CBA announces major lending changes

From The Adviser.

CBA has today revealed a raft of changes including LVR caps and restrictions to rental income for serviceability that will impact mortgage brokers and their clients from next week.

On Saturday (2 December) CBA will introducing a new Home Loan Written Assessment document called the Credit Assessment Summary (CAS) for all owner occupied and investment home loan and line of credit applications solely involving personal borrowers.

“These changes further strengthen our responsible lending commitments related to the capture and documentation of customer information,” the bank said.

“The CAS will present a summary of the information you provided on behalf of your borrower(s) and / or that the Bank has verified (where relevant) and used to complete its credit assessment.”

It will include a summary of loan requirements and objectives, personal details and financial information, total monthly living expenses at a household level and information about the credit applied for.

CBA said the CAS will form part of the loan offer document packs for all owner occupied and investment home loan and line of credit applications.

“The CAS will not be issued for Short Form Top Up applications or applications involving non-person applicants (i.e. Trust or Company). The Document Checklist, which is on the last page of the Covering Letter to Borrower (Full Pack), will indicate when a CAS has been issued,” the group said.

“An application exception will be raised if the CAS is not returned or not signed by all personal borrowers. The application will not progress to funding until the exception is resolved.”

LVR and postcode restrictions

Meanwhile, CBA confirmed that it will introduce credit policy changes for certain property types in selected postcodes from Monday 4 December.

The changes include reducing the maximum LVR without LMI from 80 per cent to 70 per cent, reducing the amount of rental income and negative gearing eligible for servicing and changing eligibility for LMI waivers including all Professional Packages and LMI offers for customers financing security types in some postcodes.

“We continue to lend in all postcodes across Australia,” CBA said.

However, on Monday the bank will also introduce what it has called the Postcode Lookup Tool, which will be available under the Tools and Calculators section on CommBroker.

“This tool will provide you with detail on policies that may apply in certain areas. You should use this tool during your customer discussions to understand policies that may apply to postcodes in which they have expressed a home lending need. If policies apply, you should discuss these with your customers,” the bank said.

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.”

NZ Reserve Bank Consults On DTI Restrictions

The NZ Reserve Bank has released its consultation paper on possible DTI restrictions. The 36+ page report is worth reading as it sets out the risks ensuring from high risk lending, leveraging experience from countries such as Ireland.

Interestingly they build a cost benefit analysis, trading off a reduction in the costs of a housing and financial crisis with a reduction in the near-term level of economic activity as a result of the DTI initiative and the cost to some potential homebuyers of having to delay their house purchase.

Submissions on this Consultation Paper are due by 18 August 2017.

In 2013, the Reserve Bank introduced macroprudential policy measures in the form of loan to-value ratio (LVR) restrictions to mitigate the risks to financial system stability posed by a growing proportion of residential mortgage loans with high LVRs (i.e. low deposit or low equity loans). This increase in borrower leverage had gone hand-in-hand with significant increases in house prices, particularly in Auckland. The Reserve Bank’s concern was the possibility of a sharp fall in house prices, in adverse economic circumstances where some borrowers had trouble servicing loans. Such an event had the potential to undermine bank asset quality given the limited equity held by some borrowers.

The Reserve Bank believes LVR restrictions have been effective in reducing the risk to financial system stability that can arise due to a build-up of highly-leveraged housing loans on bank balance sheets. However, LVRs relate mainly to one dimension of housing loan risk. The other key component of risk relates to the borrower’s capacity to service a loan, one measure of which is the debt-to-income ratio (DTI). All else equal, high DTI ratios increase the probability of loan defaults in the event of a sharp rise in interest rates or a negative shock to borrowers’ incomes. As a rule, borrowers with high DTIs will have less ability to deal with these events than those who borrow at more moderate DTIs. Even if they avoid default, their actions (e.g. selling properties because they are having difficulty servicing their mortgage) can increase the risk and potential severity of a housing related economic crisis.

While the full macroprudential framework will be reviewed in 2018, the Reserve Bank has elected to consult the public prior to the review. This consultation concerns the potential value of a policy instrument that could be used to limit the extent to which banks are able to provide loans to borrowers that are a high multiple of the borrower’s income (a DTI limit). A number of other countries have introduced DTI limits in recent years, often in association with LVR restrictions. In 2013, the Bank and the Minister of Finance agreed that direct, cyclical controls of this sort would not be imposed without the tool being listed in the Memorandum of Understanding on Macroprudential Policy (the MoU). Hence, cyclical DTI limits will only be possible in the future if an amended MoU is agreed.

The purpose of this consultation is for the Reserve Bank, Treasury and the Minister of Finance to gather feedback from the public on the prospect of including DTI limits in the Reserve Bank’s macroprudential toolkit.

Throughout the remainder of the document we have listed a number of questions, but feedback can cover other relevant issues. Information provided will be used by the Reserve Bank and Treasury in discussing the potential amendment of the MoU with the Minister of Finance. We present evidence that a DTI limit would reduce credit growth during the upswing and reduce the risk of a significant rise in mortgage defaults during a subsequent severe economic downturn. A DTI limit could also reduce the severity of the decline in house prices and economic growth in that severe downturn (since fewer households would be forced to sharply constrain their consumption or sell their house, even if they avoided actual default). The strongest evidence that these channels could materially worsen an economic downturn tends to come from countries that have experienced a housing crisis in recent history (including the UK and Ireland). The Reserve Bank believes that the use of DTI limits in appropriate circumstances would contribute to financial system resilience in several ways:

– By reducing household financial distress in adverse economic circumstances, including those involving a sharp fall in house prices;
– by reducing the magnitude of the economic downturn, which would otherwise serve to weaken bank loan portfolios (including in sectors broader than just housing); and
– by helping to constrain the credit-asset price cycle in a manner that most other macroprudential tools would not, thereby assisting in alleviating the build-up in risk accompanying such cycles.

The policy would not eliminate the need for lenders and borrowers to undertake their own due diligence in determining that the scale and terms of a mortgage are suitable for a particular borrower. The focus would be systemic: on reducing the risk of the overall mortgage and housing markets becoming dysfunctional in a severe downturn, rather than attempting to protect individual borrowers. The consultation paper notes that DTIs on loans to New Zealand borrowers have risen sharply over the past 30 or so years, with further increases evident since 2014. This partly
reflects the downward trend in interest rates over the period. However, interest rates may rise in the future. While the Reserve Bank is continuing to work with banks to improve this data, the available data also show that average DTIs in New Zealand are quite high on an international basis, as are New Zealand house prices relative to incomes.

Other policies (such as boosting required capital buffers for banks, or tightening LVR restrictions further) could be used to target the risks created by high-DTI lending. The Bank does not rule out these alternative policies (indeed, we are currently undertaking a broader review of capital requirements in New Zealand) but consider that they would not target our concerns around mortgage lending as directly or effectively. For example, while higher capital buffers would provide banks with more capacity to withstand elevated housing loan defaults, they would do little to mitigate the feedback effects between falling house prices, forced sales and economic stress.

The Reserve Bank has stated that it would not employ a DTI limit today if the tool was already in the MoU (especially given recent evidence of a cooling in the housing market and borrower activity), it believes a DTI instrument could be the best tool to employ if house prices prove resurgent and if the resurgence is accompanied by further substantial volumes of high DTI lending by the banking system. The Reserve Bank considers that the current global environment, with low interest rates expected in many countries over the next few years, tends to exacerbate the risk of asset price cycles arising from ‘search for yield’ behaviour, making the potential value of a DTI tool greater.

The exact nature of any limit applied would depend on the circumstances and further policy development. However, the Reserve Bank’s current thinking is that the policy would take a similar form to LVR restrictions. This would involve the use of a “speed limit”, under which banks would still be permitted to undertake a proportion of loans at DTIs above the chosen threshold. By adopting a speed limit approach, rather than imposing strict limits on DTI ratios, there would be less risk of moral hazard issues arising from a particular ratio being seen as “officially safe”. Exemptions similar to those available within the LVR restriction policy would also be likely to apply.


Property price growth putting banks at risk: S&P

From Australian Broker

Most Australian banks are facing a one or two notch rating downgrade over the next two years as rising residential property prices put financial institutions at risk.


In a commentary on Australian banks entitled Rising Economic Risks Could Cut Ratings on Most Australian Financial Institutions by One Notch, S&P Global Ratings has examined the dangers of Australia’s hot housing market.

Rising economic imbalances are increasing the risk of a sharp correction in property prices, analysts at the global ratings agency said.

If such a scenario occurs, S&P highlighted eight financial institutions (including six banks) which would incur large credit losses and a subsequent credit rating downgrade.

S&P makes these ratings adjustments by focusing on the Risk Adjusted Capital (RAC) Framework.

“Our risk weights applicable to a bank’s loans are calibrated to the economic risk we see in the country. Consequently, as economic risks in a country rise in our opinion, we increase the risk weights, and that pushes down the capital ratios,” Sharad Jain, director at S&P Global Ratings, told Australian Broker.

“This in turn, could have an additional downward impact on bank ratings. This is because our risk adjusted capital ratios are a key driver of our capital and earnings assessment – which is an analytical factor in our assessment of a bank’s rating.”

In the event of rising economic risks facing banks in a particular country, this by itself would be enough to place pressure on bank ratings within that country, he said.

S&P expects property price growth to moderate and then remain at relatively low levels during the next 12 to 18 months.

However, analysts warned there is a one-in-three chance of a ‘downside scenario’ occurring in which property prices spiked. The resultant rise in risk would weaken the capital ratios of all banks in Australia.

For most banks, this movement would not be enough to put further pressure on their credit profiles. Thus, most financial institutions would only be downgraded by one notch.

However, S&P Global gave a warning about eight Australian financial institutions, highlighting two banks – Auswide Bank and MyState Bank – as being at greatest risk in this ‘downside scenario’.

“It is important to point out that, if our downside scenario materialises, to review our ratings on these institutions, we would make an assessment of their position and plans in relation to capital, business, and broader financial profile,” Jain said.

“A two-notch downgrade would be only one of the three likely outcomes in that scenario. The other two likely outcomes are a one-notch downgrade with stable outlook or a one-notch downgrade with a negative outlook.”

S&P Global also warned about the risks posed for AMP Bank, HSBC Bank Australia, ME Bank and P&N Bank in these circumstances although the agency admitted that parent support from these institutions is highly likely to prevent a two notch downgrade.

Westpac just one of 11 Lenders in ASIC home loan investigation

As reported by the ABC, ASIC says it has been investigating up to 11 banks over their home lending practices, amid concerns loans are being given to people that cannot afford to repay them.

Appearing before Senate Estimates, the Australian Security and Investments Commission (ASIC) was questioned about its Federal Court action against Westpac, announced yesterday.

ASIC’s senior executive responsible for banking, Michael Saadat, said the inquiries have been underway for a couple of years.

“It started really when we conducted our review of interest only loans in 2015,” he said.

“We looked at the conduct of 11 lenders.

“We have announced action against Westpac but we have been in discussions with other lenders and we hope to make an announcement about the work that we’ve been doing with other lenders in the next few weeks.”

Mr Saadat added that Westpac had changed its lending practices after the regulator made its concerns known in 2015.

“Despite the fact that they stopped the practice … we’ve decided to bring this action because of the importance of the issues that it raises,” he said.

Westpac not alone

It’s a fair bet all four major banks are facing ASIC scrutiny over poor home loan approval practices.

In a statement yesterday, Westpac said the loans identified by ASIC are all meeting or ahead on repayments.

However, ASIC said its action is intended to head-off possible future risks for consumers and the financial system.

“One of the aims of the responsible lending legislation is to enable ASIC to take action before the problems manifest themselves,” explained the regulator’s deputy chairman Peter Kell.

ASIC’s chairman Greg Medcraft said a key motivation for the regulator was to get other banks to change their ways.

“The issues is deterrence, and when you lodge a case it’s not just for that party, it’s to send a message to the broader sector,” he said.

ASIC said the maximum civil penalty that a court could award for breaches of the responsible lending laws is $1.7 million per contravention.

Westpac currently stands accused of seven contraventions of the law.

Here is Westpac’s media release about the matter:

Westpac will defend Federal Court proceedings commenced by ASIC in relation to a number of home loans entered into between December 2011 and March 2015, including specific allegations made by ASIC regarding seven loans. The court action does not concern Westpac’s current lending policies or practices.

Of the seven specific loan applications ASIC references in its proceedings, all loans are currently meeting or ahead in repayments.

Westpac Group, Chief Executive, Consumer Bank, George Frazis said Westpac takes its responsible lending obligations seriously and has confidence in its lending standards and processes. Our objective is to help more Australian families into their homes in a responsible way.

“It is not in the bank’s or customers’ interests to put people into loans that they cannot afford to repay. It goes hand in hand that we have robust credit approval processes while helping customers purchase their home.

“Our credit policies are informed by our deep experience and understanding of the mortgage market.

“They include a consideration of customers’ specific circumstances, including income and expenditure, previous repayments history and the overall customer relationship. We build into our processes a range of conservative inputs, including the addition of buffers to take into account possible future interest rate increases.”

Mr Frazis said Westpac uses sophisticated systems as part of its rigorous credit approval process. This includes utilising benchmarks such as the Household Expenditure Measure (HEM), published by the Melbourne Institute for Social and Economic Research, which provides broad analysis of customer expenditure based on demographic criteria.

“In our experience this survey is a useful input into our loan assessment process, in combination with our understanding of customers’ circumstances.”

Westpac disputes ASIC’s claims that Westpac relied solely on the HEM benchmark and did not have regard to a customer’s declared expenses in its unsuitability assessment.

“The Australian residential market is dynamic and we are constantly reviewing and refining our credit policies.”

“Importantly, interest-only mortgages were assessed in the same way as a standard principal and interest loan, and did not increase how much a customer could borrow.

“We are committed to meeting our responsible lending obligations and servicing the needs of customers, including prompt credit approval, which enables our customers to responsibly purchase their home with confidence,” Mr Frazis said.


Major banks reduce maximum loan amounts

In the September 2015 edition of the Property Imperative, DFA highlighted the impact of reductions in loan values being offered, as lenders tightened their lending criteria and affordability guidelines. This trend has been confirmed in more recent media reports, and will potentially make it difficult for some refinancing borrowers to get the loans they need, and further dampen property demand and prices. It will also make the on-ramp for first time buyers even steeper.

According to Australian Broker,

“Major banks have significantly reduced the amount they are prepared to lend home buyers, a new analysis by leading brokerage Home Loan Experts has revealed.

A couple with a combined income of $120,000 purchasing an investment property can now borrow up to $80,000 less from a major bank than they could a year ago, according to the calculations published in a report by the Sydney Morning Herald.

Investment property buyers aren’t the only ones affected either. The maximum loan size for the same hypothetical couple buying an owner-occupied home has fallen by up to $65,000, according to the Sydney-based brokerage’s calculations.

According to the Sydney Morning Herald report, the calculations were based on the borrowing power or maximum loan amount for a couple earning $60,000 each, with two children. The comparison compared December 2014 with December 2015 and included Commonwealth Bank, National Australia Bank and Westpac. The broker was not able to access comparative figures for ANZ from 2014.

Commonwealth Bank, for example, would have lent $640,000 as a housing investment loan a year ago, compared with $560,000 now — an $80,000 reduction.

Westpac would have lent the couple buying an owner-occupied home $645,000 a year ago, but this amount has fallen to $580,000 — a $65,000 reduction.

Home Loan Experts mortgage broker Christina Parnham told the Sydney Morning Herald that the maximum loan amount has been reduced because banks are requiring borrowers be tested against how they would cope with higher interest rates.

“You’re going to have to be able to service the loan at about 7.5 to 8%,” she said.

At the same time, Farnham says banks have adopted more conservative assumptions about living expenses”

Home Lending More Risky – APRA

Wayne Byres, Chairman APRA, “Banking On Housing“, speech today, portrayed the current state of play with regards to supervision of housing lending.  He started by noting that housing lending now accounts for around 40 per cent of banking industry assets, and a little under two-thirds of the aggregate loan portfolio. With such a concentration in a single business line, we are all banking on housing lending remaining ‘as safe as houses’.

IMF-Home-LoansSupervision is important, he say’s given the high household debt involved. As with housing prices, these debt levels are at the higher end of the spectrum. Furthermore, after plateauing for much of the past decade, the household debt-to-income ratio has begun drifting upwards again. Households still have a significant (and growing) net worth, as housing assets are increasing in value faster than debt. Nevertheless, the trends in overall level of debt bear watching.Debt-to-IncomeHe acknowledges the change in mix of loans, with the growth of investor loans.

Turning to the composition of loan portfolios, a notable change has been the well-publicised growth in lending to investors. In terms of the outstanding stock of housing lending, investors account for more than one-third; of the current flow of approvals, investors now account for more than 40 per cent. For comparison, in the mid-1990’s both those proportions were around half today’s levels.

A key question is: does this compositional shift change portfolio risk profiles? Australian data suggests that there has been little difference in the propensity of investor loans to become impaired, vis-à-vis those to owner-occupiers. However, caution is needed given the lack of any period of severe household stress over the past two decades: evidence from other countries suggests we should be wary of extrapolating the current Australian experience into more stressful scenarios.

Of course, it is not just the nature of the borrower, but also the growth in lending, that acts as a warning sign for supervisors. When we wrote to ADIs in December 2014, we flagged a benchmark for investor lending growth of 10 per cent, or higher, as a sign of increased risk. We highlighted investor lending because it was an area of accelerating credit growth and strong competition: a combination in which the temptation to compete and protect market share could drive a weakening of credit standards. By moderating growth aspirations, we are reducing the tendency for ADIs to whittle away lending standards in the name of ‘matching our competitors’ – when it comes to lower standards, it’s always the other guy’s fault.

He highlighted the rising share of loans originated via brokers.

Third-PartyAnother feature of the home lending market has been the increasing use of third-party distribution channels. There are potentially significant advantages from such an approach: for example, allowing smaller lenders or new entrants to compete more readily against the established branch networks of the bigger players. On the other hand, third-party-originated loans tend to have a materially higher default rate compared to loans originated through proprietary channels. This does not mean third-party channels have lower underwriting standards, but simply that the new business that flows through these channels appears to be of higher risk, and must be managed with appropriate care.

He also described the rise in interest only loans, and changes in LVR ratios as highlighted in yesterdays APRA data, which we discussed in detail already.

Finally, he discussed lending standards.

The final layer of analysis has been our detailed review of lending standards at individual lenders. We published some conclusions from this in May,6 and highlighted a few areas where standards were not what they could or should be. Examples included, generous interpretations of the stability and reliability of borrowers’ incomes; borrowers assumed to have very meagre living expenses; and/or a reliance on interest rates not rising very much, or (more puzzlingly) rising on new debts but not existing ones.

ASIC’s recently announced review of interest-only home lending made similar findings.

The industry has responded with improved practices in the past few months. For example, it is now commonplace for lenders to apply a haircut to unstable sources of income, and to assume a minimum interest rate of around 7.25 per cent – well above rates currently being paid – when assessing a borrower’s ability to service a loan. These steps should give greater comfort about the quality of new business now being written.

However, a close eye will need to kept on policy overrides – in other words, the extent to which lenders approve loans outside their standard policy parameters. There are some definitional issues that mean care is needed with this data, but the rising trend for loans to be approved outside policy needs to be watched: as lenders strengthen their lending policies, it’s important to make sure this good intent isn’t being undone by an increasing number of policy exceptions.

OutsideServiceBefore I wrap up, I’d like to comment on the potential for further action by APRA, including targeted measures that, it has been suggested, we should employ to specifically respond to rising housing prices in Sydney and Melbourne. In response, I would make three points:

First, our mandate is to preserve the resilience of the banking system, not to influence prices in particular regions; second, the broader environmental factors I outlined at the start of my remarks – high housing prices, high debt levels, low interest rates and subdued income growth – are not present only in our two largest cities; and
third, sound lending standards – prudently estimating borrower income and expenses, and not assuming interest rates will stay low forever – are just as important (and maybe even more so) in an environment where price growth is subdued as they are in markets where prices are rising quickly.

That is not to say that geographic measures would never be contemplated. Parallels are often drawn with New Zealand, where specific measures have been directed at the rapid price appreciation in Auckland. In comparing the respective actions on both sides of the ditch, it’s important to note the Reserve Bank of New Zealand (RBNZ) initiated measures for Auckland only after first instituting a range of measures that applied New Zealand-wide. In other words, more targeted measures built on, rather than substituted for, measures to reduce financial stability risks nationally.

Given many changes to lenders’ policies, practices and pricing are still relatively recent, it is too early to say whether further action might be needed to preserve the resilience of the banking system. We remain open to taking additional steps if needed, but from my perspective the best outcome will be if lenders themselves maintain a healthy dose of common sense in their lending practices, and reduce the need for APRA to do more.


Bank Profits Were $35.2 billion to March 2015

APRA released their quarterly ADI performance statistics to end March 2015 today. Over the year ending 31 March 2015, ADIs recorded net profit after tax of $35.2 billion. This is an increase of $3.0 billion (9.4 per cent) on the year ending 31 March 2014.

The most telling data relates to the relationship between loans and capital. We look at the big four,  who dominate the market. Home loans continue to grow as a proportion of total assets. The major banks have $1.42 trillion of housing, out of total assets of $2.27 trillion – 62.4% of all loans are housing related. Now, because of the generous “risk weighted” calculation, whilst the tier 1 capital ratio has moved higher for the 4 big banks, to 10.8%, if you look at shareholder funds (not risk weight adjusted) we see that the ratio of shareholder funds to total loans is lower now than its been for some time, and is continuing to fall. So the banks are using less of their own funds to grow their balance sheet and hold less in reserve for a rainy day. This is why there is a discussion about the right increases in capital weightings.

More generally, at 31 March 2015, the total assets of ADIs were $4.5 trillion, an increase of $519.9 billion (13.1 per cent) over the year. The total capital base of ADIs was $228.1 billion at 31 March 2015 and risk-weighted assets were $1.8 trillion at that date. The capital adequacy ratio for all ADIs was 12.7 per cent.

  • major banks had total assets of $3.50 trillion as at 31 March 2015, 78.0 per cent of the industry total;
  • other domestic banks had total assets of $397.7 billion, 8.9 per cent of the industry total;
  • foreign subsidiary banks had total assets of $115.1 billion, 2.6 per cent of the industry total; and
  • foreign branch banks had total assets of $404.1 billion, 9.0 per cent of the industry total.

The remainder of the industry total assets were held by building societies, credit unions and other ADIs, with $68.0 billion, 1.5 per cent of the industry total.

For all ADIs*, as at 31 March 2015:

  • Gross loans and advances were $2.80 trillion. This is an increase of $71.6 billion (2.6 per cent) on 31 December 2014 and an increase of $227.2 billion (8.8 per cent) on 31 March 2014.
  • Total liabilities were $4.22 trillion. This is an increase of $137.8 billion (3.4 per cent) on 31 December 2014 and an increase $504.3 billion (13.6 per cent) on 31 March 2014.
  • Total deposits were $2.46 trillion. This is an increase of $50.9 billion (2.1 per cent) on 31 December 2014 and an increase $196.1 billion (8.7 per cent) on 31 March 2014.
  • The net loans to deposits ratio was 112.6 per cent for the year ending 31 March 2015, an increase from 111.7 per cent for the year ending 31 March 2014.

Capital adequacy

The Common Equity Tier 1 capital ratio for all ADIs (excluding foreign branch banks and ‘other ADIs’) was 9.2 per cent as at 31 March 2015. This is an increase on 31 December 2014 (9.1 per cent) and 31 March 2014 (9.1 per cent).

The Common Equity Tier 1 capital ratio as at 31 March 2015 for each segment was:

  • 8.8 per cent for major banks (an increase from 8.7 per cent at 31 December 2014);
  • 9.6 per cent for other domestic banks (an increase from 9.3 per cent);
  • 15.1 per cent for foreign subsidiary banks (unchanged 31 December 2014);
  • 16.9 per cent for building societies (a decrease from 17.1 per cent); and
  • 15.7 per cent for credit unions (unchanged 31 December 2014).

The Tier 1 capital ratio for all ADIs (excluding foreign branch banks and ‘other ADIs’) was 11.0 per cent as at 31 March 2015. This is an increase on 31 December 2014 (10.8 per cent) and 31 March 2014 (10.8 per cent).  The Tier 1 capital ratio as at 31 March 2015 for each segment was:

  • 10.8 per cent for major banks (an increase from 10.6 per cent at 31 December 2014);
  • 10.9 per cent for other domestic banks (an increase from 10.6 per cent);
  • 15.1 per cent for foreign subsidiary banks (a decrease from 15.1 per cent);
  • 16.9 per cent for building societies (a decrease from 17.1 per cent); and
  • 15.9 per cent for credit unions (an increase from 15.8 per cent).

Impaired assets and past due items were $27.8 billion, a decrease of $5.9 billion (17.5 per cent) over the year. Total provisions were $14.4 billion, a decrease of $5.8 billion (28.9 per cent) over the year.

Impaired facilities were $15.2 billion as at 31 March 2015. This is a decrease of $0.7 billion (4.2 per cent) on 31 December 2014 and a decrease of $6.4 billion (29.7 per cent) on 31 March 2014. Impaired facilities as a proportion of total loans and advances was 0.5 per cent as at 31 March 2015. This is a decrease from 31 December 2014 (0.6 per cent) and a decrease from 31 March 2014 (0.8 per cent).

Past due items were $12.5 billion as at 31 March 2015. This is an increase of $1.1 billion (9.6 per cent) on 31 December 2014 and an increase of $534 million (4.4 per cent) on 31 March 2014. Total provisions held were $14.4 billion as at 31 March 2015. This is a decrease of $0.6 billion (4.0 per cent) on 31 December 2014 and a decrease of $5.8 billion (28.9 per cent) on 31 March 2014.


APRA On Lending Standards And Capital

APRA’s Wayne Byres today spoke at the COBA CEO & Director Forum in Sydney. His speech was entitled ‘Sound lending standards and adequate capital: preconditions for long-term success’. He highlights some interesting behaviourial differences between banks when it comes to the appraisal of mortgage loans, and also talks (and reinforces APRA’s position) with regards to capital measures.

I’d like to use my time today to talk about two issues of relevance to all ADIs: credit risk and capital. In the world of banking supervision, these are at the heart of what we do: credit risk because it is far and away the biggest risk that ADIs take on, and capital because it is a critical form of defence for when those risks go awry. Sound lending and adequate capital do not guarantee long-run success, but they are certainly a precondition for it.

Reinforcing sound lending standards

For many of you in the room today, the largest part of your loan portfolios is lending for housing. In that, you are reflective of the broader banking system in Australia. Across all ADIs, the proportion of lending attributable to housing has increased over the past decade from (an already dominant) 55 per cent to a little under 65 per cent today. For credit unions and building societies, the trend is directionally the same, but the dominance of housing even greater (Chart 1).

Chart1: Housing loans as a share of total lending

I have made the point elsewhere that the traditionally low risk nature of Australian housing portfolios has provided important ballast for the Australian banking system – a steady income stream and low loss rates from housing loan books have helped keep the system on a reasonably even keel, despite occasional stormy seas and misadventures elsewhere1. Much of the ongoing trust and confidence in the system, by Australian depositors and international investors alike, is founded on this history of stability.

It is not something we should place at risk.

The current economic environment for housing lenders is characterised by heightened levels of risk, reflecting a combination of historically low interest rates, high household debt, subdued income growth, unemployment that has drifted higher, significant house price growth, and strong competitive pressures. Many of these features have been emerging over a number of years, and APRA’s supervision has been intensifying in response. In addition to a heightened level of supervisory activity at individual ADIs, APRA has, for example:

  • increased the level of analysis of mortgage portfolios, including regular review of detailed data on ADI underwriting policies and key risk indicators, to identify outliers;
  • written to boards of the larger lenders, seeking their written assurances with respect to their oversight of the evolving risks in residential mortgage lending;
  • issued a prudential practice guide (APG 223) on sound risk management practices for residential mortgage lending; and
  • completed a stress test of the largest ADIs, with two scenarios focussed on a severe downturn in the housing market.

Not all of you have been directly involved with every one of these initiatives, but I’m sure you will have felt APRA’s presence in some shape or form.

We see this increasing intensity as an example of APRA’s risk-based approach to supervision. As housing-related risks have potentially grown, we have sought to ‘turn up the dial’ of our supervisory scrutiny and, importantly, ensure that Boards and management of ADIs are doing likewise.

Our most recent turning up of the dial was the letter sent to all ADIs in December last year regarding our plans to reinforce sound lending standards2. The letter, beyond expressing some of the general concerns I have just touched upon, also set out some more specific areas that APRA supervisors would be focussing on, and how we would respond if we felt our concerns were not being addressed. Similar sentiments have also been included in more recent letters sent to smaller ADIs.

There are a number of additional regulatory and supervisory tools that APRA has available to address emerging risks: additional supervisory monitoring and oversight, supervisory actions involving Pillar 2 capital requirements for individual ADIs, and higher regulatory capital requirements at a system-wide level. Beyond this, there are more direct controls that are increasingly being used in other jurisdictions, such as limits on particular types of lending – what are commonly referred to as macro-prudential controls.

Up to this point, we have opted to stick with traditional micro-prudential tools targeted at individual ADIs and their specific practices, albeit with an eye to financial stability risks as well as the safety and soundness of individual entities. We are not seeking to determine an appropriate level of house prices, or a particular level of household debt. That is beyond our mandate. Our goal is simpler: reinforcing sound lending standards, which is the ‘bread and butter’ work of a banking supervisor.

Credit assessments – room for improvement

Accurately assessing a borrower’s ability to service and ultimately to repay a loan without undue hardship, including under periods of economic stress, is an inherent component of sound credit risk management, particularly for residential mortgage lending.3

One of the interesting challenges of assessing serviceability practices has been that, just as the vast majority of motor vehicle drivers believe they are above average in driving ability, ADIs invariably claim their lending standards are at the more conservative end of the spectrum, and that it is their competitors that are the source of poor practices. As with everyone claiming to be an above-average driver, not every ADI can be right.

To help us get to the bottom of this, we recently undertook a small hypothetical borrower survey. We asked a number of the larger housing lenders (including a few mutuals) to provide their serviceability assessments for four hypothetical borrowers that we invented (two owner-occupiers, and two investors). The outcomes for these hypothetical borrowers helped to put the spotlight on differences in credit assessments and lending standards. The outcomes were quite enlightening for us – and, to be frank, a little disconcerting in places.

Mortgage lending is often thought of as a fairly commoditised product, but in reality there are wide differences in how lenders assessed the risk of a given borrower. The first surprising result from our review was the very wide range of loan amounts that, hypothetically, were offered to our borrowers. It was not uncommon to find the most generous ADI was prepared to lend in the order of 50 per cent more than the most conservative ADI.

More importantly, the exercise also allowed us to explore the key drivers of difference in risk assessments across lenders. Serviceability is obviously multi-dimensional; it depends on how big a loan is extended, relative to a borrower’s income (and the reliability of the various components of that income) and the nature and extent of non-housing obligations that a borrower needs to meet.

One significant factor behind differences in serviceability assessments, particularly for owner occupiers, was how ADIs measured the borrower’s living expenses (Chart 2a and 2b). As a regulator, it is hard to understand the rationale for large differences in what should be a relatively objective, and extremely critical, metric.4

Chart 2a: Minimum living expense assumptions shows percentage of owner-occupier borrower pre-tax salary income between 20%-35%
Chart 2b: Minimum living expense assumptions shows percentage of investor borrower pre-tax salary income between 0%-25%

Of major concern were a few ADIs who opted to make their credit assessment based on a lower level of living expenses than that declared by the borrower. That is obviously a practice that should not continue, and ADIs should be making reasonable inquiries about a borrower’s living expenses. In fact, best practice (and intuition) would be to apply minimum living expense assumptions that increase with borrower incomes; this was a practice adopted by only a minority of ADIs in our survey.

The treatment of other income sources (such as bonuses, overtime and investment earnings) also played a large role in credit decisions (Chart 3). Common sense would suggest it is prudent to apply a discount or haircut to these types of income, reflecting the fact they are often less reliable means of meeting regular loan repayments. Unfortunately, common sense was sometimes absent.

Chart 3: Income recognised (less tax and haircuts) shows percentage of investor borrower gross pre-tax income

Another area of interest was the discount or ‘haircut’ applied to declared rental income on an investment property. The norm in the ADI industry seems to be a 20% haircut, but we noted in our exercise that some ADIs based their serviceability assessment on smaller, or even zero, haircuts. Bearing in mind that the cost of real estate fees, strata fees, rates and maintenance can easily account for a significant part of expected rental income, and this does not take into account potential periods of vacancy, the 20% norm itself does not seem particularly conservative. We also came across a few instances in which ADIs were relying on anticipated future tax benefits from negative gearing to get a borrower over the line for a mortgage.

Variations in assessments were also driven by the size of interest-rate buffers applied to the new loan (Chart 4) – something we flagged in our December letter as an area of particular importance. For investor lending, this issue was more pronounced: a major driver of differences across ADIs was whether an interest-rate buffer was applied to both the investor’s existing debts (such as loans outstanding on existing owner-occupied or investment properties), as well as to the proposed new loan. As of earlier this year when the survey was conducted, only about half of the surveyed ADIs applied such a buffer to existing debts (all applied some form of buffer to new debts). I confess to struggling to see the logic of such an approach – after all, any rise in interest rates will at some point in time affect the borrower’s other debts just as they will for the new loan being sought.

Chart 4: Existing mortgage debt shows interest rate used in investor serviceability assessment between 4%-9%

The final area I would highlight were differences in the treatment of interest only loans. Our test included one borrower seeking a 30-year loan, with the first 5 years on an interest-only basis. Only a minority of surveyed ADIs calculated the ability to service principal and interest (P&I) repayments over the residual 25 year term. Despite the contractual terms, the majority assumed P&I repayments over the full 30-year term, and hence were able to inflate the hypothetical borrower’s apparent surplus income by, in our particular example, around 5 per cent.

So there is no confusion, let me be clear that Australian ADIs are thankfully well away from the types of subprime lending that have caused so many problems elsewhere (eg lending with an LVR in excess of 100 per cent, at teaser rates, to borrowers with no real capacity to repay). Nevertheless, our overall conclusion from this hypothetical borrower exercise was that there were clearly examples of practice that were less than prudent. As a result, we have shown ADIs that participated in the exercise how they compare to their peers and where their serviceability assessments could be strengthened: in all of the examples above, we expect to see changes to practices across a range of ADIs.

In doing so, we have been asked whether APRA is trying to standardise mortgage risk assessments or impose a common ‘risk appetite’ across the industry. In fact, we do think it important that ADIs adhere to some minimum expectations with respect to, for example, interest-rate buffers and floors, and adopt prudent estimates of borrower’s likely income and expenses. In that regard, to the extent we are reinforcing a healthy dose of common sense in lending standards, greater convergence is probably warranted.

At the same time, we certainly want to see competition between lenders and fully accept that different ADIs can have different risk appetites. And we are not seeking to interfere in ADIs’ ability to compete on price, service standards or other aspects of the customer experience. However, making overly optimistic assessments of a borrower’s capacity to repay does not seem a sensible or sustainable basis on which to attract new customers or retain existing ones. It also runs the risk of adverse selection and an accumulation of higher risk customers who (perhaps quite justifiably) cannot get finance elsewhere. To go back to my opening remarks, it does not fulfil the precondition for long-term success.

I have mentioned all of this for two reasons:

  • First, because what at first glance might seem prudent practice is not always so. When our December letter was issued, a number of ADIs were quick to point out they were already utilising a floor rate of 7 per cent and a buffer of 2 per cent within their serviceability assessments. Leaving aside that our letter suggested it would be good practice to operate comfortably above those levels, if the buffers are being applied to overly optimistic assessments of income, or only to part of the borrower’s debts, they do not serve their purpose.
  • Second, because much of the attention given to our December letter has focussed on the 10 per cent benchmark for growth in investor lending. I want to emphasise that our analysis goes much broader than just investor lending growth, and captures ADIs’ lending standards and risk profile across the board. Investor lending aspirations will only be one factor in our consideration of the need for further supervisory action.

This work on lending standards has been intensive and time-consuming for APRA and, no doubt, all of the ADIs involved, but has been well worth it if we have been able to reinforce sound lending standards across the industry. (If you have not yet looked at your own policies in the areas I have outlined, I would encourage you to do so as a matter of priority.) Of course, we will need to keep up our scrutiny and be alert to both subsequent policy changes, and/or substantial policy overrides (ie loan approvals outside policy). The latter will warrant particular attention by both ADIs and APRA: if policies are tightened only for overrides to correspondingly increase, we will have not achieved our objective.

That also applies to business plans and growth aspirations: where we have agreed plans with ADIs, we will obviously be monitoring closely to see that they kick into effect in the second half of the year. We recognise that it takes time for growth plans to alter course, especially given lending pipelines of pre-approved loans (there is also typically slightly stronger growth in the second quarter of the calendar year). However, ADIs have now had long enough to revise their ambitions where needed, and we will be watching carefully to see a moderation in growth in investor lending in the second half of the year as revised plans are implemented.

Developments in capital standards

Let me now turn to capital adequacy.

As most of you know, there were five recommendations from the Final Report of the Financial System Inquiry that relate to ADI capital:

  • Recommendation 1 – that we set ADI capital standards in such a manner as to ensure ADIs are ‘unquestionably strong’ (with a suggestion this could be met by having Australian banks in the top quartile when measured against the capital ratios of international peers);
  • Recommendation 2 – that we narrow the differential in risk weights on mortgages between the standardised and internal-ratings based (IRB) approaches (again, with a suggestion of a 25-30 per cent risk weight for the IRB approach);
  • Recommendation 3 – that we should implement a framework for additional loss absorbing and recapitalisation capacity in line with international practice;
  • Recommendation 4 – that we develop a reporting template that allows the capital ratios of Australian ADIs to be reported without the impact of APRA adjustments to the Basel minimums; and
  • Recommendation 8 – that we introduce a leverage ratio as a backstop to the risk-based capital framework.

In addition, the Basel Committee has work underway that will intersect with these recommendations. Most relevantly, it is currently considering:

  • responses to submissions on proposed revisions to the standardised approach, including, importantly, to housing risk weights;
  • responses to submissions on proposed revisions to the capital floor for banks using the IRB approach; and
  • how the IRB framework can be reinforced, given the increasing scepticism towards modelling approaches in light of the excessive variability in capital requirements they are producing.

To repeat what I have said previously, it is to everyone’s benefit that we approach the FSI and Basel proposals in a coordinated manner. But that does not mean waiting until every i is dotted and t is crossed.

The Basel Committee meets again in June to review the way ahead on its various proposals. I do not think it will be too long after that that we are able to announce how we will respond to those issues that are easiest to tackle sooner rather than later (particularly Recommendations 2 and 4). Other items will take a little longer to pin down the precise detail. But the direction is clear, and we fully support the FSI’s recommendation that Australian ADIs should be unquestionably strong. So it also makes sense to start early and move forward in an orderly fashion wherever possible: affected ADIs should, provided they take sensible opportunities to accumulate capital, be well-placed to accommodate these changes when they occur.

What does all of it mean for customer-owned banking organisations? As this audience already knows, the capital ratios of credit unions and building societies stand, on average, well above that of the rest of the banking sector (Chart 5), providing a healthy buffer with which to accommodate any future changes. I suspect that, when looked at in aggregate, mutual ADIs will be less impacted by the collective set of changes to regulatory requirements than other parts of the ADI sector. Of course, within the sector, there are differences from ADI to ADI, so I am wary of making sweeping statements. But there is no doubt that mutual ADIs generally start with high capital ratios vis-à-vis many of their larger competitors, and the impact of changes are likely to be felt more acutely elsewhere.

That said – and I wouldn’t be true to my role as a prudential supervisor if I did not sound a note of caution before I conclude – it doesn’t mean the changes won’t be felt at all, or that changes in the competitive landscape will provide a panacea to the strategic challenges that face smaller organisations in a more demanding environment. Long-standing issues of scale, geographic concentration, technological capacity, and more mobile and demanding customers will not be diminished by regulatory changes. The only suggestion I would offer on these today is that the challenges will be more likely to be overcome if, consistent with the mutual ethos that underpins COBA and its members, the mutual sector works cooperatively together to address them.

Concluding remarks

I opened by setting out two necessary – but not sufficient – preconditions for long-term success: sound lending standards and adequate capital.

Lending standards are important for the stability of the Australian banking system, and given the importance of housing-related lending, it should not be surprising that APRA supervisors are increasingly vigilant on the risks this lending presents. Put simply, if all our eggs are increasingly being placed in one basket, we need to make sure the basket isn’t dropped. ADIs that have continued to adopt sensible practices and prudent credit assessments should welcome this approach, as it strengthens their capacity to compete without being reckless. On the other hand, ADIs with more aggressive practices should fully expect to find APRA increasingly at their doorstep.

When it comes to capital, we will have more to say shortly. But my message today is that we will respond to all of the FSI’s recommendations as soon as we can, bearing in mind the need for a coordinated approach that factors in international work that is still in the pipeline. No one disputes the benefits of having an unquestionably strong banking sector, so where it makes sense to move ahead, we will get on with it. ADIs should adopt a similar approach in their capital planning: to the extent further capital accumulation is needed, there is little to be lost from starting early.

1 Seeking Strength in Adversity, AB+F Randstad Leaders Lecture Series, 7 November 2014

2 Reinforcing Sound Residential Mortgage Lending Practices, 9 December 2014

3 APG223, Residential Mortgage Lending, November 2014. See also Financial Stability Board, Sound Residential Mortgage Underwriting Practices, April 2012.

4 Estimated living expenses between the most conservative and the least conservative ADI varied by at least 30 per cent, and in some cases significantly more (depending on the borrower’s characteristics).

Risky Lending In A Low Interest Rate Competitive Environment

Regulators have been concerned about the quality of lending, and have been increasing their supervision, conscious of the potential impact on financial stability. However, a paper from the Bank for International Settlements  – Bank Competition and Credit Booms highlight that especially when interest rates are low, and competition intense, banks will naturally and logically drop underwriting standards. This observation is highly relevant to the Australian context, where competition for home loans in particular is leading to heavy discounting from already low rates, and potential lax underwriting. It suggests that lowering rates further will exacerbate the effect.

Greater bank competition and a lower risk-free rate raise the screening costs of lending, which can result in sharp increases in credit supply and deteriorations in average loan quality, which are inefficient for banks. Banks’ incentives to make risky loans can vary despite unchanged capital structure, thus highlighting the role of a risk-taking mechanism. This approach helps explain the existing mixed empirical results on the relationship between bank competition and financial stability. The model can be used to define a neutral interest rate in the context of financial cycles.

There is a growing recognition that the relationship between finance and growth may be unstable in practice. Past financial crises serve as painful reminders that increasing financial access by too much too fast is subject to diminishing returns at best, and can even lead to severe output losses when the financial sector is in disarray. Despite ample evidence for this perverse nonlinearity, there is less understanding about the exact mechanism by which excessive finance that is harmful for stability can arise as an equilibrium phenomenon. Similarly, the role of policy in navigating the trade-o between growth and financial stability, unlike that between growth and inflation, remains a relatively uncharted territory.

This paper proposes a simple model of bank lending decision, where a`credit boom’ could emerge as an equilibrium phenomenon. Two key forces interact to determine the equilibrium. First, banks have an incentive to screen out bad clients by restricting the amount of lending per contract, as riskier firms are known to seek larger loans despite a lower chance of success. Such screening entails costs to both banks and good firms, given that credits are being rationed to meet incentive compatibility conditions. This feature is essentially classic credit rationing.

The second force comes into play when banks enjoy some monopolistic power over their loan market, but can attempt to poach clients from another bank by offering cheaper loan contracts. Lowering prices of loans raises the screening costs, because it necessitates even greater credit rationing if banks were to screen out risky fi rms. When the degree of bank competition for borrowers is suciently intense, it becomes optimal for banks to stop screening and rush to dominate the market by off ering contracts with larger loans to all firms. This new pooling equilibrium is characterised by a low lending interest rate (relative to the average productivity of underlying projects), a larger loan size, and a higher probability of loan defaults.

A lower risk-free rate increases the banks’ incentives to lend by lowering the opportunity cost of funds. But how the credit market equilibrium responds to changes in the risk-free rate also depends on the market structure in which banks operate. In particular, when a bank can gain more market share for a given cut in lending rate, the degree of competiton tends to be higher in equilibrium for any level of risk-free rate. Credit booms are therefore more likely to occur when banks compete more aggressively and/or the risk-free rate is low. In this context, the notion of `fi nancial stability neutral’ monetary policy can be given an explicit de nition, namely that which will prevent a pooling equilibrium from occuring. At the same time, the presence of intense bank competition can limit the effectiveness of monetary policy in containing a credit boom and achieving the financial stability objective.