Economics and Banking – Page 444 – Digital Finance Analytics (DFA) Blog

How Dangerous Is The Rise In Investor Loans?

The public statements from the Reserve Bank suggests they are monitoring the situation, and working with APRA on potential measures should the need arise. However, the recent freedom of information request reveals a significant and important dialogue within the bank about the potential impact of investor loans. A highly restricted document from 2014 makes the following points. Two concerns on increase in investor lending:

Macroeconomic:

Extra speculative demand can amplify the property price cycle and increase the potential for prices to fall later. Such a fall would affect household spending and wealth. This effect is likely to be spread across a broader range of households than the investors that contributed to the heightened activity.

Concentration risk:

Lending has been concentrated in Sydney and Melbourne, creating a concentrated exposure in these cities. The risk could come from a state-based economic shock, or if the speculative upswing in demand brings forth an increase in construction on a scale that leads to a future overhang of supply.
In Sydney, the risk of oversupply appears limited because of the pick-up in construction follows a period of limited new supply and it has been spread geographically and by dwelling type. While the unemployment rate has picked up a little over the past 18 months, the overall economic environment in NSW is in a fairly good state.
In Melbourne, there has been a greater geographic concentration of higher-density construction in inner-city areas. Some developments have a concentration of smaller-sized apartments that may only appeal to some renters, or purchasers in the secondary market. Economic conditions are not as favourable in Victoria and the unemployment rate is 6.8%.

In addition there were concerns about the low interest rate environment:

While a pick-up in risk appetite of households is to some extent an expected outcome given the low interest rate environment, their revealed preference is to direct investment into the housing market.
Historically low interest rates (combined with rising housing prices and strong price competition in the mortgage market) means that some households may attempt to take out loans that they would not be able to comfortably service in a higher interest rate environment.
APRA’s draft Prudential Practice Guide (PPG) emphasises that ADIs should apply an interest rate add-on to the mortgage rate, in conjunction with an interest rate floor in assessing a borrower’s capacity to service the loan. In order to maintain the risk profile of borrowers when interest rates are declining, the size of the add-on needs to increase (or the floor needs to be sufficiently high).

… and on Lending standards

In aggregate, banks’ lending standards have been holding fairly steady overall; lending in some loan segments has eased a little, while lending in some other segments has tightened up a bit.
The main lending standard of concern is the share of interest-only lending, both to owner-occupiers and investors. For investors, 64% of banks’ new lending is interest-only loans and for owner-occupiers the share is 31%.
The typical interest-only period is 5 years, but some banks allow the interest-only period to extend to 15 years. During this period, the loan is amortising more slowly than a loan that requires principal and interest (P&I) payments. If housing prices should fall, this increases the risk that the loan balance may exceed the property value (negative equity). There is some risk that the borrower could face difficulty servicing the higher P&I payments when the interest-only period ends, although this is typically mitigated by banks assessing interest-only borrowers on their ability to make P&I payments.

Then, we noted the Reserve Bank of NZ view that the risks in investment loans are different from owner occupied loans and should have different capital rules applied.

We continue to stress the fact the lending for investment property is unproductive, we need more finance for business, which can create productive growth.

Finally, we note the capital regulatory discussions on forthcoming changes to the capital rules under Basel IV, and where investment loans fit in.

Put all this together, and the risks to the broader economy, and the banking system from higher investment property loans, at a time of low interest rates, and high prices are significantly higher than acknowledged in public by the regulators in Australia. In addition, the recent interest rate cut makes even less sense.

Australia Fiscal Plan Weakens, But Core Strengths Intact – Fitch

According to Fitch Ratings, Australia’s Commonwealth budget, released on 12 May 2015, highlights the continued weakening of the country’s long-term fiscal consolidation plans, but does not fundamentally alter the core factors supporting Australia’s ‘AAA’ rating. These include low debt-to-GDP versus ratings peers, a stable banking system and a credible fiscal policy framework.

Deterioration in the fiscal outlook since the last budget was widely expected alongside the continued weakening of labour market conditions and a tepid recovery in commodity prices that has not brought prices back to levels seen before the downturn.

The fiscal cash deficit widened and government debt projections increased in the fiscal year ending 30 June 2016 (FY16) budget, reflecting in part the deterioration in economic growth dynamics linked to the fall in commodity prices and slowdown in China. Falling terms of trade have impacted long-term revenue growth projections, which have been revised down to 6.3% annually to 2018 from 6.6% at the last economic and fiscal update. Wage growth and corporate income will continue to be challenged by lower commodity prices, resulting in AUD20bn less in tax revenues over the coming four years compared with the outlook in the 2014 budget.

The deteriorating cash balance also reflects higher spending forecasts compared to the government’s Mid-year Economic and Fiscal Outlook in December.

The government still aims to return to a balanced budget by FY20 – even though fiscal consolidation plans have weakened. It is notable though that with a three-year federal election cycle – the next election is due by January 2017 – there remains significant uncertainty as to whether the political commitment to achieve this target will be sustained. Nonetheless, Australia does benefit from a credible policy framework and Fitch expects Australia to continue to have a significantly lower debt burden than its ‘AAA’-rated peers – general government debt was 31.8% of GDP in 2014 versus the ‘AAA’ median of 41.3%. Notably too, the government forecasts debt-to-GDP to begin falling by FY18 after rising for the next two fiscal years. As such, the budget should not have a significant effect on Australia’s existing strong credit profile.

Fitch believes that the iron ore forecast price in the budget of USD48/tonne seems a reasonable base case, but the budget will remain sensitive to further price falls. Australia’s dependence on commodity exports, especially to China, indicates that the sovereign may need a slightly larger buffer in its public finances than some of its peers at the ‘AAA’ level.

Over the longer term, reducing Australia’s dependence on commodities would mitigate a key vulnerability of the economy and sovereign. The FY16 budget includes some policy measures, including infrastructure investments and targeted SME tax cuts, to raise potential growth and spur service sector exports. As yet, it is uncertain to what extent these sorts of policies will be successful in transitioning growth away from mining.

The Global Implications of Diverging Monetary Policy Settings in Advanced Economies

Panel remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Sixth High Level Conference on the International Monetary System: Monetary Policy Challenges in a Changing World, Zurich, Switzerland, 12 May 2015.

I will focus my remarks on the global implications of U.S. monetary policy normalization – paying particular attention to the potential implications for emerging market economies (EMEs). I put the focus here because these economies were greatly affected in 2013 during the so-called “taper tantrum” and many of these economies have been under stress from the weakness in global commodity prices. As always, what I have to say today reflects my own views and not necessarily those of the Federal Open Market Committee (FOMC) or the Federal Reserve.

But before I get to the implications for EMEs and what the Fed should do or not do to mitigate the impact, a few words on the timing of normalization. To be as direct as possible: I don’t know when this will occur. The timing of lift-off will depend on how the economic outlook evolves. Since the economic outlook is uncertain, this means the timing of liftoff must also be uncertain.

At the same time, though, I can be clear about what conditions are needed for normalization to begin. If the improvement in the U.S. labor market continues and the FOMC is “reasonably confident” that inflation will move back to our 2 percent objective over the medium-term, then it would be appropriate to begin to normalize interest rates.

Because the conditions necessary for liftoff are well-specified, market participants should be able to think right along with policymakers, adjusting their views about the prospects for normalization in response to the incoming data. This implies that liftoff should not be a big surprise when it finally occurs, which should help mitigate the degree of market turbulence engendered by lift-off.

Nevertheless, I think it would be naïve not to expect some impact. After more than six years at the zero lower bound, lift-off will signal a regime shift even though policy would only be slightly less accommodative after lift-off than it is before. I expect that this will have implications for global capital flows, foreign exchange valuation and financial asset prices even if it is mostly anticipated when it occurs.

Which leads to the key question I want to address in the remainder of my remarks: What should the Federal Reserve do to minimize the impact?

Like other central banks, our monetary policy mandate has a domestic focus. Our monetary policy actions, though, often have global implications that feed back into the U.S. economy and financial markets, and we need to always keep this in mind.

From one perspective, the unconventional nature of monetary policy around the world adds little that is fundamentally new to the challenges that face EMEs. Today’s monetary policies simply represent a way of easing that was necessitated by hitting the zero lower bound here and elsewhere. Central bankers have managed differences across countries in cyclical positions and policy stances many times in the past. This time should not be fundamentally different.

But, from another perspective, we have less experience operating with unconventional monetary policy, we have been in this regime for a long time and this creates more potential uncertainties. These uncertainties put a premium on clear communication among central bankers as well as between central bankers and market participants. In my view, an important fact is that the large scale asset purchase programs undertaken in the United States and elsewhere have dramatically shrunk the size of bond risk premia globally. This new set of monetary policies affects financial asset prices in a different way compared to changes in short-term interest rates, and we should be humble regarding what we claim to understand about this distinction.

Looking ahead, it seems likely that markets will remain focused on those vulnerabilities that they might have ignored prior to the taper tantrum in 2013. The greater premium on strong fundamentals, policy coherence and predictability will likely remain. Although we will undoubtedly experience further bumps in the road. I think we can remain generally optimistic about the prospects for adjustment. But for this to occur, it will be important for market participants to appropriately discriminate across countries, rather than treating EMEs as a single group.

The good news is that many EMEs generally appear to be better equipped today to handle the Fed’s prospective exit from its exceptional policy accommodation than they were during past tightening cycles. This reflects the fundamental reforms that EMEs have put in place over the past 15 years, as well as the hard lessons learned from past periods of market stress. Among the positives are:

The absence of pegged exchange rate regimes that often came undone violently during periods of acute stress;

Improved debt service ratios and generally moderate external debt levels;

Larger foreign exchange reserve cushions;

Clearer and more coherent monetary policy frameworks, supporting what are now generally low to moderate inflation rates;

Generally improved fiscal discipline; and

Better capitalized banking systems, supported by strengthened regulatory and supervisory frameworks.

Of course, progress has not been uniform across EMEs, and more work remains to further strengthen institutional structures in some countries. In particular, vulnerabilities remain in several important EMEs, and some have been hit by the sharp adverse turn in their terms of trade due to the recent fall in global commodity prices. Still, the fundamental improvements I’ve cited leave many EMEs better positioned than in the past to weather those times in the cycle when the external environment becomes more difficult.

The impact that changes in Fed policy can have beyond our borders has led to calls for us to do more to internalize those impacts, or even further, to internationally coordinate policymaking. As I’ve already noted, we are mindful of the global effects of Fed policy, given the central place of U.S. markets in the global financial system and the dollar’s status as the global reserve currency. Accordingly, we seek to conduct monetary policy transparently and based on clear principles. Promoting growth and stability in the U.S., I believe, is the most important contribution we can make to growth and stability worldwide.

There is, of course, the argument that Fed policy has been too accommodative for too long, creating risks for financial stability worldwide. Here, I think it’s important to consider carefully the counterfactual. Would countries beyond our borders really have been better off with a weaker U.S. economy – an economy that might have required exceptional monetary policy accommodation for a much longer period of time? The fundamental issue is whether U.S. monetary policy has helped support our dual objectives of maximum employment in the context of price stability, and whether this support is consistent with a healthy global economy.

While explicit coordination looks neither feasible nor desirable, there may be more that central banks in general, and the Fed in particular, could do to be better global stewards. As an example, I would emphasize the importance of effective Fed communication. It is clear, in retrospect, that our attempts in the spring of 2013 to provide guidance about the potential timing and pace of tapering confused market participants. Market participants seemed to conflate the prospective tapering of asset purchases with monetary policy tightening, and pulled forward their expectations about the likely timing of liftoff and raised their expected paths for policy rates. Lately, we seem to have done better: the tapering down of the Fed’s asset purchase program went smoothly and market participants now seem to share the assessment embodied in the FOMC’s March Summary of Economic Projections that lift-off is likely to begin sometime later this year.

As you know, we’ve taken a number of steps in recent years to increase transparency and improve our communications. This includes regular press conferences by the Fed chair following FOMC meetings; the publishing of growth, inflation and short-term rate forecasts of FOMC participants; and a concerted attempt to lay out the guideposts that the FOMC will look at to assess progress toward our mandate. We also have explained in considerable detail what tools we will use and how we will likely use them to ensure to ensure a smooth lift-off.

A second area we have focused on is doing a better job safeguarding financial stability. Simply put, we failed to act both early enough and decisively enough to stem the credit excesses that spawned the financial crisis and the Great Recession. The U.S. was not alone in this shortcoming, but given our position in the global financial system, we especially should have done better. We’ve taken important steps through new legislative mandates and a broader effort to rethink our regulatory and supervisory framework. In particular, systemically important banking organizations must now hold amounts of capital and liquidity that are better aligned with their risk profiles. Other changes have also been implemented, such as central clearing of standardized OTC derivatives contracts, that should make the global financial system more resilient and robust.

Although this effort remains very much a work in progress, I think it will enable us to avoid repeating the mistakes of the past decade, and enable us to take a more proactive stance toward mitigating potential future vulnerabilities. Of course, we at the Fed are not alone here. Since the recent financial crisis, central banks worldwide have been engaged in a broad rethinking of how to better fulfill their mandates.

Let me close with a final thought. The largest problems that countries create for others often emanate from getting policy wrong domestically. Recession or instability at home is often quickly exported abroad. Equally important, growth and stability abroad makes all our jobs at home easier. This illustrates the externalities in the work we all do, with more effective fulfillment of our domestic mandates helping to bring us collectively to a better place.

Inquiry On Home Ownership Launched

The House of Representatives Economics Committee has announced a new inquiry into home ownership. The Chair of the Committee, John Alexander, said that ‘home ownership is an issue that lies at the core of the Australian dream and represents the largest investment that most taxpayers will make during their lifetime. The importance of this issue throughout our nation makes it worthy of a detailed inquiry.’

The Committee will inquire into and report on:

current rates of home ownership;
demand and supply drivers in the housing market;
the proportion of investment housing relative to owner-occupied housing;
the impact of current tax policy at all levels; and
opportunities for reform.

The Committee invites submissions to the inquiry by Friday 26 June 2015, and the proposed reporting date is 03 December 2015.

This follows on from the previously released Senate report on Housing Affordability. We wonder if more committee review is an excuse not to tackle the critical issues which need to be addressed! We shall see.

WA Budget Kills First Owner Grants For Established Property

In WA’s 2015 budget, first time buyers wanted to purchase an established property will loose the ability to tap into the $3,000 FHOG. It had already been reduced for established buyers from $7,000 to $3,000 in 2013. However, the FHOG remains unchanged at $10,000 for those wanting to build their first home. Treasure Mike Nahan said the change was in line with the State Government’s policy objective of focusing financial support on residential construction. Cutting the grant for first time buyers purchasing established homes will be a saving of about $109 million for the State Government over four years.

In other changes, whilst stamp duty concessions for first home buyers of both new and established homes remain unchanged, a new $300 flat land tax scale will come into effect in 2015-16 for land with an unimproved value of between $300,000 and $420,000. This new “flatter” land tax scale is expected to raise an additional revenue of $184 million in 2015-16 and about $826 million over the next four years. Those properties with an unimproved value of less than $300,000 will be exempt.

We think FHOG should be abolished entirely because it distorts the market, but the removal from established dwellings makes perfect sense. You can read our background discussion on why FHOG’s are bad news here.

Lending Up Thanks To Housing and Commercial, In March – ABS

The ABS released the Lending Finance data for March 2015 today. Comparing March with February, Housing for owner occupation excluding alterations and additions rose 0.8% in trend terms, and the seasonally adjusted series rose 1.6%. The trend series for the value of total personal finance commitments rose 0.3% although the seasonally adjusted series fell 0.9%. The trend series for the value of total commercial finance commitments rose 2.0% whilst the seasonally adjusted series rose 0.4%. The trend series for the value of total lease finance commitments rose 1.4% in March 2015 and the seasonally adjusted series rose 3.0%, following a rise of 3.6% in February 2015.

Looking at all lending, 43% was for residential property – including investment property loans, and we see a slight downward drift, as lending for other business purposed improved a little.

Looking at all commercial lending (fixed and revolving), we see that 28.8% was for residential investment property purchases, down from a high of 29.9% at the end of last year. This again shows that non-residential property lending to business lifted a little, and could suggest investment lending growth may be slowing a tad. However, investment lending remains at unprecedented levels.

To reinforce this view, we can compare the proportion of all commercial fixed term loans to those relating to housing investment.

The point we make again is that lending for investment property, whilst inflating house prices and bank balance sheets is unproductive. We need more lending to productive businesses to sustain growth, but the banks are finding it easier and more profitable to extend credit to investors, thanks to lower loss experience and capital benefits. This continues to be a significant structural problem, which needs to be addressed.

Domestic and Cross-border Spillovers of Unconventional Monetary Policies

Interesting remarks from Benoît Coeuré, Member of the Executive Board of the European Central Bank, at the SNB-IMF Conference “Monetary Policy Challenges in a Changing World”, Zurich today. The discussion centres of the risk of bubbles when interest rates are artificially low, and exacerbated by other unconventional monetary strategies, why investment property is attractive in these conditions, and how macroprudential should be used to manage these unintended consequences in the context of growth. An edited version follows:

In recent years, there has been an intense discussion, both at the national and the international level, about the potential financial market implications of unconventional monetary policies. At the international level, policy makers have been particularly concerned with the surge in capital inflows, and the resulting exchange rate appreciation pressures in emerging markets. More recently, amid monetary policy normalisation in the United States and additional monetary policy easing in the euro area, including through the launch of the public sector purchase programme (PSPP), a new, but conceptually related discussion has emerged on the global financial market implications of diverging monetary policy cycles. At the national level, the main concerns were spillovers to equity and real estate markets, and the worries about the emergence of asset price bubbles as a result of unconventional policy measures.

Monetary policy always has unintended consequences, no matter where it is pursued. By altering short-term interest rates, central banks affect the inter-temporal decisions of households. Inter-temporal redistribution is at the heart of monetary policy that is aimed at ensuring price stability, and it thus has effects on the income distribution of savers and spenders.

But monetary policy also affects the distribution of income along the intra-temporal and spatial (cross-country) dimension. Changes in short-term interest rates affect consumption, savings and wealth in different ways, depending on the characteristics of individual households in different jurisdictions. But all these effects can be considered temporary, indirect and unintended, i.e. a side effect of a strategy that is aimed at ensuring price stability in the economy.

That said, it would be a logical fallacy to conclude that all domestic spillovers are acceptable. Bubbles are a case in point. Bubbles are a possible, but not an inevitable result of unconventional monetary policies. And if they are welcome at all, then only in a severely constrained, second-best world. But in this case, we should ask ourselves how we can overcome the constraints that prevent better policy outcomes, rather than settling for bubbles to temporarily mask the constraints.

Facing the threat of a persistent low-growth and low-inflation environment and a binding floor on standard policy rates, many central banks have resorted to unconventional measures. These measures were aimed at further pushing down nominal interest rates along the maturity spectrum to track the secular decrease in the natural, “Wicksellian” real rate of interest. Thereby, they helped induce firms and households bring forward their investment and consumption spending in comparison with that in a no policy-change scenario and, ultimately, bring the natural rate back to more normal levels.

I am convinced that there is no alternative for us than acting this way in order to deliver on our mandate. Yet, there is a danger associated with the temporary, yet potentially extended period where low interest rates are needed to stimulate investment and consumption. With real interest rates below potential growth, private agents may just borrow to purchase assets in limited or rigid supply (e.g. real estate property). In this dynamically inefficient world with structurally weak growth prospects, this may actually become an attractive way for savers to generate returns on their savings that investments in the productive sector are unable to generate.

In this case, we end up with a “rational bubble”. While unconventional monetary policy is not a necessary condition for this type of bubble to emerge, it may render it more likely – and more violent in the event of its materialising. So what are the consequences of such bubble?

In the short-term, it may indeed generate a temporary boost to the economy. And for a while this boost would be difficult to distinguish from the regular workings of asset purchase programmes, which actually embed asset price increases as a desired effect, which passes on the initial impulse to broader financing conditions via portfolio rebalancing. But this boost would ultimately be very costly. Not only does it does it come with welfare decreasing macroeconomic instability, but it also brings about an arbitrary redistribution of wealth that may, in the worst case, undermine social cohesion and trust that the central bank is acting within its narrow price stability mandate. And moreover, it can create financial stability risks elsewhere, generating negative spillovers from what should otherwise be a normal international adjustment process.

Against this background, it would be wrong to treat bubbles as a welcome replacement therapy to a sustainable growth model. Instead, macroeconomic and structural policies have to set the necessary conditions so that investment in productive sectors becomes attractive again and investment in bubble-prone areas is discouraged, so that total factor productivity is increased and the natural rate of interest ultimately reverts to what is normal.

We take monetary policy decisions with a view to attaining our primary objective of price stability. Thereby, we establish a stable nominal anchor for the private sector, which in turn is a fundamental precondition for overall macroeconomic stability. Without prejudice to this objective, we take financial stability risk seriously and monitor closely whether severe imbalances are emerging in the financial sector. In this context, we consider the financial stability risks related to our policy measures to be contained. Should risks emerge, macro-prudential policy is best suited to safeguard financial stability. Macroprudential instruments can be targeted more efficiently to those sectors and countries where systemic risks may be materialising. Finally, we encourage national authorities to do whatever is in their power to place the euro area on a more dynamic growth path, thereby creating attractive investment projects that generate high, but fundamentally justified, returns. These are the conditions for unconventional monetary policies policies to bring economies back to a stable and sustainable growth path, both at home and abroad.

Housing Market Imbalances Pose Long-term Challenges for Australian Banks – Moody’s

Moody’s Investors Service says that underwriting discipline and capital are key variables in maintaining the health of bank credit profiles in Australia, in the face of rising housing market imbalances.

“Rapid house appreciation, particularly in Sydney, as well as lending imbalances are increasing the risks of a housing market correction,” says Ilya Serov, a Moody’s Vice President and Senior Credit Officer. “This poses long-term challenges to Australian bank credit profiles”.

“We expect that over time the banks will revise up their mortgage risk weights and capital levels to better recognize the rising tail risks embedded in their housing portfolios,” adds Serov .

Moody’s analysis is contained in its just-released report titled “Rising Housing Market Imbalances Pose Long-Term Challenges for Australian Banks,” and is authored by Serov.

Moody’s report points out that dividend policy initiatives announced recently by major Australian banks — including National Australia Bank’s announcement of a capital raising of AUD5.5 billion — represent the start of a capital accumulation phase that is likely to extend well into 2016.

In Moody’s assessment, the risks in Australia’s housing market risks are skewed towards the downside. While over the short run, stability in the housing market will be supported by low interest rates and the healthy state of bank balance sheets, elevated and rising house prices are intensifying imbalances in the housing market.

Moody’s evaluation of the Australian housing market suggests that housing affordability is falling, despite the low interest rate environment. Similarly, lending imbalances, including a decline in the proportion of first-time home buyers and a sharp rise in residential investment activity, pose a further source of risk.

In Moody’s view, Australian banks are well-positioned to adjust their origination practices and capital levels to better recognize the rising tail risks embedded in their housing portfolios.

Moody’s report says likely regulatory changes will see average mortgage risk weights for the major banks in Australia increase to the 20%-25% range, up from the current 15%-20%. It estimates that Australia’s four major banks — National Australia Bank Limited (NAB, rated Aa2 stable, a1), Westpac Banking Corporation (Aa2 stable, a1), Australia and New Zealand Banking Group Limited (Aa2 stable, a1) and the Commonwealth Bank of Australia (Aa2 stable, a1) — are well-positioned to absorb such a change.

However, Moody’s also anticipates a broader increase in regulatory capital requirements, in line with the November 2014 recommendation by Australia’s independent Financial System Inquiry that Australian bank capital ratios should be “unquestionably strong” and rank in the top quartile of internationally active banks. This scenario would necessitate deeper adjustments to the banks’ dividend policies, and potentially the raising of new capital.

Moody’s report points out that the latest regulatory data suggests that Australian banks have become more conservative in their underwriting, as they have curtailed their exposure to high loan-to-value ratio loans. Such moves would help offset the risks posed by the country’s deepening housing market imbalances.

The rating agency sees ongoing adjustment to banks’ underwriting practices to bring them into line with the guidelines released by the Australian Prudential Regulation Authority in December 2014, which include limiting growth in investor housing loans to 10% per annum and specific guidance around stressed debt-service requirements, as supportive of the banks’ high rating levels.

Moody’s report notes that since May 2014, median home prices have risen by 10% nationwide, and by 16% in the core Sydney market . The report further notes that Australian home prices have risen by 23% since the start of the latest interest rate cutting cycle in November 2011.

Overall, Moody’s says that the banks’ asset quality metrics and portfolio quality will remain strong in calendar 2015, supported by Australia’s low interest-rate environment.

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).

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

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.

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.

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).

NZ Property Investors Highly Geared – RBNZ

In the May Stability Report the RBNZ have drilled into the Investment Property sector. They say they will be publishing more detailed data, but the current article makes interesting reading. Housing investors have consistently accounted for over one-third of property purchase transactions over the past decade, with the share rising slightly following the introduction of loan-to-value ratio (LVR) restrictions in October 2013 (figure A1). Sales to investors in the Auckland market have picked up in line with the rise in sales activity since November, and this is likely to be contributing to recent strength in Auckland house prices. Investors are also a key source of new mortgage credit demand, with property investors accounting for approximately one-third of new mortgage lending over the six months ended March 2015.

Although New Zealand has not experienced a financial crisis associated with the housing market, a range of international evidence suggests that defaults on investor lending tend to be significantly higher than for owner occupiers during severe downturns. For example, Irish investor mortgage default rates were around 20 percent higher than total mortgage default rates in the two years following the GFC. Default probabilities were estimated to have been significantly higher than owner-occupiers at any given LVR. Evidence from the UK and the US also finds that default rates were relatively high among investors in severe downturns. The Reserve Bank’s proposal to apply higher risk weights to investor lending, and introduce a differential LVR threshold for investors relative to owneroccupiers in Auckland, is consistent with this evidence.

A key driver of the higher default propensity of residential property investors is higher debt-to-income ratios (income gearing) relative to owner-occupiers. For example, an investor who has borrowed to buy four houses will end up with much larger negative equity relative to their labour income, if house prices fall, than an owner-occupier with just one house and a similar LVR. Higher income gearing reduces the incentive for the investor to continue servicing the outstanding loans, resulting in a greater tendency for investors to default when they have negative equity.

Another possible reason for the higher risks associated with investor lending is that investor house purchases have, in some countries, tended to be concentrated in areas with high expected capital growth. These expectations are often based on recent house price appreciation.

Evidence from the US suggests that increases in house prices prior to the GFC were particularly pronounced in regions where the investor share of house purchases increased. In turn, areas with rapid house price inflation experienced relatively large house price falls in the aftermath of the crisis.

In New Zealand, a significant proportion of property investors have large portfolios, implying a large degree of gearing relative to their underlying labour income. For example, the 2014 ANZ Residential Property Investment Survey shows that 26 percent of surveyed investors held seven or more investment properties (figure A2). Around half of investor commitments are at LVRs of more than 70 percent. Preliminary Reserve Bank survey data suggests that investors tend to make greater use of interest-only loans, which may partly reflect investors’ ability to offset mortgage expenses against personal income for tax purposes. As a result, investor loans are likely to retain a higher level of gearing over the long term than their owner-occupier counterparts.

The risks associated with investor lending are likely to be greatest in the Auckland region. Rapid house price appreciation in Auckland has compressed rental yields, and this is likely increasing income gearing among Auckland investors. Auckland rental yields are at record lows, while national yields are close to their 10-year average (figure A3). Relatively strong capital gain expectations among Auckland investors may explain why they are willing to accept such low rental yields. According to the 2014 ANZ Residential Property Investment Survey, investors in Auckland expected house price inflation to average 12 percent per annum in the region over the coming five years, compared to 8 percent nationwide. CoreLogic data also show that investors in the Auckland region are more likely to use mortgage finance than investors outside the Auckland region.