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.”

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.