, but the New Zealand view is that savers should make a risk assessment of banks and select where to deposit funds accordingly. But I am not sure how you do that, given the current low level of disclosures. APRA releases mainly aggregate data and protects the confidentially of individual banks as they are required to do under the APRA act.

Next, do not assume deposits are risk free, they are not. This means lenders should be offering rates of return more reflective of the risks we are taking, currently they are not (in fact deposit rates are sliding, as banks seek to repair margins).  You might consider spreading the risks across multiple institutions

Consider alternative savings options (which are limited). Clearly, property, stocks and shares and even crypto currencies are all risky – there are no safe harbours. I guess there is always the mattress.

One other point to make. Several people are calling a bill to bring a Glass-Steagall split between core banking operations and the speculative aspects of banking. Glass-Steagall was enacted in the US in 1933 after the great crash, separating commercial and investment banking and preventing securities firms and investment banks from taking deposits. But in 1999 the US Congress passed the Gramm–Leach–Bliley Act, also known as the Financial Services Modernization Act, to repeal them. Eight days later, President Bill Clinton signed it into law.  Following the financial crisis of 2007-2008, legislators unsuccessfully tried to reinstate Glass–Steagall Sections 20 and 32 as part of the Dodd–Frank Wall Street Reform and Consumer Protection Act. Both in the United States and elsewhere, banking reforms have been proposed that refer to Glass–Steagall principles. These proposals include issues of “ring fencing” commercial banking operations and narrow banking proposals that would sharply reduce the permitted activities of commercial banks.

The point of the bill was to isolate the risky bank behaviour, relating to derivatives and trading from core banking activities.  In the case of a banking crisis, triggered by a collapse in the financial markets such an arrangement would protect the operations of the core banking. We got a glimpse of that a month ago when US trading volatility shot through the roof.

But, in Australia, the bulk of the risks in the banking system comes not from the derivatives side of the business, but the massive exposure to household debt and the property sector, and the risky loans they have made. We discussed this on the ABC yesterday. More than 60% of all banking assets are aligned with home lending, plus more relating to commercial property. Thus I do not believe a Glass-Stegall type separation would help to mitigate risks to the banking sector here much at all.

Better to push for a definitive change to the APRA Bill and get deposits excluded from the risk of bail-in.  Or place a levy on all banks to directly protect depositors as has been put in place in Germany, where a dedicated government entity has been created for just this purpose.

What I find remarkable is that following loose banking regulation for years, during which the banks have returned massive profits to shareholders, and ramped up their risks, depositors are being lined up by the Government to bail out a failing bank. This is simply wrong.

APRA’s Latest On IO and Investment Loans

Wayne Byres, APRA chairman appeared before the Senate Economics Legislation Committee today.

During the session he said that the 10% cap on banks lending to housing investors imposed in December 2014 was “probably reaching the end of its useful life” as lending standards have improved. Essentially it had become redundant.

But the other policy which is a limit of more than 30% of lending interest only will stay in place. This more recent additional intervention, dating from March 2017, will stay for now, despite it being a temporary measure. The 30% cap is based on the flow of new lending in a particular quarter, relative to the total flow of new lending in that quarter.

This all points to tighter mortgage lending standards ahead, but still does not address the risks in the back book.

But the tougher lending standards which are now in place will be part of the furniture, plus the new capital risk weightings recently announced. Its all now focussing on loan serviceability, something which should have been on the agenda 5 years ago!

The evidence before the Senate on mortgage fraud is worth watching.

He also included some interesting and relevant charts.

Around 10% of new loans are still Loan to income is still tracking above 6 times loan to income.

This despite a fall in high LVR new loans.

The volume of new interest only loans is down, 20% of loans from the major banks are interest only, higher than other ADI’s

Overall investor loan growth is lower, in fact small ADI’s have slightly higher growth rates than the majors.

As a result of the changes the share of new interest only loans has dropped below the target 30%, to about 20%.

And investor loans are growing at less than 5% overall, significantly lower than previously.

So you could say the APRA caps have worked, but more permanent and calibrated measures are the future.

More broadly, here are his remarks:

I’d like to start this morning by highlighting the importance of the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Bill 2017 which – with the welcome endorsement of this Committee – was recently passed into law by the Parliament.

The Bill delivers a long-awaited and much needed strengthening of APRA’s crisis management powers, better equipping us to deal with a financial crisis and thereby to protect the financial well-being of the Australian community. Put simply, these powers give us enhanced tools to fulfil our key purpose in relation to banking and insurance: to protect bank depositors and insurance policyholders. That purpose is at the heart of all that we do, and the legislation is designed with that protection very much in mind.

With the Bill now passed, the task ahead for APRA is to invest in the necessary preparation and planning to make sure the tools within the new legislation can be effectively used when needed. We hope that is neither an imminent nor common occurrence, but we have much work to do in the period ahead to make sure we, along with the other agencies within the Council of Financial Regulators that will be part of any crisis response, have done the necessary homework to use these new powers effectively when the time comes.

So that is one key piece of work for us in the foreseeable future. But it is far from the only issue on our plate. With the goal of giving industry participants and other stakeholders more visibility and a better understanding of our work program, we released a new publication in January this year outlining our policy priorities for the year ahead across each of the industries we supervise.1 Initial feedback has welcomed this improved transparency of the future pipeline of regulatory initiatives, and the broad timeline for them.

That publication is one example of our ongoing effort to improve our processes of engagement and consultation with the financial sector and other stakeholders. Another prominent example is that we’ve just embarked on our most substantial program of industry engagement to date as we seek input into the design and implementation of our next generation data collection tool.2 Through this process, which we launched on Monday this week, all of our stakeholders will have an opportunity to tell us – at an early stage of its design – what they would like to see the new system deliver, as well as influence how we roll it out.

More generally, and recognising the increased expectations of all public institutions, I thought it would also be timely to briefly recap the ways APRA is accountable for the work we do supervising financial institutions for the benefit of the Australian community. At a time when Parliament has moved to strengthen APRA’s regulatory powers, we fully accept that these accountability measures take on added importance. They play a crucial role in reassuring all of our stakeholders that APRA is acting at all times according to our statutory mandate.

APRA’s accountability measures are many and varied. They start with the obvious measures such as our Annual Report, our Corporate Plan and Annual Performance Statement, and our assessment against the Government’s Regulator Performance Framework. We obviously also make regular appearances before Parliamentary committees such as this to answer questions about our activities, and now meet with the Financial Sector Advisory Council in their role reporting on the performance of regulators. Our annual budget, and the industry levies that fund us, are set by the Government, which also issues us a Statement of Expectations as to how we should approach our role. We comply with the requirements of the Office of Best Practice Regulation in our making of regulation, and our prudential standards for banking and insurance may be disallowed by Parliament, should it so wish.

To give greater visibility to these mechanisms, we have recently set out an overview of our accountability requirements – including some that we impose on ourselves – on our website so that they can be better understood by our stakeholders.3

I’d like to also note that we will be subject to additional scrutiny this year through two other means:

  • We expect that aspects of APRA’s activities will be of interest to the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. We have already provided, at their request, documents and information to the Commission, and will continue to cooperate fully as it undertakes its important work.
  • We will be subject to extensive international scrutiny from the IMF over the year ahead as part of its 2018 Financial Sector Assessment Program (FSAP).4 The FSAP will look at financial sector vulnerabilities and regulatory oversight arrangements in Australia, providing a report card on Australia (and APRA in particular) against internationally-accepted principles of sound prudential regulation. As was the case previously, we expect the IMF to find things we could do better. APRA is ready, along with other members of the regulatory community, to give the IMF our full cooperation and look forward to their feedback.

Finally, time does not permit me to discuss our on-going work in relation to housing lending but, anticipating some questions on this issue, I have circulated some charts which might be helpful for any discussion (see attached).

With those opening remarks, we would now be happy to answer the Committee’s questions.

Mortgage Lending Sags In January

The latest APRA Monthly Banking Statistics to January 2018 tells an interesting tale. Total loans from ADI’s rose by $6.1 billion in the month, up 0.4%.  Within that loans for owner occupation rose 0.57%, up $5.96 billion to $1.05 trillion, while loans for investment purposes rose 0.04% or $210 million. 34.4% of loans in the portfolio are for investment purposes. So the rotation away from investment loans continues, and overall lending momentum is slowing a little  (but still represents an annual growth rate of nearly 5%, still well above inflation or income at 1.9%!)

Our trend tracker shows the movements quite well. (August 2017 contained a large adjustment.

Looking at the lender portfolio, we see some significant divergence in strategy.  Westpac is still driving investment loans the hardest, while CBA and ANZ portfolios have falling in total value, with lower new acquisitions and switching. Bank of Queensland and Macquarie are also lifting investment lending.

The market shares are not moving that much overall, with CBA still the largest OO lender, and Westpac the largest Investor lender.

Looking at investor portfolio movements for the past year, again significant variations with some smaller players still above the 10% speed limit, but the majors all well below (and some in negative territory).

We will report on the RBA data later on, which gives us an overall market view.

Did You Know How Big The IO Mortgage Book Is?

OK, so there has been lots of noise about the Mortgage Interest Only Exposures the banks have, and both APRA and the RBA say they are potentially risky, compared with Principal and Interest Loans. We already showed that conservatively $60 billion of IO loans will fail current underwriting standards.   That is more than 10% of the portfolio.

But how many loans are interest only, and what is the value of these loans? A good question, and one which is not straightforward to answer, as the monthly stats from the RBA and ABS do not split out IO loans. They should.

The only public source is from APRA’s Quarterly Property Exposures, the next edition to December 2017 comes out in mid March, hardly timely. So we have to revert to the September 2017 data which came out in December. This data is all ADI’s with greater than $1 billion of term loans, and does not include the non-bank sector which is not reported anywhere!

They reported that 26.9% of all loans, by number of loans were IO loans, down from a peak of 29.8% in September 2015. They also reported the value of these loans were 35.4% of all loans outstanding, down from a peak of 39.5% in September 2015.

So, what does this trend look like. Well the first chart shows the value of loans in Sept 2017 was $549 billion, down from a peak of $587 billion in March 2017. The number of loans outstanding was 1.56 million loans, down from a peak of 1.69 million loans in December 2016.

If we plot the trends by number of loans and value of loans, we see that the value exposed is still very high.

Finally, the average loan size for IO loans is significantly higher at $347,000 compared with $264,300 for all loans. Despite the fall in volume the average loan size is not falling (so far).

The point is the regulatory intervention is having a SMALL effect, and there is a large back book of loans written, so the problem is risky lending has not gone away.


Moody’s On APRA’s Credit Reforms

Last Wednesday, the Australian Prudential Regulation Authority (APRA) proposed key revisions to its capital framework for authorized deposit taking institutions (ADIs). The revisions cover the calculation of credit,
market and operational risks. These proposed changes are credit positive for Australian ADIs because they will improve the alignment of capital and asset risks in their loan portfolios. Moody’s says the key proposals are as follows:

  • Revisions to the capital treatment of residential mortgage portfolios under the standardized and advanced approaches, with higher capital requirements for higher-risk segments
  • Amendments to the treatment of other exposures to improve the risk sensitivity of risk-weighted asset outcomes by including both additional granularity and recalibrating existing risk weights and credit
    conversion factors for some portfolios
  • Additional constraints on the use of ADIs’ own risk parameter estimates under internal ratings-based approaches to determine capital requirements for credit risks and introducing an overall floor to riskweighted assets for ADIs using the standardized approach
  • Introduction of a single replacement methodology for the current advanced and standardized approaches to operational risks
  • Introduction of a simpler approach for small, less complex ADIs to reduce the regulatory burden without compromising prudential soundness

A particularly significant element of the new regime is a reform of the capital treatment of residential mortgages, given that more than 60% of Australian banks’ total loans were residential mortgages as of January 2018.

The improved alignment of capital to risk for residential mortgages will come from hikes in risk weights on several higher-risk loan segments. APRA proposes increased risk weights for mortgages used for investment purposes, those with interest-only features and those with higher loan-to-valuation ratios (LVR). At the same time, risk weights for some lower-risk segments likely will drop. For example, under the standardized approach, standard mortgages with LVR ratios lower than 80% will require risk weights of only 20%-30%, down from 35% under current requirements.

The higher capital charges on investment loans will better reflect their higher sensitivity to economic cycles. During periods of economic strength investment loans perform well. As Exhibit 1 shows, on a national basis
and during a time of strong economic growth, defaults on investment loans have been lower than owner occupier loans.

However, in Western Australia, where the economy has deteriorated following the end of the investment boom in resources, defaults on investment loans have been higher than owner-occupier loans, as Exhibit 2 shows.

Investment loans also are sensitive to the interest rate cycle. During periods of rising interest rates, investment loans tend to experience higher default rates than owner-occupier loans, as shown in Exhibit 3.

Turning The Screws On Mortgage Lending – The Property Imperative Weekly 17th Feb 2018

Listen, You Can Hear the Screws Tightening On Mortgage Lending.  Welcome to The Property Imperative Weekly to 17th February 2018.

Watch the video, or read the transcript.

In this week’s digest of finance and property news we start with Governor Lowe’s statement to the House of Representatives Standing Committee on Economics.  He continued the themes, of better global economic news, lifting business investment and stronger employment on one hand; but weak wage growth, and high household debt on the other. But for me one comment really stood out. He said:

it would be a good outcome if we now experienced a run of years in which the rate of growth of housing costs and debt did not outstrip growth in our incomes in the way that they did over the past five years.

This is highly significant, given the fact the lending for housing is still growing faster than wages, at around three times, and home prices are continuing to drift a little lower. So don’t expect any moves from the Reserve Bank to ease lending conditions, or expect a boost in home prices. More evidence that the property market is indeed in transition. The era of strong capital appreciation is over for now.

There was lots of news this week about the mortgage industry. ANZ and Westpac have tightened serviceability requirements.  Westpac recently introduced strict tests of residential property borrowers’ current and future capacities to repay their loans. The change is said to be intended to identify scenarios that might affect borrowers’ capacity to pay back their loans. These scenarios include having dependents with special needs that might require borrowers to spend on long-term care and treatment. ANZ has added “a higher level of approval for some discretions” used in its home loan policy for assessing serviceability, reducing approvals outside normal terms.

Talking of lending standards, APRA released an important consultation paper on capital ratios. This may sound a dry subject, but the implications for the mortgage industry and the property market are potentially significant.  As part of the discussion paper, APRA, says that addressing the systemic concentration of ADI portfolios in residential mortgages is an important element of the proposals. They have FINALLY woken up to the risks in the system, just years too late!  We have significant numbers of loans in the system currently that would now not pass muster. More about that next week.

Their proposals, which focus in on mortgage serviceability, would change the industry significantly, as lower risk loans will be more highly prized (so expect low rate offers for lower LVRs), whilst investment loans, and interest only loans are likely to cost more and be harder to find. Combined this could certainly move the market!  The proposals introduce “standard” and “non-standard” risk categories.

As well as increasing the risk weights for some mortgages, they also continue to close the gap between the advanced (IRB) internal approach used by large lenders, and the standard approach used by smaller players. Those in transition (e.g. Bendigo Bank) may find less of an advantage in moving to advanced as a result. You can watch our separate video on this important topic.

Whilst the overall capital ratios will not change much, there is a significant rebalancing of metrics, and Banks will more investment and interest only loans will be most impacted.  So getting an investment loan will be somewhat harder and this will impact the property market. The proposals are for consultation, with a closing data 18 May 2018.

Another data point on the property market came from a new report by Knight Frank which claims that in 2017, one-third of Australian residential development sites were sold to Chinese investors and developers. The share of sales to Chinese buyers has tripled since 2013, but decreased from the 38 per cent recorded in 2016. The level of Chinese investment in residential development sites varied from state to state: in Victoria, 38.7 per cent of residential site sales were to Chinese buyers; in New South Wales, 35.6 per cent of residential site sales were to Chinese buyers, and in Queensland, Chinese buyers comprised 7.4 per cent of total residential site sale volumes. So this is one factor still supporting the market, though in Australia, the Australian Prudential Regulatory Authority has encouraged local financial institutions to impose stricter controls, while in China the government has attempted to moderate capital outflow with China’s Central Bank imposing new rules for companies which make yuan-denominated loans to overseas entities.

The data from the ABS on Lending Finance, the last part of the finance stats for December, really underscores the slowing momentum in investment property lending, especially in Sydney (though it is still a significant slug of new finance, and there is no justification to ease the current regulatory requirements.) The ABS says the total value of owner occupied housing commitments excluding alterations and additions rose 0.1% in trend terms, total personal finance commitments fell 0.2%. Revolving credit commitments fell 1.4%, while fixed lending commitments rose 0.5%. There was a small rise in lending for housing construction, but overall mortgage momentum looks like it is still slowing and the mix of commercial lending is tilting away from investment lending and towards other commercial purposes at 64%, which is a good thing.

There is an air of desperation from the construction sector, as sales momentum continues to ease, this despite slightly higher auction clearance rates last week. CoreLogic said the final auction clearance rate was 63.7 per cent clearance rate across almost double the volume of auctions week-on-week (1,470). Over the week prior, a clearance rate of 62.0 per cent was recorded across 790 auctions. Both auction clearance rate and volumes were lower than what was seen one year ago, when a 73.2 per cent clearance was recorded across 1,591 auctions. There is significant discounting going on at the moment to shift property, and some builders are looking to lend direct to purchases to make a sale. For example, Catapult Property Group launched a new lending division that will help first home buyers get home loans with a deposit of only $5,000. The Brisbane-based company encourages first home buyers in Queensland to enter the real estate market now by taking advantage of the state government’s $20,000 grant that is ending on 30 June 2018. This is at a time when lenders are insisting on larger deposits, and are applying more conservative underwriting standards.

Economic data out this week showed that according to the ABS, trend unemployment remained steady at 5.5%, where it has hovered for the past seven months.  The trend unemployment rate has fallen by 0.3 percentage points over the year but has been at approximately the same level for the past seven months, after the December 2017 figure was revised upward to 5.5 per cent. The ABS says that full-time employment grew by a further 9,000 persons in January, while part-time employment increased by 14,000 persons, underpinning a total increase in employment of 23,000 persons. The fact is that while more jobs are being created, it is not pulling the rate lower, and many of these jobs are lower paid part time roles – especially in in the healthcare sector. In fact, the growth in employment is strong for women than men.  A rather different story from the current political spin!

In a Banking Crisis, are Bank Deposits Safe? We discussed the consequences of recently introduced enhanced powers for APRA to deal with a bank in distress this week. There were several well publicised Government bail-out’s of banks which got into problems after the GFC. For example, the UK’s Royal Bank of Scotland was nationalised. This costs tax payers dear, so there were measures put in place to try to manage a more orderly transition when a bank gets into difficulty and raises the question of “Bail-in” arrangements.  Take New Zealand for example. There regulators have specific powers to grab savings held in the banks in assist in an orderly transition in the case of a failure, alongside capital and other bank assets.  And, given the New Zealand position (and the tight relationship between banking regulators in Australia and New Zealand), we should look at the position in Australia.  Are deposit funds in Australia likely to be “bailed-in”? Well, the Treasury confirmed that because deposits are not classified as capital instruments, and do not include terms that allow for their conversion or write-off, they cannot be ‘bailed-in’. But we have a catch all clause in APRA’s powers that says they can grab “any other instrument” and deposits, despite the Treasury reassuring words, is not explicitly excluded. So I for one cannot be 100% convinced savings will never be bailed-in. And that’s a worry! I recall the Productivity Commission comment last week, that financial stability had taken prime place compared with competition (and so customer value) in financial services. The issue of bail-in of deposits appears to be shaping the same way. You can watch our separate video discussion on this important topic.

The first round of public hearings for the Banking Royal Commission will focus on lending, including mortgages, credit cards and car loans; we heard during the opening session. The Commission highlighted the large size of the lending market, and the significant number of submissions they have already received on misconduct in this area, including relating to intermediaries, commission and advice. In addition, as part of the opening address, we were told that some of the major players were unable to provide the full range of misconduct information that Commission requested. Some players offered a few case studies, and were then asked to provide more detail over the past 5 years (as opposed to 10) but said they could not meet the required deadline. Based on the opening round, Banks are going to find this a painful process. Not least because The Commission is publishing information on the sector. In its first release, it pointed to declining competition in the banking sector, with the number of credit unions falling due to consolidation and the major banks holding 75 per cent of total assets held by ADIs in Australia. The paper noted that five of the 20 listed companies that make up the ASX20 are banks, noting that the major banks have “generally achieved higher profit margins than other types of ADIs” with a profit margin of 36.4 per cent in the June quarter 2017. They also underscored that Australia’s major banks are “comparatively more profitable” than some of their international peers in Canada, Sweden, Switzerland and the UK.

We expect to hear more from the Royal Commissions on unfair and predatory practices. To underscore this there was some good news for Credit Card holders, with new legalisation passed in parliament to force Credit card providers to scrap unfair and predatory practices. However, the implementation timetable is extended into 2019. The reforms include:

Requiring affordability assessments be based on a consumer’s ability to repay the credit limit within a reasonable period (from July 2018).  This tightens responsible lending obligations for credit card contracts.

Banning unsolicited offers of credit limit increases (from January 2019). At the moment, whilst the law forbids providers from making these sorts of offers in writing, offers can be made by phone and other mediums. This loophole has been exploited, but will now be closed.

Simplifying how credit card interest is calculated, especially, banning the practice of backdating interest rate charges. Currently, some providers were attracting new customers with promotional low rate, or no rate offers, say for the first month. But, if a customer failed to pay off in full a credit card bill after the first month, the credit card company was often retrospectively applying the new interest rate to previous purchases. This was allowed in the banks’ small print, but the government said the practice did “not align with consumers’ understanding and expectation about how interest is to be charged”. This will be banned, from next year.

Requiring credit card providers to have online options to cancel cards or to reduce credit limits (from January 2019). At the moment, some card providers force customers to come into a bank branch to reduce limits or terminate cards, and when they did come in were often persuaded not to do it. The asymmetry between fast credit card approvals online, and slow cancellation will end.

So another week highlighting the stresses and strains in the banking sector, and the forces behind slowing momentum in the property market. And based on the stance of the regulators, we think the screws will get tighter in the months ahead, putting more downward pressure on mortgage lending home prices and the Banking Sector. Something which the RBA says is a good thing!

APRA Homes In On Mortgage Risk

As part of the discussion paper, released today APRA, says that addressing the systemic concentration of ADI portfolios in residential mortgages is an important element of the proposals. They have FINALLY woken up to the risks in the system, just years too late!  We have significant numbers of loans in the system currently that would now not pass muster.

These proposals, which focus in on mortgage serviceability, would change the industry significantly, as lower risk loans will be more highly prized (so expect low rate offers for lower LVRs), whilst investment loans, and interest only loans are likely to cost more and be harder to find. Combined this could certainly move the market!  The proposals introduce “standard” and “non-standard” risk categories.

The proposals are for consultation, with a closing data 18 May 2018.

As well as increasing the risk weights for some mortgages, they also continue to close the gap between the advanced (IRB) internal approach used by large lenders, and the standard approach used by smaller players. Those in transition (e.g. Bendigo Bank) may find less of an advantage in moving to advanced as a result.

Also they are proposing some simplification for small ADI’s as the cost of these measures may outweigh the benefit to prudential safety. Proportionate and tailored requirements for small ADIs could reduce regulatory burden without compromising prudential safety and soundness. Calibration of a simpler regime would be broadly aligned to the more complex regulatory capital framework, yet would be designed to suit the size, nature, complexity and risk of small ADIs.

Here are some of the key paragraphs from their paper.

APRA’s view is that there are potential systemic vulnerabilities to the financial system created from high levels of residential mortgage lending for investment purposes. As noted by the RBA, investment lending can amplify borrowing and house pricing cycles:

Periods of rapidly rising prices can create the expectation of further price rises, drawing more households in the market, increasing the willingness to pay more for a given property, and leading to an overall increase in household indebtedness.

Similarly, the significant share of interest-only housing lending, including to owner-occupiers, is a structural feature that increases the risk profile of the Australian banking system. Interest-only borrowers face a longer period of higher indebtedness, increasing the risk of falling into negative equity should housing prices fall.  Borrowers may also use interest-only loans to maximise leverage, or for short-term affordability reasons.  Even though loan servicing ability (serviceability) is now tested at levels that include the subsequent principal repayments, borrowers may face ‘payment shock’ when the interest-only period ends and regular repayments increase, in some cases significantly. This payment shock is particularly acute when interest rates are low.

Over the past two decades, residential mortgages in Australia as a share of ADIs’ total loans have increased significantly, from just under half to more than 60 per cent. While losses incurred on residential mortgage portfolios in this period have been limited, this level of structural concentration poses prudential and financial stability risks, particularly in an environment of high household debt, high property prices, weak income growth and strong competitive pressures among lenders. In such circumstances, households, individual ADIs and the broader banking sector are vulnerable to economic shocks.

Similar to other jurisdictions facing comparable risks, APRA has undertaken a series of actions to help contain the risks associated with ADIs’ residential mortgage portfolios. These actions include promoting significantly strengthened loan underwriting practices, increasing the amount of capital held by IRB ADIs for residential mortgage exposures and establishing benchmarks to moderate lending for property investment and lending on an interest-only basis. As set out in APRA’s July 2017 information paper on unquestionably strong capital, APRA also intends to further strengthen capital requirements for residential mortgage lending to reflect the concentration risk it poses to the banking sector.

A key focus is the appropriate capital requirement for investment and interest-only mortgage loans. Although, as a class, investment loans have typically performed well under normal economic conditions in Australia, this segment has not been tested in a nationwide downturn. Further, an increasing proportion of highly indebted households own investment property relative to past economic cycles. Experience in the United Kingdom and Ireland during the global financial crisis, for example, showed that previously better-performing investment loans can fall into arrears in higher volumes than loans to owner-occupiers in times of stress.

So now they propose to target higher-risk residential mortgage lending, balanced against the need to avoid undue complexity. Under the proposals, residential mortgage exposures would be segmented into the following categories with different capital requirements applying to each segment:

  • loans meeting serviceability requirements made to owner-occupiers where the borrower’s repayment is on a principal and interest (P&I) basis;
  • loans meeting serviceability requirements made for investment purposes or where the borrower’s repayment is on an interest-only basis; and
  • other residential property exposures, including those that do not meet serviceability requirements.

Specifically, for the standard approach, APRA proposes that APS 112 would require ADIs to designate as non-standard eligible mortgages those where the ADI:

  • did not include an interest rate buffer of at least two percentage points and a minimum floor assessment interest rate of at least seven per cent in the serviceability methodology used to approve the loan;
  • did not verify that a borrower is able to service the loan on an ongoing basis (i.e. positive net income surplus); and
  • approved the loan outside the ADI’s loan serviceability policy.

APRA is also considering excluding certain other categories of loans considered higher risk from the definition of standard eligible mortgages, such as those with very high multiples of a borrower’s income.

APRA proposes to formalise through amendments to APS 112 its existing requirement that loans to self-managed superannuation funds secured by residential property should be treated as non-standard loans, reflecting the relative complexity of these loans and the fact that ADIs do not have recourse to other assets of the fund or to the beneficiary.

APRA also proposes that reverse mortgages, which are currently risk-weighted at 50 per cent (where LVR is less than 60 per cent) or 100 per cent (for LVRs over 60 per cent), would be treated as non-standard in light of the heightened operational, legal and reputational risks associated with these loans.

Subject to final calibration, APRA proposes that all non-standard eligible mortgages would be subject to a risk weight of 100 per cent.

APRA proposes to segment the standard eligible mortgage portfolio into lower-risk and higher-risk exposures in addition to assigning risk weights according to LVR. This approach is aligned to, but deliberately not strictly consistent with, the Basel III ‘material dependence’ concept, to appropriately reflect Australian conditions.

For the lower-risk segment, APRA proposes to broadly align the risk weights with those under the Basel III framework loans where repayments are not materially dependent on cash flows generated by the property securing the loan. This category would include owner-occupied P&I loans and would apply after consideration of any lenders mortgage insurance (LMI).

The higher-risk segment would include interest-only loans, loans for investment property and loans to SMEs secured by residential property. The determination of higher risk weights for this segment would be either by way of a fixed risk-weight schedule, or a multiplier on the risk weights applied to owner-occupied P&I loans. The benefit of a multiplier is that APRA could more easily vary the capital uplift for these higher risk loans over time depending on prevailing prudential or financial stability objectives or concerns.

Table 3 shows the indicative proposed risk-weight schedule based on the Basel III risk weights for materially dependent residential mortgage exposures.

APRA is also considering whether exposures to individuals with a large investment portfolio (such as those with more than four residential properties) would be treated as non-standard residential mortgage loans or as loans secured by commercial property. APRA invites feedback on this issue.

APRA expects to continue to incorporate relatively lower capital requirements in the standardised approach for exposures covered by LMI. LMI can reduce the risk of loss for an ADI, subject to meeting the insurer’s conditions for valid claims and the financial capacity of the LMI to pay claims. APRA is considering the appropriate methodology to recognise LMI in the capital framework for both the standardised and IRB approaches. For the standardised approach to credit risk, APRA expects that any capital benefit would continue to apply to loans with an LVR over 80 per cent. APRA’s preferred approach is to increase the Table 3 risk weights (as finally calibrated) for standard loans with an LVR over 80 per cent that do not have LMI. For the IRB approach, APRA is considering potential options for the recognition of LMI.

For IRB Bank (those using their own internal models, APRA believes that material changes are required in Australia in order to:

  • improve the alignment of capital requirements with risk for particular exposures;
  • further address the FSI recommendation that the difference in average mortgage risk weights between the standardised and IRB approaches is narrowed; and
  • ensure an appropriate overall calibration of capital for residential mortgage exposures given the concentration of IRB ADI portfolios in this segment.

On their own, however, these IRB mortgage risk-weight functions are not expected to result in a sufficient level of capital to meet APRA’s objectives for increased capital for residential mortgage exposures. However, any further increase in correlation for the IRB mortgage risk-weight function creates inconsistencies with correlation factors for other asset classes.

As a result, other adjustments are likely to be necessary to meet unquestionably strong capital expectations. For residential mortgages, this is expected to be through additional RWA overlays on top of the outputs of the IRB risk-weight function, including both an overlay specifically for residential mortgages and an overlay for total RWA.

The exact form and size of these overlays will be determined after APRA has completed its QIS analysis. In determining final calibration of the regulatory capital requirement for residential mortgage exposures, APRA will consider the appropriate difference in the average risk weights under the IRB and standardised approaches, consistent with recommendation 2 of the FSI. As detailed in the final report of the FSI, given the IRB approach is more risk sensitive, some difference between the average risk weights for residential mortgage exposures under the different approaches to credit risk may be justified; however, it should not be of a magnitude to create unwarranted competitive distortions.

SME exposures secured by residential property that meet certain serviceability criteria would be included in the same category of exposures as residential mortgages for investment purposes and interest-only loans.

In APRA’s experience, these exposures have historically had higher losses than non-SME owner-occupier residential mortgage exposures.

For SME exposures that are not secured by property, APRA proposes to reduce the 100 per cent risk weight currently applied under APS 112 to 85 per cent. This gives some recognition to the various types of collateral, other than property, that SMEs provide as security. APRA does not propose to implement the Basel III 75 per cent risk weight for retail SME exposures, as there is insufficient empirical evidence that retail SME exposures in Australia exhibit a lower default or loss experience through the cycle than corporate SME exposures. SME exposures in this category would be limited to corporate entities where consolidated group sales are less than or equal to $50 million.


APRA Kicks Off Capital Framework Discussion

The Australian Prudential Regulation Authority (APRA) has released two discussion papers for consultation with authorised deposit-taking institutions (ADIs) on proposed revisions to the capital framework.

The key proposed changes to the capital framework include:

  • lower risk weights for low LVR mortgage loans, and higher risk weights for interest-only loans and loans for investment purposes, than apply under APRA’s current framework;
  • amendments to the treatment of exposures to small- to medium-sized enterprises (SME), including those secured by residential property under the standardised and internal ratings-based (IRB) approaches;
  • constraints on IRB ADIs’ use of their own parameter estimates for particular exposures, and an overall floor on risk weighted assets relative to the standardised approach; and
  • a single replacement methodology for the current advanced and standardised approaches to operational risk.

The paper also outlines a proposal to simplify the capital framework for small ADIs, which is intended to reduce regulatory burden without compromising prudential soundness.

The papers include proposed revisions to the capital framework resulting from the Basel Committee on Banking Supervision finalising the Basel III reforms in December 2017, as well as other changes to better align the framework to risks, including in relation to housing lending. APRA is also releasing a discussion paper on implementation of a leverage ratio requirement.

In the papers released today, APRA is not seeking to increase capital requirements beyond what was already announced in July 2017 as part of the ‘unquestionably strong’ benchmarks.

During the process of consultation, APRA will undertake further analysis of the impact of these proposed changes on ADIs. This analysis will include a quantitative impact study, which will be used to, where necessary, calibrate and adjust the proposals released today.

APRA Chairman Wayne Byres said that, taken together, the proposed changes are designed to lock in the strengthening of ADI capital positions that has occurred in recent years.

“These changes to the capital framework will ensure the strong capital position of the ADI industry is sustained by better aligning capital requirements with underlying risks. However, given the ADI industry is on track to meet the ‘unquestionably strong’ benchmarks set out by APRA last year, today’s announcement should not require the industry to hold additional capital overall,” Mr Byres said.

APRA has also released today a discussion paper on implementing a leverage ratio requirement for ADIs. The leverage ratio is a non-risk based measure of capital strength that is widely used internationally. A minimum leverage ratio of three per cent was introduced under Basel III, and is intended to operate as a backstop to the risk-weighted capital framework. Although the risk-based capital measures remain the primary metric of capital adequacy, APRA has previously indicated its intention to implement a leverage ratio requirement in Australia. This approach was also recommended by the Financial System Inquiry in 2014.

APRA is proposing to apply a higher minimum requirement of four per cent for IRB ADIs, and to implement the leverage ratio as a minimum requirement from July 2019.

In addition to the two papers released today, APRA will later this year release a paper on potential adjustments to the overall design of the capital framework to improve transparency, international comparability and flexibility.