APRA – Page 29 – Digital Finance Analytics (DFA) Blog

Basel III Status Update – Where Australia Stands

The Basel Committee on Banking Supervision has today issued the Twelfth progress report on adoption of the Basel regulatory framework. This included a status summary for Australian Banks and shows that there are substantial steps to be taken to complete the current implementation, yet alone responding to the APRA-led proposals for further capital reform, which we expect to be the result of a discussion paper expected later in the year.

The complexity of the Basel capital frameworks continues to grow.

This report sets out the adoption status of Basel III standards for each BCBS member jurisdiction as of end-March 2017. It updates the Committee’s previous progress reports which have been published on a semiannual basis since October 2011 under the Committee’s Regulatory Consistency Assessment Programme (RCAP).

The report shows that:

all 27 member jurisdictions have final risk-based capital rules, LCR regulations and capital conservation buffers in force;

26 member jurisdictions have issued final rules for the countercyclical capital buffers;

25 have issued final or draft rules for domestic systemically important banks (D-SIBs) frameworks and, with regards to the global systemically important banks (G-SIBs) framework, all members that are home jurisdictions to G-SIBs have final rules in force;

20 have issued final or draft rules for margin requirements for non-centrally cleared derivatives.

Further, while some members have reported challenges in implementing the following standards for which the implementation dates have now passed, the report shows that:

21 member jurisdictions have issued final or draft rules of the revised Pillar 3 framework;

19 have issued final or draft rules of the SA-CCR and capital requirements for equity investments in funds;

17 have issued final or draft rules of capital requirements for CCP exposures.

Member jurisdictions are now turning to the implementation of other Basel III standards, including those on TLAC holdings, the market risk framework, the leverage ratio and the net stable funding ratio.

The Basel III framework builds on and enhances the regulatory framework set out under Basel II and Basel 2.5. The attached table is designed to monitor the adoption progress of all Basel III standards, which will come into effect by 2019. The monitoring table no longer includes the reporting columns for Basel II and 2.5, nor those Basel III standards that have been implemented by all BCBS members (definition of capital, capital conservation buffer and liquidity coverage ratio).

The following aspects of the risk-based capital standards are still being implemented:
o Countercyclical buffer: The countercyclical buffer is phased in parallel to the capital conservation buffer between 1 January 2016 and year-end 2018, becoming fully effective on 1 January 2019.
o TLAC holdings: The TLAC holdings standard was issued by the Committee in October 2016. It applies to all banks and describes the prudential treatment for holdings of instruments that comprise TLAC for the issuing G-SIB. The standard will take effect from 1 January 2019.
o Minimum capital requirements for market risk: In January, the Committee issued the revised minimum capital requirements for market risk, which will come into effect on 1 January 2019.
o Capital requirements for equity investment in funds: In December 2013, the Committee issued the final standard for the treatment of banks’ investments in the equity of funds that are held in the banking book, which took effect from 1 January 2017.
o SA-CCR: In March 2014, the Committee issued the final standard on SA-CCR, which took effect on 1 January 2017. It replaced both the Current Exposure Method (CEM) and the Standardised Method (SM) in the capital adequacy framework, while the IMM (Internal Model Method) shortcut method is eliminated from the framework.
o Securitisation framework: The Committee issued revisions to the securitisation framework in December 2014 and July 2016 to strengthen the capital standards for securitisation exposures held in the banking book, which will come into effect in January 2018.
o Margin requirements for non-centrally cleared derivatives: In September 2013, the Committee issued the final framework for margin requirements for non-centrally cleared derivatives. Subsequently, in March 2015, the Committee published a revised version. Relative to the 2013 framework, the revised version changes the beginning of the phase-in period for collecting and posting initial margin on non-centrally cleared trades from 1 December 2015 to 1 September 2016. The full phase-in schedule has been adjusted to reflect this nine-month change in implementation. The revisions also institute a six-month phase-in of the requirement to exchange variation margin, beginning 1 September 2016.
o Capital requirements for bank exposures to central counterparties: In April 2014, the Committee issued the final standard for the capital treatment of bank exposures to central counterparties. These came into effect on 1 January 2017.

Basel III leverage ratio: In January 2014, the Basel Committee issued the Basel III leverage ratio framework and disclosure requirements. Implementation of the leverage ratio requirements began with bank-level reporting to national supervisors until 1 January 2015, while public disclosure started on 1 January 2015. The Committee will carefully monitor the impact of these disclosure requirements. Any final adjustments to the definition and calibration of the leverage ratio will be made by 2017, with a view to migrating to a Pillar 1 (minimum capital requirements) treatment on 1 January 2018 based on appropriate review and calibration.

Monitoring tools for intraday liquidity management: This standard was developed in consultation with the Committee on Payment and Settlement Systems to enable banking supervisors to better monitor a bank’s management of intraday liquidity risk and its ability to meet payment and settlement obligations on a timely basis. The reporting of the monitoring tools commenced on a monthly basis from 1 January 2015 to coincide with the implementation of the LCR reporting requirements.

Basel III net stable funding ratio (NSFR): In October 2014, the Basel Committee issued the final standard for the NSFR. In line with the timeline specified in the 2010 publication of the liquidity risk framework, the NSFR will become a minimum standard by 1 January 2018.

G-SIB framework: In July 2013, the Committee published an updated framework for the assessment methodology and higher loss absorbency requirements for G-SIBs. The requirements came into effect on 1 January 2016 and become fully effective on 1 January 2019. National jurisdictions agreed to implement the official regulations/legislation that establish the reporting and disclosure requirements by 1 January 2014.

D-SIB framework: In October 2012, the Committee issued a set of principles on the assessment methodology and the higher loss absorbency requirement for domestic systemically important banks (D-SIBs). Given that the D-SIB framework complements the G-SIB framework, the Committee believes it would be appropriate if banks identified as D-SIBs by their national authorities were required to comply with the principles in line with the phase-in arrangements for the G-SIB framework, ie from January 2016.

Pillar 3 disclosure requirements: In January 2015, the Basel Committee issued the final standard for revised Pillar 3 disclosure requirements, which took effect from end-2016 (ie. banks are required to publish their first Pillar 3 report under the revised framework concurrently with their year-end 2016 financial report). The standard supersedes the existing Pillar 3 disclosure requirements first issued as part of the Basel II framework in 2004 and the Basel 2.5 revisions and enhancements introduced in 2009.

Large exposures framework: In April 2014, the Committee issued the final standard that sets out a supervisory framework for measuring and controlling large exposures, which will take effect from 1 January 2019.

Interest rate risk in the banking book: In April 2016, the Committee issued the final standard for Interest Rate Risk in the Banking Book (IRRBB), which is expected to be implemented by 2018.

APRA releases consultation package on revisions to large exposures

Last week, APRA released a consultation draft aimed at reducing “contagion risk”. Banks would be required to limit their exposures to unrelated counterparties to 25 per cent of Tier 1 Capital and 15 per cent of Tier 1 Capital to exposures to a bank designated as a global systemically important bank. This would bring Australian banks into line with Basel recommendations.

The Australian Prudential Regulation Authority (APRA) has today released for consultation a discussion paper setting out proposed revisions to its prudential framework on large exposures for authorised deposit-taking institutions (ADIs).

APRA’s large exposure framework aims to limit the impact of losses when a counterparty defaults, and restrict contagion risk from spreading across the financial system.

The proposed revisions are intended to strengthen the supervisory framework for large exposures, reduce system-wide contagion risk and maintain an alignment to the Basel Committee on Banking Supervision’s large exposures standards.

The consultation package released today includes a draft revised Prudential Standard APS 221 Large Exposures (APS 221), as well as associated reporting standards, reporting forms and reporting form instructions.

The discussion paper proposes revisions to large exposure requirements, including that:

the limit to an unrelated ADI and their subsidiaries be reduced from 50 per cent of Total Capital to 25 per cent of Tier 1 Capital;

a new limit of 15 per cent of Tier 1 Capital be applied to exposures to a bank designated as a global systemically important bank, and to exposures between banks designated by APRA as domestic systemically important banks; and

new criteria apply to identifying a group of connected counterparties and measuring large exposure values.

APRA invites written submissions on the proposals in the discussion paper by Wednesday 5 July 2017.

APRA expects to release a response paper and its final revised APS 221 and associated reporting package in the second half of 2017.

APRA’s intention is that the revised large exposure requirements will come into effect from 1 January 2019, in line with the internationally-agreed timetable.

Why The Gap Between Bank Serviceability And Real Life?

Following the recent coverage of our mortgage stress analysis (light it seems is now dawning on regulators, industry commentators and others that household debt is a real and growing issue), one question we get asked is – yes, but surely the banks have guidelines on affordability and serviceability, minimum assumed rate 2%+ above current rates, or 7%+?

So surely, households should have buffers as rates rise?

This is a great question, with a long history attached to it. A couple of years ago the regulators got a shock when them looked at bank practice, and started putting out more specific expectations on lending standards. Back in 2015, Wayne Byres made this point in a speech on lending standards. At its core was the observation that borrowers appeared to be able to get very different loan amounts from a selection of lenders, using the same base financial profile.

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.

In 2014, the RBA made this statement in their Financial Stability Report.

Although aggregate bank lending to these higher-risk segments has not increased, it is noteworthy that a number of banks are currently expanding their new housing lending at a relatively fast pace in certain borrower, loan and geographic segments. There are also indications that some lenders are using less conservative serviceability assessments when determining the amount they will lend to selected borrowers. In addition to the general risks associated with rapid loan growth, banks should be mindful that faster-growing loan segments may pose higher risks than average, especially if they are increasing their lending to marginal borrowers or building up concentrated exposures to borrowers posing correlated risks. As noted above, the investor segment is one area where some banks are growing their lending at a relatively strong pace. Even though banks’ lending to investors has historically performed broadly in line with their lending to owner-occupiers, it cannot be assumed that this will always be the case. Furthermore, strong investor lending may contribute to a build-up in risk in banks’ mortgage portfolios by funding additional speculative demand that increases the chance of a sharp housing market downturn in the future.”

“A build-up in investor activity may also imply a changing risk profile in lenders’ mortgage exposures. Because the tax deductibility of interest expenses on investment property reduces an investor’s incentive to pay down loans more quickly than required, investor housing loans tend to amortise more slowly than owner-occupier loans. They are also more likely to be taken out on interest-only terms. While these factors increase the chance of investors experiencing negative equity, and thus generating loan losses for lenders if they default, the lower share of investors than owner-occupiers who have high initial loan-to-valuation ratios (LVRs; that is an LVR of 90 per cent or higher) potentially offsets this. Indeed, the performance of investor housing loans has historically been in line with that of owner-occupier housing loans.

The trouble is that the basis on which banks have been assessing available income has been too optimistic. This is because they are based their calculations on historic mortgage book performance, when incomes were rising strongly, and loan losses were very low.

But we are now in a new normal. We have flat incomes. We have rising costs. We have underemployment. We have low growth. But costs of living are rising (and higher for many than the ABS CPI figure would suggest). Affordability is not what it was. Lenders need to adjust, hard to do when home prices are so high.

Combined, many households are stretched, and the prospect of rising interest rates in these conditions are making things harder.

In addition, households have been willing to gear up with the prospect of future capital growth, so reach for the largest mortgage they can get. Perhaps sometimes they exaggerate their incomes, and understate their costs. This is true we think for households with larger incomes, and lifestyles. Some of these are now under pressure.

So, the root cause of the gap between theoretical affordability and real life is a serious one. Banks often set and forget loans, so do not revisit households finances unless there is a reset or a crisis. But for many, available incomes are falling (and bracket creep is not helping). Ongoing financial health-checks might be in order.

ASIC is rightly looking at this issue anew, but we fear the horse may have already bolted. APRA will tighten capital. Both will put upward pressure on mortgage rates, and test affordability further. This is a paradigm shift.

Australia’s Limits on Interest-Only Mortgages Will Curb Riskier Lending

Moody’s says last Friday, the Australian Prudential Regulation Authority (APRA) announced new measures to restrict growth in riskier mortgage loans, including limiting the origination of interest-only mortgages, particularly those with high loan-to-value (LTV) ratios. On Monday, the Australian Securities Investments Commission (ASIC) announced that it will closely monitor lenders and mortgage brokers to ensure they are not inappropriately recommending more expensive interest-only loans to borrowers.

The new measures are credit positive for Australian banks, residential mortgage-backed securities (RMBS) and covered bonds because they will curb growth in riskier mortgage loans amid rising house prices and high household indebtedness. The measures include limiting the flow of new interest-only mortgages by banks to 30% of total new residential mortgage lending. Banks also will be required to have internal limits on the volume of interest-only lending at LTV ratios of more than 80% and ensure that there is strong justification for any interest-only loan with an LTV of 90% or more.

Interest-only loans accounted for 38% of total housing loan approvals in December 2016 and for more than 30% of total housing-loan approvals every month since June 2009 (see Exhibit 1). Housing investment loans, which are often interest-only loans, accounted for 35% of total housing loan approvals as of December 2016. In the RMBS sector, interest-only loans account for 35% of the mortgages backing the deals we rate.

We expect banks to raise interest rates on interest-only loans to reduce growth in this segment and support their net interest margin from ongoing price competition for lower-risk loans and stable deposits. When APRA introduced limits on housing investment loans in December 2014, banks responded by raising interest rates on such loans. In addition to the new limits on interest-only loans, APRA instructed banks to ensure that growth in housing investment loans remains “comfortably” below the 10% limit introduced in December 2014. APRA advised that banks will no longer have leeway to exceed this growth speed limit and that any breach will immediately prompt a review of the offending bank’s capital requirements. This contrasts with APRA’s original guidance, under which the 10% cap was not a hard limit.

APRA also announced that it would monitor the warehouse facilities that banks use to fund non-bank lenders. APRA does not regulate non-bank lenders, but monitoring the warehouse facilities will effectively allow the regulator to influence non-banks’ mortgage underwriting standards and promote the overall stability of the financial system. Non-bank lenders have increased housing investment lending since the introduction of the 10% limit on such loans (see Exhibit 1).

Although the APRA’s and ASIC’s measures add a layer of protection against a house price correction for banks, RMBS and covered bonds, it remains to be seen how effective these measures will be amid moderating house price appreciation, particularly when low interest rates continue to support housing demand. As Exhibit 2 shows, house prices have continued to rise, despite previous measures to slow the housing market.

APRA’s and ASIC’s latest measures and interest rate increases by banks on interest-only loans will slow demand for housing, but we continue to expect house prices in Australia to rise amid low interest rates. Although low interest rates will continue to support borrowers’ capacity to service their debt, rising house prices, in combination with high household leverage and low wage growth, remain risks for banks, RMBS and covered bonds.

APRA Looking At Capital Ratios For Mortgages

Wayne Byres speech “Fortis Fortuna Adiuvat: Fortune Favours the strong”, as Chairman of APRA, at the AFR Banking & Wealth Summit, makes two significant points.

First, there are elevated risks in the residential lending sector (even after the recent tactical announcements on interest only loans). Banks remain highly leveraged businesses.

Second, despite the delays from Basel, APRA will consult this year on potential changes to the capital ratios, reflecting the Australian Banks’ focus on mortgage lending and the need to be “unquestionably strong”.

A further indication that mortgage costs will continue to rise!

In the past few days, there has been a great deal of attention given to our recent announcement on additional measures to strengthen one particular part of the financial system: the residential mortgage lending market. These measures build on the steps we have taken over the past two years to bolster loan underwriting practices and moderate investor lending, in an environment that we considered to be one of heightened risk.

Those measures had a positive impact (Chart 1), but at the same time the risk environment certainly hasn’t moderated:

house prices remain high;

household income growth remains subdued;

the already high ratio of household debt to income has got higher;

the already low official cash rate has got lower (although not all of this reduction has flowed to borrowers, particularly investors; and

competitive pressures haven’t diminished.

It’s important to be clear that our goal in implementing the additional measures we announced on Friday is not to determine house prices. Housing prices are not within the control, nor the mandate, of the prudential regulator. Nor, as the Reserve Bank Governor said last night, can prudential measures address underlying supply-demand issues within the housing market. Rather, our role in the current environment is to promote a higher-than-normal degree of prudence – definitely by lenders and, ideally, also borrowers – in both credit decisions and balance sheet strength. On this occasion, we have focussed on interest-only lending to complement our earlier measures. Although there are perfectly legitimate reasons why individual borrowers might prefer an interest-only loan, in aggregate the level of interest-only lending creates additional vulnerabilities and we came to the view some additional moderation in this area was warranted.

We chose not to lower the investor lending growth benchmark at this point in time, given the need to accommodate the increasing supply of housing in the construction pipeline. However, limitations on the volume of new interest-only lending will impact investors more acutely than owner-occupiers, given that around two-thirds of lending to investors is on an interest-only basis. Furthermore, although the 12-month annual growth rate for investor lending is currently below the 10 per cent benchmark, the run rate in more recent months has been closer to (if not a little above) 10 per cent on an annualised basis. Therefore, even with the benchmark unchanged, lenders are still likely to have to tighten their lending practices and slow lending from that in recent months to ensure they remain comfortably below the desired level.

This latest step is a tactical response to current market conditions – we can and will do more (or less) as conditions evolve. We also developing a more strategic response that recognises that, in the Australian banking system, housing lending risks and capital adequacy are far from independent issues.

The banking system certainly has higher capital adequacy ratios than it used to. But overall leverage has not materially declined. The proportion of equity that is funding banking system assets has improved only modestly, from a touch under 6 per cent a decade ago to just on 6½ per cent at the end of 2016. Notwithstanding the extra capital that new regulation has required, banking remains a highly leveraged business.

Unquestionably strong

One way to think about our objective in establishing ‘unquestionably strong’ capital requirements is that we should be able to assert, with credibility, that the banking system can withstand reasonably foreseeable adversity and continue to provide its core function of financial intermediation for the Australian community.

Unfortunately, there is no universal measure of financial strength that provides a clear cut answer to that test. So we need to be able to look at this question through multiple lenses. In thinking about the concept of ‘unquestionably strong’, there are three basic ways to do that:

relative measures: the FSI adopted a relative approach in suggesting that unquestionably strong regulatory capital ratios would be positioned in the top quartile of international peers. We have said on a number of occasions that we do not intend to tie ourselves mechanically to some particular percentile, but top quartile positioning is a useful sense check which we can certainly use to guide our policy-making.

alternative measures: regulators do not have exclusive domain over measures of financial strength. There are a range of alternative measures, such as those used by rating agencies, which can be used to benchmark Australian banks. Again, we do not intend to tie ourselves too closely to these measures, but it would be difficult to argue the banking system is unquestionably strong if alternative measures of capital strength, particularly those that are influential in investment decision-making, were to suggest something to the contrary.

absolute measures: relative and alternative measures are useful guides, but the real test for a bank to claim it is unquestionably strong is whether it can comfortably survive extreme but plausible adversity. So stress testing, which doesn’t rely on relativities with other banks, or competing measures of strength, provides another useful guide for us.
Using multiple measures will provide useful insights on the banking system’s strength, but unfortunately will be unlikely to give us a single ‘right’ answer. At best it will provide a range for possible calibration which would reasonably meet our objective that, whichever lens you look through, we can credibly claim to have capital standards that produce an unquestionably strong banking system. We will still need to exercise judgement, taking account of other dimensions of risk within the system – both quantitative (such as liquidity and funding) and qualitative (such as risk management and risk culture within banks, and the strengths of the statutory framework and crisis management powers on which the stability of the system is built). Inevitably, some will argue the calibration should be higher, and others think it too high, but at the very least our logic and rationale should be transparent, and we can readily explain how our decisions are consistent with the FSI’s intent.

As things stand today, our plan is to issue an information paper around the middle of the year, which will set out how we view the banking system through the various lenses that I have just mentioned, the extent of further strengthening required, and the timeframe over which that can be achieved in an orderly manner.

Beyond establishing the aggregate level of capital, we will need to follow that up with consultation on how the regulatory framework should allocate that capital across the different types of risk exposure. Some of those changes will flow from the inevitable direction of the work in Basel that I referred to earlier: this will include, for example, greater limitations on the use of internal credit risk models, and the inevitable removal of operational risk models. These changes will primarily impact the larger banks.

But, coming back to my starting point, probably the biggest issue we will need to resolve in ensuring capital is appropriately allocated is whether and how we adjust the risk weights for housing-related exposures. Our announcement last week reflected a tactical response to current conditions in the housing market. We will continue to refine these sorts of measures as long as they are needed. But a longer term and more strategic response will involve a review, during the course of our work on ‘unquestionably strong’, of the relative and absolute capital requirements for housing exposures. That should not be taken to imply that there will be a dramatic increase in capital requirements for housing lending: APRA has always imposed capital requirements for housing exposures that are well above international minimum standards, so we do not start with glaring deficiencies. By anyone’s standard, however, we have a banking system that has a notable concentration in housing. It is therefore important we give that issue particular attention as we think about how to put the concept of ‘unquestionably strong’ into practice.

APRA’s housing intervention could suck billions out of the consumer economy

From Business Insider.

Despite the impression you might get from policy wrangling like we’ve seen in recent weeks over corporate tax rates, or complex arguments about the levels of growth that other policy adjustments can deliver, or the daily updates you’ll see on commodity prices, at the heart of the Australian economy there is one single force that is more important than any other. Consumers. People like you and me.

Our daily decisions to buy and sell things — the billions transactions we make every year — are by far the biggest component of economic activity. Look:

Source: JP Morgan
This broad bucket of “consumption” accounts for almost a trillion dollars of economic activity in Australia every year.

It’s why economists conduct expensive research on consumer confidence and why numbers like we’ve seen today, with the ANZ-Roy consumer confidence index slipping below its long-run average, are concerning.

If consumers enter a sustained period of uncertainty and feeling negative about the future, they’ll pull back their spending and the growth of this vast pool of economic activity will slow down.

There are tentative signs that a consumer retreat might be underway, for example in the negative growth in retail spending we saw in February. Car sales have also been looking a little weak.

The consumer confidence data out today shows a deterioration in how people are thinking about the future on a range of fronts, from the economic outlook to their own household finances. Here’s the chart showing people’s view on the medium-term economic outlook.

Source: ANZ
Ugly.

As David Scutt points out here, this is unusual given that surging properties like we’ve seen in the major cities would typically be linked with a “wealth effect”, whereby people feel better about their prospects because their house is worth more.

And this is where APRA, the banking regulator, comes in.

APRA last month introduced another range of measures to try and put the brakes on speculative activity in the housing market, chiefly by limiting the flow of new interest-only lending to 30% of new mortgage loans. The intervention has injected fresh vigour to the already intense national conversation about how expensive housing has become, particularly in the major cities.

This isn’t just about housing affordability. It comes after clear warnings from the RBA about risks to financial stability, noting last month that “recent data continued to suggest that there had been a build-up of risks associated with the housing market”.

It added that “borrowing for housing by investors had picked up over recent months and growth in household debt had been faster than that in household income”. These comments are part of a pattern of a steadily increasing focus on financial stability under the RBA governorship of Phil Lowe.

Housing can get expensive but that’s a problem you can live with. The same can’t be said of serious financial stability risks, hence the policy intervention.

It’s possible that all this talk in recent weeks has provoked Australians to reassess their prospects and come to grips with the fact that the debt taken on in getting into the property market will need to be repaid.

Feed this back into the prime importance of household consumption continuing to grow in the overall domestic picture, and you have a concerning picture.

And there’s more to come. Morgan Stanley analysts say APRA’s intervention could directly strip billions of dollars out of household consumption as banks move to reprice mortgages and investor loans that were previously interest-only roll over into much more costly principle-and-interest repayments.

In a research note the bank’s Australian equity strategy team, led by Chris Nicol, offered this calculation (emphasis added):

While this looks to be a cautious further step by APRA, we note that it comes alongside a material repricing of investor mortgages and will potentially be followed by higher risk weights. The market may also underestimate the degree to which Australian mortgage payments ‘step-up’ when rolling from IO-phase to P&I (at least +30% and often +50-70%, depending on tenors and headline rate). At an aggregate level, we calculate that a 10ppt fall in the share of IO mortgages to the new cap would reduce household free cash flow by around A$3bn (0.26% of income), with the average 14bp of mortgage hikes over the past fortnight absorbing another A$2bn (0.15%). This increases the burden on a consumer seeing no income growth (average wages were -0.5% in 2016), and we again reiterate our caution on the growth outlook, while seeing the market as too hawkish on the prospect of RBA hikes over the next 18 months.

That’s $3 billion sucked out of other parts of the consumer economy on top of the $2 billion already chipped out of households’ disposable income thanks to mortgage price increases by the banks last month.

As the saying goes, a billion here, a billion there, and sooner or later it starts to add up to real money.

In an environment where the retail industry – the biggest employment sector in the country after healthcare – is looking weak and inflation is staying low partly because consumers aren’t spending as freely as perhaps they would be if they weren’t loaded up with debt – all of this adds up to another prospective drag on the consumer outlook which is so central to economic growth.

The Interest-Only Loan Debt Trap II

Last October we wrote a series of posts on the risks related to interest only loans. Given recent developments, and the belated focus from APRA and ASIC, we revisit the topic today.

Here is a plot from the APRA data showing the relative movement of investor loans and interest only loans. Yes, there is a correlation! The ABC’s Phil Lasker used this chart in the TV News on Friday.

Lenders will need to throttle back new interest only loans. But this raises an important question. What happens when existing IO loans are refinanced?

Less than half of current borrowers have complete plans as to how to repay the principle amount.

Interest-only loans may seem like a convenient way to reduce monthly repayments, (and keep the interest charges as high as possible as a tax hedge), but at some time the chickens have to come home to roost, and the capital amount will need to be repaid.

Many loans are set on an interest-only basis for a set 5 year term, at which point the lender is required to reassess the loan and to determine whether it should be rolled on the same basis. Indeed the recent APRA guidelines contained some explicit guidance:

For interest-only loans, APRA expects ADIs to assess the ability of the borrower to meet future repayments on a principal and interest basis for the specific term over which the principal and interest repayments apply, excluding the interest-only period

This is important because the number of interest-only loans is rising again. Here is APRA data showing that about one quarter of all loans on the books of the banks are interest-only, and that recently, after a fall, the number of new interest-only loans is on the rise – around 35% – from a peak of 40% in mid 2015. There is a strong correlation between interest-only and investment mortgages, so they tend to grow together. Worth reading the recent ASIC commentary on broker originated interest-only loans.

But what is happening at the coal face? To find out we included some specific questions in our household survey, and today we present the results.

We were surprised to find that around 83% of existing interest-only loan holders expect to roll their loan to another interest-only loan, and to keep doing so. More concerning, only around 44% of borrowing households had an explicit discussion with the lender (or broker) at their last loan draw down or reset about how they plan to repay the capital amount outstanding. Some of these loans are a few years old.

Around 57% said they knew the capital would have to be repaid (we assume the rest were just expecting to roll the loan again) and 26% had no firm plans as to how to repay whereas 39% had an explicit plan to repay.

Many were expecting to close the loan out from the sale of the property (thanks to capital appreciation) at some point, from the sale of another property, or from another source, including an inheritance.

Thus we conclude there is a potential trap waiting for those with interest-only loans. They need a clear plan to repay, at some point. It also highlights that the quality of the conversation between borrower and lender is not up to scratch.

We think some borrowers on an interest-only loan may get a rude shock, when next they try to roll their interest-only loan. If they do not have a clear repayment plan, they may not get a new loan. There is a debt trap laid for the unwary and the APRA guidelines have made this more likely.

Back in 2014, we wrote about the interest only situation in the UK.

So, now lets look at the UK experience. There are 11.3 million mortgages in the UK, with loans worth over £1.2 trillion. At the end of 2013 there were an estimated 2.2 million pure interest-only loans outstanding, and a further 620,000 part interest-only, part repayment mortgages outstanding on lenders’ books. Compared to 2012 this represents a fall of around 300,000 pure interest-only mortgages (down 12%), and around 90,000 part-and-part mortgages (down 13%).

According to the Council for Mortgage Lenders, at the peak of their popularity in the late 1980s, interest-only mortgages accounted for more than 80% of all loans taken out. This year, however, lenders are likely to advance only around 40,000 new interest-only loans for residential house purchase, less than 10% of the total.

Among first-time buyers, the decline in interest-only borrowing has been particularly pronounced. CML data shows that only 2% are taking out interest-only mortgages, with 98% opting for repayment loans. Interest-only accounts for a higher proportion of new borrowing by existing owner-occupiers who are moving (10%) and those remortgaging (13%).

Most new interest-only borrowing is in the buy-to-let market (aka investment mortgage), where this option remains the norm for very good reasons. Fixed-rate interest-only mortgages minimise costs for landlords and are more likely to produce a profitable margin. Interest-only mortgages also enable landlords to meet lenders’ requirements that their rental income produces an average minimum cover of 125% of their borrowing costs.

A couple of years back, there were concerns in the UK that interest only loans may be a problem, and alongside regulatory commentary, CML produced an “interest-only toolkit” designed to help mortgage lenders to work with their interest only mortgage customers, especially those loans due for repayment before 2020.

The regulators reached the conclusion that 90% of interest-only mortgage holders have a repayment strategy in place. Lenders made a commitment with the regulator (the Financial Conduct Authority) to contact interest-only loan holders and ask about their repayment plans. The CML via it lender members found that Lenders have been using a variety of contact strategies. In addition to reminders and mailings requesting the customer’s written response (including questionnaire responses), telephone calls, face-to-face meetings and even home visits are also used by some lenders. Overall, around 30% of customers contacted have so far responded.

Among those borrowers who have responded, around four out of five already had a clear plan. Among those who did not, the survey found that the solutions and approaches lenders are offering typically include term extensions, permanent conversions to capital and interest, and overpayments.

There has also been a positive set of changes in the loan-to-value profile of outstanding interest-only mortgages. Two-thirds of outstanding interest-only mortgages have loan-to-value (LTV) ratios of less than 75% – and the vast majority of these are not due to mature until after 2020.

The chart shows that a large number of loans would have moved into a lower LTV band as a result of house price inflation alone. However, it also shows that borrowers are taking additional action to reduce their mortgage balances, as the effect of house price inflation alone would not have resulted in the improvements in outstanding LTVs that have been seen over the past year. Indeed, the number of loans in every LTV band below 75% would have seen an increase on the basis of house price inflation alone (as loans moved down from higher LTV bands) – but, in fact, every band saw a decrease.

Changes in interest-only loans outstanding, September 2012-December 2013, by LTV

Under the new mortgage regulations now in force in the UK, lenders may offer interest only loans, but only if a borrower has a credible repayment plan, at the time of application.

So some points to ponder.

1. How many interest only loans in Australia have a credible repayment strategy? To what extent is this considered by borrowers and lenders at the time of application?

2. Will rising house prices be the solution to interest-only loan repayment?

3. Are the review processes (on average each 5 years in Australia, even if the loan term is 25/30 years) sufficiently robust to identify potential issues?

4. Does Negative Gearing lead to a greater dependence on interest-only loans?

Banks and Investment Lending – The Non-Bank Winners!

APRA released their monthly statistics for February 2017 today. Overall lending for housing rose 0.4% (which is lower than the market rate of 0.6%, implying the non-bank sector is growing faster, and may account for APRA today saying they wanted to limit the bank’s ability to warehouse mortgages for other lenders prior to their securitisation).

This means the banks total book is now worth $1.54 trillion. Within that owner occupied loans rose 0.48% to $993 billion, whilst investment loans rose 0.33% to $543 billion, or 35.4%. This tells us that more investors are going to the non-banks – which are not regulated by APRA, but by ASIC as commercial companies – and they do not have the same capital requirements as the banks – this is a major regulatory blind-spot.

Looking at the ADI’s portfolio movements, CBA wrote the net largest loan volumes, followed by ANZ, then NAB. Westpac had the weakest growth among the big four. Among the smaller players, Bank of Queensland went backwards, whilst ME Bank and and AMP Bank grew relatively strongly.

The overall market share of the majors show CBA with the largest share of the OO market, and Westpac still in pole position (just) on investment loans. ANZ has a larger share than NAB of owner occupied loans, whilst in the investment loan sector, the position is reversed.

The APRA speed limit of 10% is higher than the annualised growth rate (which we calculate by summing the monthly movements from APRA), and we see that all the major players are “comfortably below” the 10%.

All in all then, we think the banks will still be writing more investment loans, and as a result, we expect the investor lending party will continue until such time as the tax breaks are reduced (which just might happen in the budget?). Therefore home prices are set to continue to push higher, as household debt rises higher. In addition, the out of cycle rises on investor loans will bolster bank profits, whilst the additional interest costs will be born by tax payers, as investors who are negatively geared offset the higher borrowing costs. There is nothing here that will fundamentally change the trajectory of the market.

One final point, APRA in their earlier release mentioned the Council of Financial Regulators, the body where the Treasury, RBA APRA and ASIC all sit to discuss strategy, so we have to assume there was agreement to adopt the current stance across these bodies.

APRA announces further measures to reinforce sound residential mortgage lending practices

The Australian Prudential Regulation Authority (APRA) is today initiating additional supervisory measures to reinforce sound residential mortgage lending practices in an environment of heightened risks.

The measures appear to target interest only loan growth, but does not formally change the overall investment loan growth speed limit. This appears a weak response, clearly aim at trimming the sails, not fundamentally changing trajectory, or materially slowing investor lending. The serviceability parameters remain the same, and they also, for the first time, mention controlling the growth of warehousing of securitised mortgage pools for other lenders (which may include non-banks).

The latest measures build on those communicated to authorised deposit-taking institutions (ADIs) in December 2014 aimed at improving the quality of new mortgage lending generally and moderating the growth of investor lending in particular. As was the case previously, these latest measures have been developed following discussions with other members of the Council of Financial Regulators (CFR).

Since December 2014, APRA, together with CFR members, has closely monitored residential mortgage lending trends and the resulting impacts on the resilience of lenders, as well as the household sector more broadly. This increased scrutiny has been in response to an environment of heightened risks, reflected in an environment of high housing prices, high and rising household indebtedness, subdued household income growth, historically low interest rates, and strong competitive pressures.

Given this environment, APRA has concluded that further steps to address risks that continue to build within the mortgage lending market are appropriate.

APRA has written to all ADIs today advising, in summary, that APRA expects ADIs to:

limit the flow of new interest-only lending to 30 per cent of total new residential mortgage lending, and within that:

place strict internal limits on the volume of interest-only lending at loan-to-value ratios (LVRs) above 80 per cent; and

ensure there is strong scrutiny and justification of any instances of interest-only lending at an LVR above 90 per cent;

manage lending to investors in such a manner so as to comfortably remain below the previously advised benchmark of 10 per cent growth;

review and ensure that serviceability metrics, including interest rate and net income buffers, are set at appropriate levels for current conditions; and

continue to restrain lending growth in higher risk segments of the portfolio (e.g. high loan-to-income loans, high LVR loans, and loans for very long terms).

APRA Chairman Wayne Byres said APRA believes the 10 per cent benchmark for growth in lending to investors continues to provide an appropriate constraint in the current environment, balancing the need to continue to moderate new investor lending with the increasing supply of newly completed construction which must be absorbed in the year ahead.

“APRA expects ADIs to target a level of investor lending growth that allows them to comfortably manage normal monthly volatility in lending flows without exceeding this benchmark level.”

However, additional supervisory measures, particularly in relation to the high level of interest-only lending, are warranted. Mr Byres said: “Our objective with these new measures is to ensure lenders are recognising the heightened risk in the lending environment, and that their lending standards and practices appropriately respond to these conditions.”

Mr Byres said lending on interest-only terms represents nearly 40 per cent of the stock of residential mortgage lending by ADIs – a share that is quite high by international and historical standards.

“APRA views a higher proportion of interest-only lending in the current environment to be indicative of a higher risk profile. We will therefore be monitoring the share of interest-only lending within total new mortgage lending for each ADI, and will consider the need to impose additional requirements on an ADI when the proportion of new lending on interest-only terms exceeds 30 per cent of total new mortgage lending.

“APRA has chosen not to set quantitative limits in relation to serviceability assessments at this point in time. However, APRA considers it important that borrowers retain some level of financial buffer to allow for unexpected events, especially for borrowers that have high levels of indebtedness.

“APRA will therefore continue to scrutinize serviceability assessments, and ADIs continue to need to advise APRA should they propose to change their existing methodologies or policies,” Mr Byres said.

APRA has advised ADIs that it is also monitoring the growth in warehouse facilities provided by ADIs to other lenders. These facilities allow lenders to build a portfolio of loans that will eventually be securitised. “APRA would be concerned if these warehouse facilities were growing at a materially faster rate than an ADI’s own housing loan portfolio, or if lending standards for loans held within warehouses are of a materially lower quality than would be consistent with industry-wide sound practices,” Mr Byres said.

He said that APRA also continues to monitor the prevalence of higher risk mortgage lending more generally, including lending at high loan-to-income ratios, lending at a high loan-to-valuation ratios, and lending at very long terms or with long interest only periods (e.g. beyond 5 years).

APRA will continue to observe conditions in the residential mortgage lending market, and may adjust the above measures, or implement additional ones, should circumstances warrant it.

A copy of the letter sent to ADIs today is available here: www.apra.gov.au/adi/Publications/Pages/other-information-for-adis.aspx

Further macroprudential action expected from APRA

From Australian Broker.

Despite the stable growth trends in some of the big four banks, trends in the national property market could see further macroprudential action by the Australian Prudential Regulation Authority (APRA).

In a Morningstar research note looking at the Commonwealth Bank of Australia (CBA), analysts predicted that the “overheating housing market” is likely to force APRA to once more slow the growth of investment lending.

“Likely action, known as macroprudential controls, include the reduction in the current 10% annual growth limit on residential lending to something around 5%-7%.

“Other less likely steps could be raising the minimum loan serviceability buffer to 3% from 2% and lifting the risk-weighted capital floor for new residential investor borrowers holding multiple properties to 75%-100%.”

At present, CBA applies a 7.25% rate to new home loan applicants to determine serviceability. This is 2.25% above the current customer rate.

Analysts said that while APRA does not publicly disclose individual bank capital requirements, it does and could “impose tougher measures on individual banks” if residential investor lending is growing at a rate deemed too risky.

While the 10% cap was introduced in December 2011, it only started to gain traction after peaking at 10.8% in June 2015 and falling to a low of 4.6% in August 2016. Since then however, growth rates have trended upwards, hitting 6.6% as of 31 January 2017.

Despite some concerns about the property market, analysts said the big four banks were “well placed to handle a modest decline in dwelling prices”.

“We believe an extended period of stable house prices or even a modest decline would be good for the housing market and reduce some of the pressure on capital city buyers and lenders.”

While historically, a period of flat house prices for five or seven years is normally expected after strong growth, analysts admitted being in “uncharted waters” with interest rates being at record lows.

Looking at CBA, Morningstar expected the bank to continue growing its home loan portfolio, albeit at a slower rate than before.

“We expect this strong growth rate to moderate during calendar 2017 and we forecast group home loan balances outstanding to grow an average of 5.5% per year from fiscal 2018-2021.”