Tag: APRA

Investors Boom, First Time Buyers Crash

The ABS released their Housing Finance data today, showing the flows of loans in January 2017. Those following the blog will not be surprised to see investor loans growing strongly, whilst first time buyers fell away. The trajectory has been so clear for several months now, and the regulator – APRA – has just not been effective in cooling things down.  Investor demand remains strong, based on our surveys. Half of loans were for investment purposes, net of refinance, and the total book grew 0.4%.

In January, $33.3 billion in home loans were written up 1.1%, of which $6.4 billion were refinancing of existing loans, $13.6 billion owner occupied loans and $13.5 billion investor loans, up 1.9%.  These are trend readings which iron out the worst of the monthly swings.

Looking at individual movements, momentum was strong, very strong across the investor categories, whilst the only category in owner occupied lending land was new dwellings.  Construction for investment purposes was up around 5% on the previous month.

Stripping out refinance, half of new lending was for investment purposes.

First time buyers fell 20% in the month, whilst using the DFA surveys, we detected a further rise in first time buyers going to the investment sector, up 5% in the month.

Total first time buyer activity fell, highlighting the affordability issues.

In original terms, total loan stock was higher, up 0.4% to $1.54 trillion.

Looking at the movements across lender types, we see a bigger upswing from credit unions and building societies, compared with the banks, across both owner occupied and investment loans. Perhaps as banks tighten their lending criteria, some borrowers are going to smaller lenders, as well as non-banks.

We think APRA should immediately impose a lower speed limit on investor loans but also apply other macro-prudential measures.  At very least they should be imposing a counter-cyclical buffer charge on investment lending, relative to owner occupied loans, as the relative risks are significantly higher in a down turn.

The budget has to address investment housing with a focus on trimming capital gain and negative gearing perks.  The current settings will drive household debt and home prices significantly higher again.

APRA Warns On Commercial Property Exposures

APRA has written to ADI’s today highlighting issues relating to the banks’ commercial property exposures, following a thematic review of commercial property lending over 2016. They say that the risk profile of lending has often been hampered by inadequate data, poor monitoring and incomplete portfolio controls across these portfolios.  They have written to individual lenders with specific requirements. APRA will conduct further work in this area during 2017.

They provided an attachment with more detailed observations from the review and some of APRA’s key expectations in relation to commercial property lending.

Underwriting Standards

Sound credit underwriting standards are fundamental to the safety and soundness of lenders, as well as the stability of the financial system as a whole. This is particularly the case in the area of commercial property lending, which has historically been the source of significant credit losses for the Australian banking industry. It is critical that ADIs maintain appropriate standards through the credit cycle, and are prepared to tighten those standards as circumstances dictate.

APRA has observed a general tightening of underwriting standards, especially for residential development lending, over the past year or so. This has not been uniform, however, and there is a need for ADIs to exercise particular care to ensure that they are not unduly accepting greater risk as other lenders step back.

The review also revealed evidence that some ADIs were justifying a particular underwriting stance based on what the ADI understood to be the criteria applied by another lender. Underwriting standards should be reflective of the ADI’s own risk appetite and not based on a potentially erroneous appreciation of a competitor’s criteria.

A summary of key observations follows:

Income producing investment lending

  • Insufficient constraints on debt size – A key concern is where ADIs have not adjusted the minimum Interest Cover Ratio (ICR), used for debt sizing investment loans, as interest rates have declined. At this point in time, APRA does not intend to prescribe an approach to setting minimum ICRs for debt sizing purposes; however, it does expect ADIs to have thoroughly considered and addressed this risk. ADIs should similarly consider their policies in relation to Loan to Valuation Ratios (LVRs) in light of recent strong asset price growth.
  • Debt yield as a complementary underwriting measure – Debt yield (net operating income to total debt) is used by some overseas banks as a key underwriting measure, but it is not commonly used within the Australian market. This metric, supported by prudent ICR and LVR measures as appropriate, could offer benefits to lenders as it provides a measurement of risk that is independent of the interest rate, amortisation period, and capitalisation rate.
  • Need for greater focus on refinancing risk – A number of ADIs demonstrated only limited analysis of the risk in refinancing a facility at maturity.

Residential Development Lending

  • Sponsors to contribute sufficient equity – A number of ADIs noted an increasing awareness of the use of mezzanine debt / quasi equity from third parties and reliance on material uplifts in land valuations to reduce the size of a sponsor’s contribution of ‘hard equity’. APRA expects ADIs ensure a sufficient level of ‘hard equity’ is at risk from sponsors.
  • Presale quality and coverage – In the past year, some ADIs have tightened underwriting criteria for presales coverage following market concerns with regard to settlement risk. ADIs are now generally requiring qualifying presales equivalent to at least 100 per cent of committed debt and have tightened the proportion of qualifying presales permitted to foreign purchasers. However, there was still scope for improvement in a number of ADIs’ policies on what constituted a qualifying presale, and the thoroughness of analysis of presales achieved for particular transactions was sometimes lacking.
  • Need to consider end product, location and quality – The consideration of potential marketability issues for properties, such as being poorly located, small apartments lacking in amenities and/or suffering from design issues, was not always evidenced in transaction analysis.

Portfolio Controls

A key finding from the thematic review is that many participating ADIs fell well short of expectations regarding portfolio controls for commercial property. This has been in part driven by an underinvestment in information systems, leading to challenges in extracting portfolio data. Ready availability of detailed and reliable transaction level data, appropriately aggregated, is a key component in obtaining a sound and complete understanding of the risk profile of the commercial property portfolio. Deficiencies in data hamper an ADI’s ability to implement and monitor underwriting standards and portfolio controls.

A summary of key observations follows:

  • Availability of transaction data lacking – The identification, recording, tracking and reporting of key transaction characteristics, in a manner which can be readily aggregated, is fundamental to sound risk management. These transaction characteristics include asset type, geographic location, construction contractor and developer concentrations and key underwriting metrics such as ICR, debt yield, loan-to-development costs (LDC), presales to debt cover and LVR. Analysis of these transaction drivers helps an ADI to understand its risk profile at different stages of the cycle. A large number of ADIs were unable to readily provide reasonably basic portfolio information to APRA as part of this review.
  • Portfolio limits can be improved – APRA expects that ADIs with commercial property exposures should manage not only the risk of individual loans but also consider build-ups in risk at the portfolio level. A deeper understanding of the portfolio can be particularly helpful for the Board and senior management in setting and monitoring portfolio limits, and adherence to the lender’s risk appetite, as market conditions change. One fundamental management control to prevent a build-up in risk is an overarching sector concentration limit, as per Prudential Standard APS 221 Large exposures. Better practice would be to also have sub-limits to control concentrations in riskier segments of the portfolio, such as lending for development or land. In addition, improvements in data and system capabilities would permit the establishment of a more targeted risk metrics and controls relating to key transaction drivers for the stage of the cycle.
  • Better practice is for deep dives into heightened risk segments – A number of participating ADIs had reacted to perceptions of heightened risk in market segments by undertaking deep dive exercises, targeted stress tests and the provisions of additional targeted reports to key stakeholders. This was particularly noticeable for locations where there was considered to be increased settlement risk and had led, in some cases, to tightened underwriting standards for that segment.Identifying and managing exposures originated outside of standards
  • Inadequate monitoring of exceptions to underwriting standards – Many ADIs fell short of APRA’s expectations with respect to monitoring exceptions to policy and underwriting standards in the commercial property portfolio. This has been a long-standing concern and many ADIs need to improve their capabilities in this area. Inadequate monitoring of policy exceptions/overrides potentially exposes the ADI to a build-up of risk outside of the documented underwriting standards, representing a shift in risk profile beyond the levels formally approved.
  • Insufficient justification for deviation from standards – APRA’s review of transactions with higher risk characteristics, or outside ADI underwriting standards, indicated varying levels of qualitative assessment supporting the taking on of higher risk. Justifying lending decisions on the basis of ‘long-standing relationship’ or ‘good track record’ are insufficient, by themselves, to mitigate higher risk characteristics such as higher leverage or weaker presale cover, especially if these are outside approved underwriting standards.

We see no room for complacency – APRA

Wayne Byres opening remarks to the Senate Economics Legislation Committee in Canberra includes comments on household debt and the mortgage industry. Further evidence this is now on the supervisory agenda following recent RBA comments.  Some might say, better late than never!

I will just start with a short statement of a few key issues currently on APRA’s plate.

Before I do, however, it’s important to note that Australia continues to benefit from a financial system that is fundamentally sound. That is not to say there are not challenges and problems to be addressed. However, as I’ve said elsewhere, to the extent we’re grappling with current issues and policy questions, they don’t reflect an impaired system that needs urgent remedial attention, but rather a desire to make the system stronger and more resilient while it is in good shape to do so.

The main policy item we have on our agenda in 2017 is the first recommendation of the Financial System Inquiry (FSI): that we should set capital standards so that the capital ratios of our deposit-takers are ‘unquestionably strong.’ We had held off taking action on this until the work by the Basel Committee on the international bank capital regime had been completed. But delays to the work in Basel mean we don’t think we should wait any longer.

Our goal in implementing the FSI’s recommendation is to enhance the capital framework for deposit-takers to achieve not only greater resilience, but also increased flexibility and transparency. And in doing all this, we will also be working to enable affected institutions to adjust to any policy changes in an orderly manner. If we achieve our goals, we will not only deliver improved safety and stability within the financial system, we will also aid other important considerations such as competition and efficiency.

We have many supervisory challenges at present, but there is no doubt that monitoring conditions in the Australian housing market remains high on our priority list. We have lifted our supervisory intensity in a number of ways, including reinforcing stronger lending standards and seeking in particular to moderate the rapid growth in lending to investors. These efforts have had the desired impact: we can be more confident in the conservatism of mortgage lending decisions today relative to a few years ago, and lending to investors was running at double digit rates of growth but has since come back into single figures.

However, strong competitive pressures are producing higher rates of lending growth again. This is occurring at a time when household debt levels are already high and household income growth is subdued. The cost of housing finance is also more likely to rise than fall. We therefore see no room for complacency, and mortgage lending will inevitably remain a very important issue for us for the foreseeable future.

The final issue I wanted to mention is our work on superannuation governance. This is an area where we remain keen to lift the bar. There are some excellent examples of good practice governance in the superannuation sector, but equally there are examples where we think more can be done to make sure members’ interests are paramount. Late last year, we finalised some changes to our prudential requirements to strengthen governance frameworks. The changes we implemented were relatively uncontroversial at the time, and have largely been included within the principles for sound governance that have subsequently been generated by the industry itself.

Banks Made $28.4 billion Year To Dec 2016, Down 22.7%

APRA has released their latest quarterly data to December 2016 on Authorised Deposit-taking Institution Performance. Profitability and return on equity are down, despite significantly lower provisioning.

A quick look at the 4 majors shows further growth in home lending assets, small falls in capital, after an earlier rise, and the continued high leverage ratio between share capital and total assets – it sits at 5.38%, which highlights the continued massive leverage in the system.

Financial performance

  • The net profit after tax for all ADIs was $28.4 billion for the year ending 31 December 2016. This is a decrease of $8.4 billion (22.7 per cent) on the year ending 31 December 2015.
  • The cost-to-income ratio for all ADIs was 47.9 per cent for the year ending 31 December 2016, compared to 49.4 per cent for the year ending 31 December 2015.
  • The return on equity for all ADIs was 10.0 per cent for the year ending 31 December 2016, compared to 13.8 per cent for the year ending 31 December 2015.

Capital adequacy

  • The  total capital ratio for all ADIs was 13.8 per cent at 31 December 2016, a decrease from 13.9 per cent on 31 December 2015.
  • The common equity tier 1 ratio for all ADIs was 9.9 per cent at 31 December 2016, a decrease from 10.2 per cent on 31 December 2015.
  • The risk-weighted assets (RWA) for all ADIs was $1.98 trillion at 31 December 2016, an increase of $109.2 billion (5.8 per cent) on 31 December 2015.

Asset quality

For all ADIs:

  • Impaired facilities were $15.3 billion as at 31 December 2016. This is an increase of $1.5 billion (11.2 per cent) on 31 December 2015. Past due items were $12.9 billion as at 31 December 2016. This is an increase of $1.2 billion (10.1 per cent) on 31 December 2015;
  • Impaired facilities and past due items as a proportion of gross loans and advances was 0.92 per cent at 31 December 2016, an increase from 0.86 per cent at 31 December 2015;
  • Specific provisions were $7.3 billion at 31 December 2016. This is an increase of $0.8 billion (12.9 per cent) on 31 December 2015; and
  • Specific provisions as a proportion of gross loans and advances was 0.24 per cent at 31 December 2016, an increase from 0.22 per cent at 31 December 2015.

On a consolidated group basis, there were 152 ADIs operating in Australia as at 31 December 2016, compared to 153 at 30 September 2016 and 157 at 31 December 2015.

  • Central Coast Credit Union Ltd changed its name from Wyong Shire Credit Union Ltd, with effect from 15 November 2016.
  • Fire Brigades Employees’ Credit Union Limited had its authority to carry on banking business in Australia revoked, with effect from 1 December 2016.
  • Bank Australia Limited changed its name from MECU Limited, with effect from 15 December 2016.

Signs of More Risk Taking In The Mortgage Book

The latest APRA data on ADI Property Exposures to December 2016 tells an interesting story.  Essentially, whilst the proportion of higher LVR loans slides, in recent times lenders – especially the big four – appear to be more willing to make interest only loans (on the back of higher volumes of investment loans) alongside out of normal criteria loans. The APRA guidance has not it seems trimmed risk appetite so far.

ADIs residential term loans to households were $1.49 trillion as at 31 December 2016. This is an increase of $110.0 billion (8.0 per cent) on 31 December 2015. There are 5,728,000 housing loans (up 3.6% a year ago). The average balance is $257,300, up 3.5% from a year ago.  $101.0 billion of loans were written in the December quarter.

Total Book

Looking in more detail, first at the aggregate data, we clearly see a rise in the proportion of new investment loans being written to December 2016.

Interest only loans are rising, to 40% and the share via brokers also trended up to 48.8%. We know loans via brokers are higher risk. The proportion of loans approved outside serviceability is also higher.

The proportion of higher LVR loans continues to trend down whilst the 60-80% LVR loans are higher, we also see a slight uptick in the 80-90% LVR bands.

The Four Majors

Turning to the aggregate data from the 4 majors, the rise in investment loans is more pronounced, to 38.4%.

The proportion of interest loan loans has risen, to 40%, from a recent low of 37%. Loans outside serviceability sits at 3.5%.

The high LVR loans are lower, more than half of new loans are in the 60-80% LVR band.

Other Banks (Regionals Etc.)

Looking at the other banks (excluding the big 4), the share of investment loans are down to 27%.

We see a fall in interest only loans, down to 30.7%, whilst the share of broker loans has risen to 52.2%, higher than the majors.

We see a similar trend in a fall in higher LVR loans.

Worth also noting the volumes through credit unions and building societies are no longer being report, thanks to low volumes. So much for the “new force” in banking from the Customer Owned Institutions.

ADI’s Still Growing Their Mortgage Books

The latest ADI data from APRA, to end January 2017 shows that the banks  have $1,529 billion in mortgage loan stock, up from $1,523 billion in December, a rise of nearly $6 billion.  The RBA credit number was $1,637.4 billion, up 1% or $15.2 billion, suggesting the non-banks have been more active recently.

When we dig into the mix between owner occupied and investment loans, we need to make an adjustment to the December numbers where ING had (we estimate) about $3 billion of investment loans reported as owner occupied loans. This was reversed this month, so a casual observer will pick a stronger growth in investment loans than is the case. Nothing in the APRA release mentions this significant movement – again!

We think owner occupied loans grew by $3.9 billion and investment loans by $1.7 billion.

The corrected movements over the months look like this, with average growth around 0.4%, down from December. Given the holidays, no surprise.

This is the silly chart you get if you do not adjust the ING reversal, with investment loans at 0.9%.

In the month, and using the adjusted data, we see CBA wrote the most loans, with Westpac and NAB in joint second place. ANZ reduced its portfolio a little.

Here is the same data, but now with ING showing the offsetting changes from last month.

CBA has the largest share of OO loans, and WBC of investment loans, though CBA was catching up prior to the recently announced changes to investment lending policies.

Here is a map of the 10% speed limit. We added a year’s worth of portfolio movements to get this data (though others may choose to gross up the past 3 or 6 months). However, on this basis, CBA is running closer to the 10% speed limit which APRA reconfirmed recently.

Tighter underwriting requirements from APRA are likely to reduce future loan growth, but we reached yet another record in January.

 

The Rise of Microprudential

APRA’s revised mortgage guidance released yesterday, on the surface may look benign but if you look at the detail there are a number of changes which together do change the game in terms of risk analysis during underwriting, and through the life of the mortgage. We think this will slow credit growth through 2017 and beyond.

We suggest this is imposing significant micro-management on the portfolio, which will force some lenders to change their current practices.

Investment Property Underwriting Tightened.

APRA says a minimum haircut of 20% on expected rental income, and larger discounts on properties where there is a higher risk of non-occupancy should be applied. They also need to taking into account a borrower’s investment property-related fees and expenses. Also, APRA highlights that an ADI should ideally “place no reliance on a borrower’s potential ability to access future tax benefits from operating a rental property at a loss”, but if an ADI chooses to do so, it “would be prudent to assess it at the current interest rate rather than one with a buffer applied”.

Serviceability Tests Strengthened

APRA reaffirmed the interest rate buffer of at least 2% and minimum lending floor rate of at least 7% for mortgages. But now APRA says ADIs should apply these buffers a borrower’s new and existing debt commitments. To do this, banks will need to have more detailed knowledge of a borrower’s existing debt commitments and history of  delinquency.

Expenses Assessment Tightened

APRA wants ADIs to use the greater of a borrower’s declared living expenses or an appropriately income scaled version of the Household Expenditure Measure (HEM) or Henderson Poverty Index (HPI). They cannot rely fully on HEM or HPI to assess living expenses. They suggest expenses should be more correlated to income.

Income Assessment Tightened

APRA says banks should apply discounts of at least 20% (instead of being calculated at the ADIs’ discretion) to be applied to most types of non-salary income (rental income on investment properties, bonuses, child benefits etc.). A larger discount should sometimes be used where income is more variable over time – “an ADI may choose to use the lowest documented value of such income over the last several years, or apply a 20 per cent discount to the average amount received over a similar period”.

Interest Only Loans More Restricted

APRA expects interest-only periods offered on residential mortgage loans to be of limited duration, particularly for owner-occupiers. Interest-only loans may carry higher credit risk in some cases, and may not be appropriate for all borrowers. This should be reflected in the ADI’s risk management framework, including its risk appetite statement, and also in the ADI’s responsible lending compliance program. APRA expects that an ADI would only approve interest-only loans for owner-occupiers where there is a sound and documented economic basis for such an arrangement and not based on inability to service a loan on a principal and interest basis.

SMSF Property Loans Require More Examination

The nature of loans to SMSFs gives rise to unique operational, legal and reputational risks that differ from those of a traditional mortgage loan. Legal recourse in the event of default may differ from a standard mortgage, even with guarantees in place from other parties. Customer objectives and suitability may be more difficult to determine. In performing a serviceability assessment, ADIs would need to consider what regular income, subject to haircuts as discussed above, is available to service the loan and what expenses should be reflected in addition to the loan servicing. APRA expects that a prudent ADI would identify the additional risks relevant to this type of lending and implement loan application assessment processes and criteria that adequately reflect these risks.

LVR Is Not A Good Risk Indicator

Although mortgage lending risk cannot be fully mitigated through conservative LVRs, prudent LVR limits help to minimise the risk that the property serving as collateral will be insufficient to cover any repayment shortfall. Consequently, prudent LVR limits serve as an important element of portfolio risk management. APRA emphasises, however, that loan origination policies would not be expected to be solely reliant on LVR as a risk-mitigating mechanism.

Genuine Savings To Be Tested

ADIs typically require a borrower to provide an initial deposit primarily drawn from the borrower’s own funds. Imposing a minimum ‘genuine savings’ requirement as part of this initial deposit is considered an important means of reducing default risk. A prudent ADI would have limited appetite for taking into account non-genuine savings, such as gifts from a family member. In such cases, it would be prudent for an ADI to take all reasonable steps to determine whether non-genuine savings are to be repaid by the borrower and, if so, to incorporate these repayments in the serviceability assessment.

Granular and Ongoing Portfolio Management Required

Where residential mortgage lending forms a material proportion of an ADI’s lending portfolio and therefore represents a risk that may have a material impact on the ADI, the accepted level of credit risk would be expected to specifically address the risk in the residential mortgage portfolio. Further, in order to assist senior management and lending staff to operate within the accepted level of credit risk, quantifiable risk limits would be set for various aspects of the residential mortgage portfolio.

A robust management information system would be able to provide good quality information on residential mortgage lending risks. This would typically include:

a) the composition and quality of the residential mortgage lending portfolio, e.g. by type of customer (first home buyer, owner-occupied, investment etc), product line, distribution channel, loan vintage, geographic concentration, LVR bands at origination, loans on the watch list and impaired;
b) portfolio performance reporting, including trend analysis, peer comparisons where possible, other risk-adjusted profitability and economic capital measures and results from stress tests;
c) compliance against risk limits and trigger levels at which action is required;
d) reports on broker relationships and performance;
e) exception reporting including overrides, key drivers for overrides and delinquency performance for loans approved by override;
f) reports on loan breaches and other issues arising from annual reviews;
g) prepayment rates and mortgage prepayment buffers;
h) serviceability buffers including trends, performance, recent changes to buffers and adjustments and rationale for changes;
i) missed payments, hardship concessions and restructurings, cure rates and 30-, 60- and 90-days arrears levels across, for example, different segments of the portfolio, loan vintage, geographic region, borrower type, distribution channel and product type;
j) changes to valuation methodologies, types and location of collateral held and analysis relating to any current or expected changes in collateral values;
k) findings from valuer reviews or other hindsight reviews undertaken by the ADI;
l) reporting against key metrics to measure collections performance;
m) tracking of loans insured by LMI providers, including claims made and adverse findings by such providers;
n) provisioning trends and write-offs;
o) internal and external audit findings and tracking of unresolved issues and closure;
p) issues of contention with third-parties including service providers, valuation firms, etc; and
q) risk drivers and other components that form part of scorecard or models used for loan origination as well as risk indicators for new lending.

When setting risk limits for the residential mortgage portfolio, a prudent ADI would consider the following areas:

a) loans with differing risk profiles (e.g. interest-only loans, owner-occupied, investment property, reverse mortgages, home equity lines-of-credit (HELOCs), foreign currency loans and loans with non-standard/alternative documentation);
b) loans originated through various channels (e.g. mobile lenders, brokers, branches and online);
c) geographic concentrations;
d) serviceability criteria (e.g. limits on loan size relative to income, (stressed) mortgage repayments to income, net income surplus and other debt servicing measures);
e) loan-to-valuation ratios (LVRs), including limits on high LVR loans for new originations and for the overall portfolio;
f) use of lenders mortgage insurance (LMI) and associated concentration risks;
g) special circumstance loans, such as reliance on guarantors, loans to retired or soon-to–be-retired persons, loans to non-residents, loans with non-typical features such as trusts or self-managed superannuation funds (SMSFs);
h) frequency and types of overrides to lending policies, guidelines and loan origination standards;
i) maximum expected or tolerable portfolio default, arrears and write-off rates; and
j) non-lending losses such as operational breakdowns or adverse reputational events related to consumer lending practices.

Good practice would be for the risk management framework to clearly specify whether particular risk limits are ‘hard’ limits, where any breach is escalated for action as soon as practicable, or ‘soft’ limits, where occasional or temporary breaches are tolerated.

 

APRA Updates Mortgage Lending Practices

APRA has updated the mortgage lending guidance, to include more specific guidance on gifts for deposits, off-the-plan lending, allowance for vacant periods on rental proprieties, allowance for irregular income and confirmation of interest rate floor and buffers. There are also important comments relating to brokers, portfolio analysis and management responsibility. For example, banks will need to have ongoing awareness of households finances, rather than making a point-in-time, set-and-forget assessment. Whilst they say these changes are not material, in practice they are significant, and it suggests a more detailed “micro” analytical approach to lending scrutiny, rather than generic portfolio analytics. This is important and will impact. We think the costs of managing a mortgage portfolio just went up!

The Australian Prudential Regulation Authority (APRA) has updated its expectations for sound residential mortgage lending practices for authorised deposit-taking institutions (ADIs) following consultation with industry and other stakeholders.

APRA released for consultation a revised draft of Prudential Practice Guide APG 223 Residential Mortgage Lending in October 2016 to incorporate measures previously announced by APRA in 2014 or communicated to ADIs since that time.

The revisions to APG 223 are designed to ensure that the sound lending practices that have been implemented across the industry since late 2014 are maintained and reinforced.

As a result of the consultation, APRA has made a small number of refinements to the prudential practice guide, which are explained in a letter to ADIs released today. APRA does not expect these refinements to result in material changes to existing lending practices across the industry as a whole.

APRA is continuing to maintain its close monitoring and supervision of residential mortgage lending practices, including growth in investor lending, as part of its broader mandate to build resilience in the financial sector and promote financial system stability.

There are a few important comments which may trouble some lenders. For example:

Where residential mortgage lending forms a material proportion of an ADI’s lending portfolio and therefore represents a risk that may have a material impact on the ADI, the accepted level of credit risk would be expected to specifically address the risk in the residential mortgage portfolio.

In order to establish robust oversight, the Board and senior management would receive regular, concise and meaningful assessment of actual risks relative to the ADI’s risk appetite and of the operation and effectiveness of internal controls. The information would be provided in a timely manner to facilitate early corrective action.

A robust management information system would be able to provide good quality information on residential mortgage lending risks.

In Australia, it is standard market practice to pay brokers either an upfront commission or a trailing commission, or both. A prudent approach to the use of third parties for residential mortgage lending would include appropriate measures to ensure that commission-based compensation does not create adverse incentives.

When an ADI is increasing its residential mortgage lending rapidly or at a rate materially faster than its competitors, either across the portfolio or in particular segments or geographical areas, a prudent Board would seek explanation as to why this is the case.

Where an ADI uses different serviceability criteria for different products or across different ‘brands’, APRA expects the ADI to be able to articulate and be aware of commercial and other reasons for these differences, and any implications for the ADI’s risk profile and risk appetite.

Good practice would apply a buffer over the loan’s interest rate to assess the serviceability of the borrower (interest rate buffer). This approach would seek to ensure that potential increases in interest rates do not adversely impact on a borrower’s capacity to repay a loan. The buffer would reflect the potential for interest rates to change over several years. APRA expects that ADI serviceability policies should incorporate an interest rate buffer of at least two percentage points. A prudent ADI would use a buffer comfortably above this level.

In addition, a prudent ADI would use the interest rate buffer in conjunction with an interest rate floor, to ensure that the interest rate buffer used is adequate when the ADI is operating in a low interest rate environment. Prudent serviceability policies should incorporate a minimum floor assessment interest rate of at least seven per cent. Again, a prudent ADI would implement a minimum floor rate comfortably above this level.

When assessing a borrower’s income, a prudent ADI would discount or disregard temporarily high or uncertain income. Similarly, it would apply appropriate adjustments when assessing seasonal or variable income sources. For example, significant discounts are generally applied to reported bonuses, overtime, rental income on investment properties, other types of investment income and variable commissions; in some cases, they may be applied to child support or other social security payments, pensions and superannuation income. Prudent practice is to apply discounts of at least 20 per cent on most types of non-salary income; in some cases, a higher discount would be appropriate. In some circumstances, an ADI may choose to use the lowest documented value of such income over the last several years, or apply a 20 per cent discount to the average amount received over a similar period.

In APRA’s view, prudent serviceability policies incorporate a minimum haircut of 20 per cent on expected rental income, with larger haircuts appropriate for properties where there is a higher risk of non-occupancy.

Good practice would be for an ADI to place no reliance on a borrower’s potential ability to access future tax benefits from operating a rental property at a loss. Where an ADI chooses to include such a tax benefit, it would be prudent to assess it at the current interest rate rather than one with a buffer applied.

Good practice would be for an ADI, rather than a third party, to perform income verification

Some ADIs use rules-based scorecards or quantitative models in the residential mortgage loan evaluation process. In such cases, good practice would include close oversight and governance of the credit scoring processes. Where decisions suggested by a scorecard are overridden, it is good practice to document the reasons for the override.

Interest-only loans may carry higher credit risk in some cases, and may not be appropriate for all borrowers. This should be reflected in the ADI’s risk management framework, including its risk appetite statement, and also in the ADI’s responsible lending compliance program. APRA expects that an ADI would only approve interest-only loans for owner-occupiers where there is a sound and documented economic basis for such an arrangement and not based on inability to service a loan on a principal and interest basis. APRA expects interest-only periods offered on residential mortgage loans to be of limited duration, particularly for owner-occupiers.

The nature of loans to SMSFs gives rise to unique operational, legal and reputational risks that differ from those of a traditional mortgage loan. Legal recourse in the event of default may differ from a standard mortgage, even with guarantees in place from other parties. Customer objectives and suitability may be more difficult to determine. In performing a serviceability assessment, ADIs would need to consider what regular income, subject to haircuts as discussed above, is available to service the loan and what expenses should be reflected in addition to the loan servicing. APRA expects that a prudent ADI would identify the additional risks relevant to this type of lending and implement loan application assessment processes and criteria that adequately reflect these risks.

Although mortgage lending risk cannot be fully mitigated through conservative LVRs, prudent LVR limits help to minimise the risk that the property serving as collateral will be insufficient to cover any repayment shortfall. Consequently, prudent LVR limits serve as an important element of portfolio risk management. APRA emphasises, however, that loan origination policies would not be expected to be solely reliant on LVR as a risk-mitigating mechanism.

ADIs typically require a borrower to provide an initial deposit primarily drawn from the borrower’s own funds. Imposing a minimum ‘genuine savings’ requirement as part of this initial deposit is considered an important means of reducing default risk. A prudent ADI would have limited appetite for taking into account non-genuine savings, such as gifts from a family member. In such cases, it would be prudent for an ADI to take all reasonable steps to determine whether non-genuine savings are to be repaid by the borrower and, if so, to incorporate these repayments in the serviceability assessment.

In the case of valuation of off-the-plan sales, developer prices might not represent a sustainable resale value. Consequently, in such circumstances, a prudent ADI would make appropriate reductions in the off-the-plan prices in determining LVRs or seek independent professional valuations.

A prudent ADI would regularly stress test its residential mortgage lending portfolio under a range of scenarios. Scenarios used for stress testing would include severe but plausible adverse conditions

LMI is not an alternative to loan origination due diligence. A prudent ADI would, notwithstanding the presence of LMI coverage, conduct its own due diligence, including comprehensive and independent assessment of a borrower’s capacity to repay, verification of minimum initial equity by borrowers, reasonable debt service coverage, and assessment of the value of the property.

 

 

APRA fiddles on bank risk while Rome burns

From The Conversation.

Australian Prudential Regulation Authority (APRA) chairman Wayne Byers has made it clear the bank regulator will be cracking down on bank capital levels this year.

Bank capital reserves are a loss-absorber, designed to protect creditors if banks suffer significant losses. That protection, in turn, will – ostensibly – prevent panicked withdrawals by depositors, thereby preventing financial contagion and financial crises.

[DFA notes, its the Council of Financial Regulators that is the coordinating body for Australia’s main financial regulatory agencies. Its membership comprises the Reserve Bank of Australia (RBA), which chairs the CFR; the Australian Prudential Regulation Authority (APRA); the Australian Securities and Investments Commission (ASIC); and The Treasury — so APRA is just part of the problem!]

Byers has decided that Australian banks’ capital levels must be “unquestionably strong” in keeping with the findings of the Financial System Inquiry. But how much capital equals “unquestionably strong”? We don’t know.

What we do know is that the inquiry handed down that finding in November 2014. More than two years have passed and only now is APRA getting a wriggle on.

The problem is that, according to the IMF, when it comes to Tier 1 bank capital, this time last year Australia was ranked 91st in the world. That puts us close to the bottom of the G20, the OECD and the G8. Our position has fluctuated, but at no time during the preceding four quarters have we risen above 60th.

Ranked above Australia were Swaziland, Afghanistan and even Greece. That sounds like, at best, unquestionably ordinary. Maybe even unquestionably weak. But definitely not “unquestionably strong”.

The global financial crisis could’ve led to change

Some argue, determinedly and erroneously, that when functioning correctly bank capital levels are almost magical things. As former US Federal Reserve chair Alan Greenspan once said:

The reason I raise the capital issue so often is that … it solves every problem.

Greenspan, as Fed chair, was ultimately responsible for the health of the US financial system. Having touted capital levels, his tenure ended just before the sub-prime disaster turned into the global financial crisis. This earned Greenspan Time Magazine’s moniker as one of the 25 people most to blame for the crisis.

However, bank capital levels were in place before the crisis hit. The Basel Committee – a sort-of UN for Reserve Bank governors and bank regulators – introduced global standards for bank capital as far back as 1988.

Back then, it set the capital level at 8%. In other words, for every $100 in liabilities, banks had to retain $8 in cash (or close to cash). But this level was simply a reflection of the average of the day.

Codifying the average into a global standard was an excellent trick. No-one was made to feel left out, or inadequate.

Then came the global financial crisis. It resulted in an output loss of somewhere between US$6 trillion and US$14 trillion in the US alone.

The Basel Committee said it was going to raise bank capital levels in response to the crisis. This meant it was going to do more of the thing (bolster capital levels) that had been meant to prevent such a crisis from occurring in the first place, but had failed.

What now?

The Basel Committee’s latest attempt to take action on capital levels involves curbing “internal risk-based models”. These models allow banks to determine how risky their assets are, and therefore how much expensive and unusable capital they have to set aside for loss-absorption, to match the risk profile of their assets.

That’s like you or I determining how risky we are as borrowers, and therefore deciding how much interest we should be charged on the money we borrow.

European banks have pushed back against curbing internal risk-based models. They resent not being able to have absolutely everything their own way. And the Basel Committee has proven to be a push-over.

Australian banks have pushed back too, with a not-so-subtle threat that customers will bear the costs of higher capital levels. If Byers and APRA do what they are supposed to, and what the government told them to do in late 2015, Australia’s banks will need to raise A$15 billion or more to rectify their thin capital position.

That’s $15 billion not earning returns or bringing in bonuses. No wonder our bankers aren’t happy.

And while APRA and Byers have fiddled on this issue and effectively ignored government instructions, and Australian banks remained capital-thin, conditions have arisen that economist John Adams argues may result in an “economic Armageddon” for Australia.

If that happens, guess who will be bailing out the banks? You, the taxpayer.

Author: Andrew Schmulow , Senior Lecturer, Faculty of Law, University of Western Australia

APRA Reaffirms 10% Investor Loan Growth Cap

Speaking today at the A50 Australian Economic Forum in Sydney, APRA Chairman Wayne Byres reaffirmed the 10% speed limit for investor loans.

Sort of makes sense given the CBA slowing of investor loans we discussed yesterday, but 10% is, in our view too high, given current salary growth and inflation rates. This is what he said:

Let me start with a warm welcome to everyone who has travelled here to be part of this event.  A little over two hundred years ago this beautiful location was seen as an ideal place for a penal colony.  Thankfully, Sydney is no longer regarded as a hardship destination, but as someone who does a reasonable amount of international travel, I know it is still quite some distance from wherever you have journeyed from.  I hope you are finding the travel to be worth it.

A few quick words about APRA. We are Australia’s prudential regulator, responsible for the prudential oversight of deposit-taking institutions; life, general, and private health insurers; and most of Australia’s superannuation assets. All up, we have coverage of just under $6 trillion in assets, which represents around 3-and-a-half times Australian GDP.

That broad coverage of the financial sector means we inevitably have a large agenda of issues on our plate, but we also have the relative luxury of working with a financial system that is fundamentally sound. To the extent we are grappling with current issues and policy questions, they don’t reflect an impaired system that needs urgent remedial attention, but rather a desire to make the system stronger and more resilient while it is in good shape to do so.

Our mission is to achieve safety within a stable, open, efficient and competitive financial system. We don’t pursue a safety-at-all-costs strategy. But it is also pretty clear the Australian financial system has benefited over the long run from operating with fairly conservative policy and financial settings.

To give you an example, the headline capital ratios of the major  Australian banks might seem low relative to international peers – collectively, they have a CET1 ratio of a touch over 9-and-a-half per cent, whereas a more normal expectation in this day and age might be something comfortably in double digits. But the Australian ratios reflect a set of conservative policy decisions that produce a lower headline capital ratio, but give us a much greater level of confidence in the financial health of the banking system.

One result of that approach is that, even though the major Australian banks are either just inside, or just outside, the top 50 banks in the world when ranked by asset size, they are amongst the small number who have retained AA credit ratings, and we have one bank in the top 10, and the remainder in or around the top 20, when ranked by market capitalisation. Clearly, investors – both debt and equity – understand their underlying quality, and the Australian community gets great benefit from the market access that provides.

The Financial System Inquiry held a couple of years ago endorsed our approach, as did the Government in its response to the Inquiry’s recommendations.

So with that background, let me turn to a few of the important issues on our plate.

The main policy item we have on our agenda in 2017 is the first recommendation of the Financial System Inquiry: that we should set capital standards so that the capital ratios of our deposit-takers are ‘unquestionably strong.’ We have been doing quite a bit of thinking on this issue, but had held off taking action until the international work in Basel on the bank capital regime had been completed.
Unfortunately, the timetable for that Basel work now seems less certain, so it would be remiss of us to wait any longer.

We will have more to say in the coming months about how we propose to give effect to the concept of unquestionably strong, but in the meantime the banking industry has been assiduously building its capital strength in anticipation. Looking through the effects of policy changes, the major banks have added in the order of 150 basis points to their CET1 ratios over the past couple of years. Assuming the industry continues to steadily build its capital, we expect it will be well placed to respond to future policy changes in an orderly manner.

If capital for the banking system is our main policy item, then housing is our main supervisory focus. I know there is always a great deal of interest in the Australian housing market, so it is probably something I should say a few words about.

It should not be surprising we have been paying particular attention to the quality of housing portfolios for some time – and particularly the quality of new lending – given housing represents the largest asset class on the banking industry’s balance sheet.

We have lifted our supervisory intensity in a number of ways – collecting more data from lenders, putting the matter on the agenda of Boards, establishing stronger lending standards that will serve to mitigate some of the risks from the current environment, and seeking in particular to moderate the rapid growth in lending to investors. These efforts are often tagged ‘macroprudential’, but in an environment of historically low interest rates, high household debt, relatively subdued wage growth, and strong competitive pressures, we see our role – in simple terms, seeking to make sure lenders continue to make sound loans to borrowers who can afford to pay them back – as really pretty basic bank supervision.

And just to be clear about it, we are not predicting whether house prices will go up or down or sideways (as the Governor of the Reserve Bank said last night, they are doing all these things in different parts of the country), but simply seeking to make sure that bank balance sheets are well equipped to handle whatever scenarios eventuate.

As things stand today, our recent efforts have generated a moderation in investor lending, which was accelerating at double digit rates of growth but has now come back into single figures. We can also be more confident in the quality of mortgage lending decisions today relative to a few years ago.

We are not complacent, however, as recent months have seen a pick-up in the rate of new lending to investors. That pick-up in itself is not necessarily surprising – with so much construction activity being completed and the resulting settlement of purchases, some pick-up in the rate of growth might be expected. But, at least for the time being, the benchmarks that we communicated – including the 10 per cent benchmark for annual growth in investor lending – remain in place and lenders that choose to operate beyond these benchmarks are under no illusions that supervisory intervention, probably in the form of higher capital requirements, is a possible consequence. If that is encouraging them to direct their competitive instincts elsewhere, then that’s probably a good thing for the system as a whole.

I have focussed very much on banking in my remarks thus far, so before my time is up I thought I would also comment on an issue that is relevant right across the financial system: the need to continue investment in existing technology platforms while at the same time putting money into new technology which may well replace it. This conundrum exists for all firms we supervise, and the issue is going to rise in importance as time goes by.

The Australian financial sector is, on the whole, pretty quick to adapt new technology as it emerges. And we have some important new infrastructure currently being built, like the New Payments Platform that will facilitate payments 24/7. But we also face the challenge that, like many parts of the world, large parts of financial firms’ core operating platforms are still based on technology that is increasingly dated, and not as integrated as it needs to be.

Particularly with the rise of fintech and potential disruptors, the temptation in the current environment is to devote a larger proportion of any investment budget to shiny new toys at the front end that excite the customer, and perhaps defer a bit of maintenance on the back office functions that make sure the customers’ transactions actually get processed and recorded correctly. As a supervisor, we are very keen to see investment in new technology by financial firms, because we think it offers considerable benefit to the soundness, efficiency and competitiveness of the financial system. The important thing for us is to make sure investment budgets are expanding to accommodate that, and it is not simply funded by a diversion of resources from other essential tasks.

I’ll conclude here and give the floor to my other panellists. I will, of course, be happy to take any questions you might have once they have had a chance to make their remarks.