Fitch Ratings says the Reserve Bank of Australia’s (RBA) recent interest rate cut is likely to lead to a strengthened macro-prudential response from the Australian Prudential Regulatory Authority (APRA) for the Australian banking system, although implementation will probably remain targeted and occur on a bank-by-bank basis.
Today’s rate cut is likely to further fuel the Australian property market, particularly in Sydney, at a time when the authorities are trying to take the steam out of the market. Macro-prudential tools allow the regulator to influence banks’ risk appetite, preserving asset quality and limiting potential losses in the event of an economic shock. The Australian banking system benefits from strong loss absorption capacity given the banks’ sound profit generation and provision levels, as well as adequate capitalisation. These strengths could be undermined by further increases in property prices and household debt, given mortgages form the largest asset class for Australian banks.
APRA has targeted certain higher risk areas such as investor mortgages, indicating growth in excess of 10% per annum would trigger closer regulatory monitoring and may lead to tougher capital requirements. In addition, APRA could use a set of other macro-prudential tools which may include a combination of debt-servicing requirements, additional capital requirements and/or loan-to-value ratio (LVR) restrictions, depending on each lender. Given the existence of lenders’ mortgage insurance (LMI), which mitigates the banks’ risk of higher LVR mortgages, debt-servicing requirements and higher capital requirements on a bank-by-bank basis are likely to be the preferred options.
Growing risks in the housing market and the banks’ mortgage portfolios could be exacerbated if further macro-prudential scrutiny is not forthcoming. The recent interest rate cut may lead to further house price appreciation, especially in cities such as Sydney and Melbourne, where there has been greater investor activity over the past 12 to 18 months. The first rate cut in February 2015 was followed by increased activity in these housing markets. The growth in house prices exceeded lending growth up to the end of 2014, but this trend could reverse as interest rates are at historical lows. At the same time, it makes borrowers vulnerable to a potential increase in interest rates in the medium term. Australia has one of the highest household debt levels globally, and if low interest rates contribute to higher credit growth, it could drive up household indebtedness from already historically high levels.
Falling interest rates may also result in further growth in potentially higher-risk loan types, such as interest-only and investor loans. These loan types already represent a high proportion of new approvals for Australian banks, as shown in Fitch’s “APAC Banks: Chart of the Month, February 2015”. The proportion of new interest-only mortgages is higher than new investor mortgages, suggesting that owner-occupiers are increasing the use of these types of loans at a time when historically-low interest rates should encourage borrowers to pay off debt. Serviceability testing at Fitch-rated Australian banks may provide some offset to this risk, with loans assessed on a principle and interest basis and at interest rates well above the prevailing market rate.
