APRA – Page 32 – Digital Finance Analytics (DFA) Blog

Super Now Worth $2.15 Trillion

APRA has released the latest superannuation statistics to September 2016. Total superannuation assets are worth $2,145.6 billion up +7.4% in the past year. Of this, $1,330.5 billion are in entities regulated by APRA, up 8.7% in the past year.

Self managed superannuation balances reached $635.9 billion, up +8.0% in the past year.

Total assets in MySuper products totalled $492.2 billion at the end of the September 2016 quarter. Over the 12 months from September 2015 there was a 13.6 per cent increase in total assets in MySuper products, and a 23.7 per cent decrease in total assets in accrued default amounts to $39.6 billion.

There were $23.2 billion of contributions in the September 2016 quarter, down 4.7 per cent from the September 2015 quarter ($24.4 billion). Total contributions for the year ending September 2016 were $103.1 billion. Outward benefit transfers exceeded inward benefit transfers by $1.0 billion in the September 2016 quarter.

There were $17.0 billion in total benefit payments in the September 2016 quarter, an increase of 6.6 per cent from the September 2015 quarter ($15.9 billion). Total benefit payments for the year ending September 2016 were $65.7 billion. Lump sum benefit payments ($8.3 billion) were 49.1 per cent and pension benefit payments ($8.6 billion) were 50.9 per cent of total benefit payments in the September 2016 quarter. For the year ending September 2016, lump sum benefit payments ($33.0 billion) were 50.2 per cent and pension payments ($32.7 billion) were 49.8 per cent of total benefit payments.

Net contribution flows (contributions plus net benefit transfers less benefit payments) totalled $5.3 billion in the September 2016 quarter, a decrease of 30.4 per cent from the September 2015 quarter ($7.6 billion). Net contribution flows for the year ending September 2016 were $31.7 billion.

APRA On Securitisation – Will It Benefit Smaller Players?

APRA says their recent changes to securitisation will enable a much larger funding-only market and so provide ADIs the opportunity to strengthen their balance sheet resilience by accessing new sources of term funding, hopefully at relatively attractive pricing. In addition, with the more straight-forward approach to achieving capital relief, securitisation can also be valuable for capital management purposes, perhaps this is particularly so for smaller ADIs and this may bring benefits to the competitive environment. So said Pat Brennan, Executive General Manager APRA, when he spoke at the Australian Securitisation Forum Conference, Sydney and discussed the recent changes to the updated prudential standard APS 120 Securitisation (APS 120), and an associated prudential practice guide.

This marks the culmination of some five years of policy formulation, and APRA’s updates on progress over this period have featured prominently at previous ASF gatherings.

In all prudential policy development APRA is guided by its statutory mandate: to balance the objectives of financial safety and efficiency, competition, contestability and competitive neutrality – and in doing so, promote financial system stability. In addition, when finalising the prudential settings for securitisation APRA also remained true to the principles that guided the policy development process throughout:

to facilitate a much larger, simple and safe, funding-only market;

to facilitate an efficient capital-relief securitisation market; and

to have a simpler and safer prudential framework.

Over the last five years APRA’s policy deliberations were greatly assisted by the active engagement of industry in the consultation process. This was both through the ASF and bi-laterally, through formal submissions and informal meetings. It seems fitting at this point to reflect back on this process and note some key aspects of how policy evolved through the consultation process. I will then make a few comments thinking of the role of securitisation looking forward.

Funding only securitisation

Let me start with the subject of the first principle I noted – funding-only securitisation – that is where an Authorised Deposit-taking Institution (ADI) is not seeking capital relief, rather the focus is on accessing term funding to support their lending activities.

Early in the consultation process APRA had serious reservations regarding date-based calls when combined with a bullet maturity structure. Whilst contractually in the form of an option, such a feature may create an expectation that repayment will definitely occur on the stated date regardless of circumstances. This represents a prudential risk should investors be allowed the ‘best of’ either repayment from the underlying pool of loans or from the originating ADI. This type of arrangement is allowed in the case of covered bonds, but controlled within a legislative limit. To allow a proliferation of other covered bond-like arrangements would be imprudent.

Through consultation industry clearly articulated the benefits of bullet maturity structures:

with their more certain cash-flow structures, a much broader range of investors can be accessed;

hedging costs for ADIs are reduced, possibly materially so; and

these factors clearly support a much larger funding-only market.

Industry also accepted that the prudential risk can be managed by the requirements of APS 120, but also through the approach taken by ADIs. Specifically, an ADI should create no impression that the call is anything other than an option for the ADI, and that a call is only exercised when the underlying assets are performing. To put it plainly: an ADI must never bear losses that are attributable to investors.

The finalised APS 120 therefore facilitates bullet structures – this is probably the most significant single development in APRA’s securitisation reforms and is the product of constructive consultation and careful consideration by APRA of how to strike the best balance of the various elements of its mandate.

Tranching

Moving on, many in this room will recall APRA’s early aspiration for a simple, two-class structure with substantially all the credit risk contained in the lower ranking tranche. Such a structure would avoid the problems of complexity and opaqueness associated with securitisation – problems that manifested so clearly through the global financial crisis.

In a general sense simplicity is good – but finance is often not simple. Industry feedback was clear – the concept of a two-class structure has significant shortcomings as the risk preferences of investors in subordinated tranches are varied, and to have an active capital-relief securitisation market greater risk-differentiation, and therefore tranching, is necessary. APRA heard this not only from ADIs but other industry participants as well, including investors – and we were convinced.

As a result APRA has relaxed its approach regarding the number of tranches, though we hope industry will not pursue complexity for complexity’s sake – this is a trap structured finance has fallen into before, with unhappy outcomes.

As a side note, and one that applies much more broadly than securitisation, at times there is a need to consider how things may be, and not be unnecessarily anchored to the current reality we are familiar with. When APRA embarks on this type of consultation it can, on occasion, open possibilities for better outcomes, outcomes that were not previously contemplated, perhaps also bringing opportunities for industry innovation. Policy reform by its very nature is about changing the status quo and industry needs to acknowledge that just because something has traditionally been done a certain way is not, in itself, an argument that it should always be so.

Risk retention

Risk retention is another area where consultation lead to a significant change in APRA’s thinking. Whilst the originate-to-distribute model has not been prevalent in Australia, APRA’s early view was that if there was to be a risk retention requirement it should be set at a level that will truly make a difference and bring alignment of interests between originators and investors. We proposed a level of 20 per cent. At the time there was also an expectation that international practices would be broadly consistent.

As time progressed a variety of skin-in-the-game requirements emerged internationally, generally set at lower levels. Assisted by industry feedback APRA reflected that an Australian requirement, in addition to the varied international requirements, would add regulatory burden for limited prudential benefit. So when balancing APRA’s mandate in the context of the feedback received through consultation, we placed greater weight on efficiency considerations and hence did not implement a risk retention requirement.

Capital requirements

Whilst APRA’s securitisation reforms relate mainly to ADIs as issuers, we are also naturally interested in the amount of capital ADIs hold for their securitisation exposures. We have updated capital requirements following the Basel Committee’s framework, but with adjustments reflecting the Australian context and in light of APRA’s objectives.

Once such adjustment is that APRA has not implemented the approach involving the use of internal models for setting regulatory capital requirements. Instead APRA has implemented the remaining two approaches from the Basel framework: an approach based on external ratings and a standardised approach. Whilst many in industry would have preferred APRA to allow the use of internal models, as we have implemented the risk weight floor of 15 per cent this considerably limits the potential differences in outcomes. This is because a floor of 15 per cent is likely to have been applied to the majority of securitisation exposures if internal models were used, reflecting the relatively high credit quality of the underlying loans. In addition, not implementing the internal models approach is consistent with the objective to have a simpler and safer prudential framework.

A second adjustment is APRA’s requirement that an ADI deducts holdings of subordinated tranches from their own capital. There is frequent comment on APRA’s conservative approach to capital settings throughout the prudential framework. The Basel framework sets minimum standards and the relevant authorities around the globe are expected to set higher standards where they see this as being appropriate – Australia is not alone in setting conservative standards. In the Australian context, with the majority of ADI assets being residential mortgage loans, APRA’s view is there is substantial potential risk in having any incentive in the prudential framework for ADIs to hold the more risky tranches of other originator’s securitisations.

After the lengthy and detailed consultation, APRA is firmly of the view the principles underlying these adjustments are appropriate. I note that, as a result of the consultation process, APRA did relax the level at which the deduction approach applies as industry outlined that with limited additional risk certain common securitisation structures will be viable for ADIs to use if such a relaxation was applied.

Warehouse arrangements

Throughout the process of reforming APRA has been motivated to remove the current unsustainable situation that can arise through warehouse arrangements where capital leaves the banking system with no reduction in risk in the system. In 2014 APRA proposed that a concession remain, but be limited in time to a period of one year. This proposal proved unpopular with industry, which APRA found a little surprising at the time given it was designed to retain the concession in full for a year, and we anticipated this would be economically attractive over at least a two year period. Nevertheless, industry feedback was clear and negative.

In 2015 we put this subject back to industry to propose potential solutions, noting that in the absence of any viable option being identified APRA would simply treat warehouses as any other securitisation – either capital relief or funding only depending on the degree to which each arrangement meets the relevant requirements.

The feedback we received generally asked for the existing concession to remain indefinitely, and as APRA had said, that was unsustainable. So on warehouses, the consultation process did not offer any viable alternatives.

The final APS 120 accommodates warehouses, but with no special treatment when compared to other forms of securitisation. APRA hopes that efficient funding structures are agreed between market participants so the benefits of warehouse arrangements can continue.

From these examples you can see that the final form of APS 120 is different to how it would have appeared if it was finalised even just two years ago, and very different to how it would have appeared if it was finalised a year or two prior to that. APRA has materially changed some policy positions and modified others as a direct result of consultation. In a few areas, where the prudential stakes were sufficiently high, APRA did not change its basic position – though the consultation process brought healthy challenge to APRA’s approach and caused us to consider aspects of the policy from a new perspective. In both cases – where policy was changed and where it was not – a constructive consultation process proved essential to arrive at the best possible prudential policy.

Looking forward we all hope to see the Australian securitisation market grow and prosper. Having a much larger funding-only market would provide ADIs the opportunity to strengthen their balance sheet resilience by accessing new sources of term funding, hopefully at relatively attractive pricing. With the more straight-forward approach to achieving capital relief, securitisation can also be valuable for capital management purposes, perhaps this is particularly so for smaller ADIs and this may bring benefits to the competitive environment.

APRA is soon to finalise the Net Stable Funding Ratio (NSFR) to be applied to 15 larger, more complex ADIs, and this is expected to be implemented in 2018 alongside the securitisation reforms. The Australian banking system has some notable features that are not very common around the globe. On the asset side the banking system essentially funds lending for housing on its collective balance sheet, whilst on the liability side the Australian banking system has a relatively low deposit to loan ratio. Whilst the affected ADIs are reasonably well placed to meet the NSFR requirement, new opportunities to strengthen funding profiles will assist in strengthening this measure over time – and this strengthening will make the system more resilient.

Whilst a much larger Australian securitisation market depends on market forces, which have ebbed and flowed considerably in recent years, it seems certain that over time opportunities to grow the market will present themselves. The updated prudential framework, and accommodating bullet maturity structures in particular, places ADIs well to take advantage of those opportunities as they arise.

APRA To Publish Additional Liquidity Statistics From End November

APRA published the outcomes from their consultation relating to publishing additional ADI liquidity data each quarter. They say that on the basis that submissions were broadly supportive of the proposal to publish additional liquidity statistics, APRA will incorporate the expanded liquidity statistics for the September 2016 edition of QADIP, to be released 29 November 2016.

These expanded statistics will promote understanding of the ADI industry and provide users of APRA’s statistics with additional information to make well-informed decisions.

To provide users with additional information, and to ensure that the new statistics are not misused or misinterpreted, APRA will also release an explanatory note that explains how the liquidity statistics should be interpreted and used.

The September 2016 edition of QADIP as well as the explanatory information will be available from 29 November 2016

APRA says it seeks to publish as much of the data collected as is considered useful, subject to APRA’s confidentiality obligations with respect to individual institutions’ data. APRA intends to consult ADIs and other interested parties in 2017 about the segments in its ADI statistics to ensure that the statistics APRA produces meet user needs and are not likely to be misinterpreted or misused.

While APRA currently publishes financial performance and financial position statistics for mutual ADIs, prudential statistics are not published for mutual ADIs. APRA does not intent to publish liquidity statistics for mutual ADIs at this stage.

Institution-level liquidity statistics are generally protected by the secrecy provisions in section 56 of the Australian Prudential Regulation Authority Act 1998. APRA says it will consider the suggestion of publishing institution-level liquidity statistics and welcomes feedback from ADIs.

We think individual institution level data should be published, because better transparency should be encouraged, and whilst the “smoke-screen” of commercial confidentially will be cited, we think public interest should carry more weight. Relative to a number of other countries, we are more reticent in Australia to disclose. There is a strong case to change this.

APRA Re-Calibrates IRB Bank Capital

Wayne Byres APRA Chairman spoke at Finsia’s ‘The Regulators’ event, Melbourne. He discussed risk culture, profitability and returns in the financial system, and Basel risk capital. We focus on the capital discussion, because he warned that the IRB banks are re-calibrating their models to get closer to the 25% risk weighting. As a result there could be some “noise in the system”. Also it appears Basel III won’t really be complete in 2017.

The Basel Committee needs to complete the final work on Basel III. All the key components of the capital framework are still under review in one way or other, with the ambitious goal to:

improve the risk sensitivity of some parts of the framework;

reduce excessive variability in others; and

not significantly increase capital requirements overall.

If the Committee achieves all these things to everyone’s satisfaction, it will be a miracle!

I’ll be happy to just get some finality to the deliberations. The Committee meets again in a couple of weeks, and hopefully an agreement will be reached that will allow the complete package of reforms to be endorsed by the Governors and Heads of Supervision of Basel Committee member countries in January. If that happens, our return to work in the New Year should be accompanied by the revised international capital framework. That process sounds relatively orderly, but behind the scenes there is still much horse trading to do.

However, the Basel framework doesn’t purport to deliver ‘unquestionably strong’ capital. It is simply the minimum international standard. In Australia, we have long applied more robust requirements¹ – an approach that has stood us in good stead. Even without the reinforcing view of the FSI, there’s no reason why we would take a different path now. I mention this to dampen any enthusiasm that might be generated when the new rules are released, by calculating what would happen if APRA was to simply apply the new Basel framework to Australian ADIs. I can tell you the answer now – it would produce a material reduction in capital requirements. Before anyone gets too excited by that, I can also tell you we won’t be pursuing that course.

Once the Basel Committee has set out the minimum requirements, the task for APRA is to think through how and where we build further resilience into the new Basel framework to deliver ‘unquestionably strong’ capital ratios. But that’s not our sole objective. As we make policy choices, we’ll also be considering:

how we make the framework more flexible, so that it is better able to respond to business and financial cycles;

how to improve transparency, so that investor understanding of capital strength is enhanced; and

heeding the message of the FSI, how to take account of the competitive impacts of differing approaches (albeit that any differentiated approach will inevitably lead to different capital requirements at a product level).

The key issue, of course, is how we might calibrate the new requirements. The FSI gave us one guidepost – top quartile positioning relative to international peers – but we’ll also use others. For example, we’ll assess capital positions against rating agency measures of capital strength. The results of stress tests are also informative: banks that have difficulty demonstrating their ability to survive plausible adverse scenarios without severely curtailing lending and/or emergency capital raisings are unlikely to be seen as unquestionably strong. As with top quartile positioning, none of these are intended to be definitive benchmarks, but they do give some useful guidance against which to calibrate the final requirements.

I’ll just say a quick word on timing. Given the number and potential impact of the changes that will be proposed, 2017 will be a year of consultation. We don’t expect to have final standards before this time next year. And even if that is the case, they would not take effect until at least a year after that. But while there’s time for the changes to be worked through, that shouldn’t lead to complacency in the current environment. In that sense, the message I’ve given previously still holds: capital accumulation remains the appropriate course for most ADIs, but with sensible capital planning the actual implementation of any changes should be able to be managed in an orderly fashion.

Before I conclude on capital altogether, I want to say a few words on the FSI recommendation regarding mortgage risk weights. In July 2015, we announced higher mortgage risk weights for banks using internal model-based approach to capital. This was an interim step, but a step we were comfortable we wouldn’t need or want to materially unwind, regardless of the outcomes in Basel.

All other things being equal, we expected to raise the average mortgage risk weights for banks using internal models from around 16 per cent to at least 25 per cent. Unfortunately, in the world of internal models, all other things are rarely equal. Banks constantly refine their models, often at their own initiative but also sometimes at the request of APRA. We noted earlier this year that the impact of a range of modelling changes in the pipeline, when combined with the adjustment proposed in July 2015, would have produced an average risk weight well in excess of our interim objective of 25 per cent. So we’ve had to slightly recalibrate the adjustment, with a view to ensuring the outcomes were broadly consistent with the target we announced.

I mention this because, for those who follow these numbers closely, there will be some noise in the system over the next few quarters. As various modelling changes come on stream, the average risk weight across all IRB banks will fluctuate somewhat, and will impact different banks at different times. But these differences will narrow over time.

APRA Updates Securitisation Guidelines

New securitisation guidelines from APRA may benefit competition, provide improved prudential outcomes, provide efficiency offer a stable long term funding source.

In Australia, securitisation has typically been a material share of funding for a number of ADIs. Smaller ADIs e.g. domestic banks (other than the major banks), credit unions and building societies (CUBS), in particular, use securitisation to generate a greater proportion of funds than larger ADIs.

Securitisation of loans and other assets can be an important and cost-effective mechanism by which an ADI can obtain funding for its business. Australian ADIs have used securitisation successfully for many years to diversify their funding base and make efficient use of capital.

APRA has been working to update its regulatory framework for securitisation to incorporate the most recent internationally agreed regulatory reforms, as well as to reflect the lessons of the global financial crisis and provide a more sustainable basis for the securitisation market going forward.

APRA has now released details of its changes to the securitisation guidlines for Australian ADI’s. The revised APS 120 will take effect from 1 January 2018.

APRA’s reforms to apply simpler approaches to assigning regulatory capital for securitisation exposures will reduce the differential treatment of ADIs using advanced and standardised approaches to regulatory capital for credit risk, which may benefit competition.

The main amendments to the draft revised APS 120 and APRA’s clarifications relate to:

reducing the scope of exposures where a Common Equity Tier 1 Capital (CET1) deduction is required;

including more flexible arrangements in regard to funding-only securitisations; and

additional flexibility for ADIs making use of warehouse arrangements that may qualify for regulatory capital relief.

APRA also decided not to modify its proposals in several areas, after considering industry submissions. APRA proposals that remain unchanged include:

removal of the advanced modelling approaches to calculating regulatory capital requirements;

treatment of securitisations of revolving credit facilities, ABCP, and synthetic securitisations; and

the treatment of shared collateral.

The final revised APS 120 also reflects APRA’s implementation of the Basel Committee’s revised securitisation framework (Basel III securitisation framework), with appropriate Australian adjustments.

To better reflect underlying risk, and to address the lessons learned from the global financial crisis, APRA’s initiatives and the Basel III securitisation reforms include more conservative regulatory capital requirements for some types of securitisation exposures. However, the underlying operational requirements for securitisation are either unchanged or have been simplified.

In responding to submissions on the revised APS 120, APRA has sought to reach an appropriate balance between the objectives of financial safety and efficiency, competition, contestability and competitive neutrality, whilst promoting financial stability. APRA considers the final revised APS 120 will, on balance, provide improved prudential outcomes and provide efficiency and competitive benefits to ADIs.

The explicit recognition of securitisation for funding purposes in the prudential standard is expected to improve the ability of ADIs to secure long-term, stable wholesale funding.

APRA’s reforms to apply simpler approaches to assigning regulatory capital for securitisation exposures will reduce the differential treatment of ADIs using advanced and standardised approaches to regulatory capital for credit risk, which may benefit competition. Further, APRA’s clarification of the regulatory capital requirements for warehouse arrangements may also assist smaller ADIs in improving access to term wholesale funding, without creating undue prudential risk.

The revised APS 120 will take effect from 1 January 2018. APRA is currently consulting on the draft revised APG 120. In the coming months, APRA will separately consult on revised reporting requirements for securitisation that would take effect at the same time as the revised prudential standard and prudential practice guide.

The Interest-Only Loan Debt Trap

Today we discuss some specific and concerning research we have completed on interest-only loans. Less than half of current borrowers have complete plans as to how to repay the principle amount.

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

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

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

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

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

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

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

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

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

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

Next time we will delve further into the interest only mortgage landscape, because we found the policies of the lenders varied considerably.

Investment Lending On Again

The latest data from APRA for September shows the portfolios of individual banks in Australia as well as details of total loan exposures.

Total lending for housing went to $1.5 trillion, up 7 billion in the month. Of that $5.2 billion was for owner occupation and $1.8 billion for investment loans. As a result 35.5% of loans are for investment purposes.

Looking at the portfolio data, we see that Westpac and CBA had the bulk of the growth, across both owner occupied and investment loans. NAB grew in both categories, whereas ANZ dialed back their investment lending (perhaps from reclassification?). It is worth noting that ING is also growing their owner occupied portfolio and Members Equity Bank grew strongly. Pressure on some of the regional banks continues.

This has done little to change the relative market shares, with CBA in first place on owner occupied loans, and Westpac first on investment lending, but with CBA now nipping at their heals.

Finally, here is the relative investment lending portfolio growth. On a 3 month annualised basis, the total market grew 2.8%, but now three of the major players are operating above system growth, though still below the 10% speed limit imposed by APRA last year.

There has clearly been a focus on energising investment lending, as we predicted in our Property Imperative report. We expect momentum to continue for some time to come, hampering the RBA’s ability to cut the cash rate if they needed to. We still believe further macroprudential measures are needed.

New APRA guidance on lending will hurt home owners when it should be the banks

From The Conversation.

The Australian Prudential Regulation Authority (APRA) has moved away from its non-prescriptive “principles based” regulatory approach to a one size fits all explicit guidance but it doesn’t appear to be encouraging lenders to be more prudent.

The housing market may be getting away from APRA and the Reserve Bank of Australia (RBA). In late 2015, both regulators voiced concerns about the “horribly low” standards of the mortgage lending sector and the risks to financial stability. Even bankers are getting jittery.

There has also been well-publicised problems with brokers originating dodgy mortgages that lenders have not picked up. In its existing guidance (which has not been changed in the latest version), APRA requires lenders to have all sorts of procedures to catch dodgy mortgage applications from brokers including procedures to verify the accuracy and completeness of provided information.

But APRA has not named and shamed the lenders who failed to catch dodgy mortgage applications, not imposed capital sanctions or reprimanded directors and management. It hasn’t required that lenders change their broker process.

What APRA is asking is that banks slug first time buyers even more. In the new rules, home buyers are now required to prove they can service a 7% mortgage interest rate on a loan to value ratio of less than 90% with less income being taken into account. This is on top of trying to save a deposit that is disappearing every day as house prices boom.

It is going to take a lot more than forgoing a few smashed avocado toasts to make up for the additional burden imposed by APRA.

There are a few important questions raised by APRA’s sudden conversion to pragmatic rather than purely principled regulation.

First, the numbers. Where did the 7% come from? APRA doesn’t disclose this, but in an era of almost zero interest rates, it’s big. And maybe in time, when the RBA announces its changes to interest rates, the 7% may be changed in-line and economists will begin to bet on whether it will go to 6.5% or 7.5%.

In looking at a borrower’s income, APRA notes that it is “prudent practice is to apply discounts of at least 20% on most types of non-salary income”. No explanation also on why this particular percent. It’s also not specific on what “most” means.

If banks are indeed lending imprudently surely the banks themselves should suffer. First by naming and shaming, then if necessary, requiring additional capital buffers, thus driving down dividends – a real market based solution.

APRA is changing the way it regulates

Throughout the turmoil of the global financial crisis and the regulatory mayhem that followed, APRA held fast to its “principles based” approach to regulation:

To be principles-based is to give emphasis to the achievement of sound prudential outcomes in setting regulatory requirements and expectations, without necessarily seeking to specify or prescribe the exact manner in which those outcomes must be achieved

In short, APRA lays out the high-level principles that it will use to supervise the banks and insurance companies that is responsible for, and then will check that those principles are being adhered to. It did not believe in a “one size fits all” approach.

But this week, there appears to have been a back-flip. In a consultation paper for an update to APRA’s guidance on mortgage lending, the regulator has been very specific indeed. It notes:

“Prudent serviceability policies should incorporate a minimum floor assessment interest rate of at least seven per cent.”

This very specific guidance replaces an earlier guidance that was more general. From a regulatory perspective, an important question is why abandon principles-based regulation? If it hasn’t worked in the past, then a rethink of the role and approach of prudential regulation is needed.

This has happened overseas, where the UK Financial Conduct Authority, while retaining 11 principles that firms should adhere to, has become much more intrusive. Unlike our regulators, the authority has even going so far as to impose massive fines for misconduct. It states:

“We also adopt a markets-focused approach to regulation, both in our work as a competition regulator and more broadly to deliver regulation that works with the market to improve consumer outcomes. Interventions at the market level are an effective and powerful way of tackling and mitigating problems across a large number of firms, which in turn benefits a large number of consumers.”

Rather than APRA slipping in such a major change like this latest one into a consultation paper, it might be appropriate to have a transparent debate about such a potentially significant change in prudential regulation in Australia.

Author: Pat McConnell, Honorary Fellow, Macquarie University Applied Finance Centre, Macquarie University

APRA Issues Revised Residential Mortgage Lending Guidelines

APRA has issued new guidance for residential mortgage lending and tabled proposed changes to the bank mortgage reporting framework. Actually this does not seem to move the risk dial very far, but makes earlier guidance more specific and tidies up what were previously ad hoc reporting requests.

APRA has issued new draft guidelines for Residential Mortgage Lending, and is inviting responses by 19th December. These include revisions to Prudential Practice Guide APG 223 Residential mortgage lending to incorporate measures either announced by APRA in December 2014 or communicated to authorised deposit-taking institutions (ADIs) since that time. APRA expects to finalise the revised guidance in the first quarter of 2017.

They include more specific guidance on risk culture, compliance, affordability buffers, interest only loans and loans to SMSF.

Here are the main changes proposed.

“Failure to meet responsible lending conduct obligations, such as the requirement to make reasonable inquiries about the borrower’s requirements and objectives, or failure to document these enquiries, can expose an ADI to potentially significant risks. A prudent ADI would conduct a periodic assessment of compliance with responsible lending conduct obligations to ensure it does not expose itself to significant financial loss”.

“An ADI’s serviceability tests are used to determine whether the borrower can afford the ongoing servicing and repayment costs of the loan for which they have applied”.

“APRA expects that any material changes to an ADI’s serviceability policy would be analysed and the potential impact on the risk profile of new loans written would be reported to appropriate risk governance forums. Reference to competitors’ policies as the primary justification for policy changes would be seen by APRA as indicative of weak risk governance”.

“ADIs generally use some form of net income surplus (NIS) model to make an assessment as to whether the borrower can service a particular loan, based on the nature of the borrower’s income and expenses”

“Good practice would ensure that the borrower retains a reasonable income buffer above expenses to account for unexpected changes in income or expenses as well as for savings purposes. It would be prudent for ADIs to monitor the level of, and trends for, lending to borrowers with minimal income buffers. High or increasing levels of marginal borrowers may indicate elevated serviceability risk”.

“A prudent ADI would include various buffers and adjustments in its serviceability assessment model to reflect potential increases in mortgage interest rates, increases in a borrower’s living expenses and decreases in the borrower’s income, particularly for less stable income sources”

“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”.

“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”.

“APRA expects ADIs to fully apply interest rate buffers and floor rates to both a borrower’s new and existing debt commitments. APRA expects ADIs to make sufficient enquiries on existing debt commitments, including consideration of the current interest rate, remaining term, and outstanding balance and amount available for redraw of the existing loan facility, as well as any evidence of delinquency. ADIs using a proxy to estimate the application of interest rate buffers and floor rates to the servicing cost of existing debt commitments would, to be prudent, ensure that such a proxy is sufficiently conservative in a range of situations, updating the methodology to reflect prevailing interest rates”.

“APRA also expects ADIs to use a suitably prudent period for assessing the repayment of outstanding credit card or other revolving personal debt when calculating a borrower’s expenses”.

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

“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 the case of investment property, industry practice is to include expected rent on a residential property as part of a borrower’s income when making a loan origination decision. However, it would be prudent to make allowances to reflect periods of non-occupancy and other costs. ADIs would normally place less reliance on third party estimates of future rental income than on actual rental receipts from a property. 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 or where fees and expenses are higher (e.g. some strata requirements). 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”.

“A borrower’s living expenses are a key component of a serviceability assessment. Such expenses materially affect the ability of a residential mortgage borrower to meet payments due on a loan. ADIs typically use the Household Expenditure Measure (HEM) or the Henderson Poverty Index (HPI) in loan calculators to estimate a borrower’s living expenses. Although these indices are extensively used, they might not always be an appropriate proxy of a borrower’s actual living expenses. Reliance solely on these indices generally would therefore not meet APRA’s requirements for sound risk management. APRA therefore expects ADIs to use the greater of a borrower’s declared living expenses or an appropriately scaled version of the HEM or HPI indices. That is, if the HEM or HPI is used, a prudent ADI would apply a margin linked to the borrower’s income to the relevant index. In addition, an ADI would update these indices in loan calculators on a frequent basis, or at least in line with published updates of these indices (typically quarterly). Prudent practice is to include a reasonable estimate of housing costs even if a borrower who intends to rely on rental property income to service the loan does not currently report any personal housing expenses (for example, due to living arrangements with friends or relatives)”.

“An override occurs when a residential mortgage loan is approved outside an ADI’s loan serviceability criteria or other lending policy parameters or guidelines. Overrides are occasionally needed to deal with exceptional or complex loan applications. However, a prudent ADI’s risk limits would appropriately reflect the maximum level of allowable overrides and be supported by a robust monitoring framework that tracks overrides against risk tolerances. It is also good practice to implement limits or triggers to manage specific types of overrides, such as loan serviceability overrides. APRA expects that where overrides breach the risk limits, appropriate action would be taken by senior management to investigate and address such excesses”.

“There are varying industry practices with respect to defining, approving, reporting and monitoring overrides. APRA expects an ADI to have a framework that clearly defines overrides. In doing so, it is important that any loan approved outside an ADI’s serviceability criteria parameters should be captured and reported as an override. This includes loans where the borrower is assessed to have a net income surplus of less than $0 (even if temporary) or where exceptions to minimum serviceability requirements have been granted, such as waivers on income verification. ADIs may have their own definitions that include other types of loans (such as those outside LVR limits) as overrides for internal risk monitoring purposes”.

“Borrowers may have legitimate reasons to prefer interest-only loans in some circumstances, such as for repayment flexibility or tax reasons. However, interest-only loans may carry higher credit risk in some cases, and may not be appropriate for all borrowers. This should need to 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 of a borrower 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. As noted above, a prudent serviceability assessment would incorporate the borrower’s ability to repay principal and interest over the actual repayment period”.

“Some ADIs provide loans to property held in SMSFs. 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. APRA also expects that a decision to undertake lending to SMSFs would be approved by the ADI at an appropriate governance forum and explicitly incorporated into the ADI’s policy framework”.

APRA has also released for consultation with ADIs proposed new reporting requirements for residential mortgage lending data. APRA expects to finalise these revised reporting requirements in the first half of 2017 with reporting to commence from the December 2017 quarter.

To better enable APRA’s supervisory monitoring and oversight of residential mortgage lending, and reduce the reliance on ad hoc information requests, APRA proposes to introduce a new reporting standard under the FSCOD Act, Reporting Standard ARS 223.0 Residential Mortgage Lending (ARS 223), and a new form, Reporting Form ARF 223.0 Residential Mortgage Lending (ARF 223.0).

These changes will enable APRA to maintain its supervisory intensity of residential mortgage lending and address emerging risks, while removing some unnecessary reporting burden on ADIs.

All locally incorporated ADIs will be subject to ARS 223.0 and required to submit ARF 223.0, 28 calendar days after the end of each calendar quarter. While smaller ADIs are currently not required to submit ARF 320.8, residential mortgage portfolios typically make up the majority of their balance sheet. Comprehensive supervisory monitoring of the credit risk of these ADIs is therefore dependent on obtaining information about their residential mortgage lending. APRA expects that much of this information will already be available by ADIs for their own internal monitoring purposes.

ARF 223.0 will collect information on both the portfolio stock and the new lending activity each quarter. ADIs with a Level 2 group will need to complete ARF 223.0 on a Level 2 basis, and other ADIs on a Level 1 basis.
Depending on their level of residential mortgage lending activity in Australia, branches of foreign banks may also be required to submit ARF 223.0 each quarter, as directed by APRA.

The proposed reporting standard, form and reporting instructions are available on the APRA website.

2.1 Details of outstanding residential mortgage loans
In order to accurately assess the risk profile of the residential mortgage loan portfolio of an ADI or the industry as a whole, APRA needs to have relatively detailed information on residential mortgage loan portfolios.

ADIs currently report outstanding loan balances to households and some loan characteristics on ARF 320.8, split by purpose of the loan. ADIs currently report the balance on impaired or past-due loans in ARF 220.0, split between owner-occupied and investor loans with no further detail.

The proposed ARF 223.0 will capture loans to households as well as borrowers which have similar risk profiles to households, such as loans to family trusts and SMSFs and to non-residents. ADIs will be required to report new information including: facility limits; a more detailed breakdown by LVRs; loan vintage; loans subject to lenders mortgage insurance; loans secured by property overseas; and loans secured by a unit or apartment.

The definitions used in ARF 223.0 have been streamlined to better align with ADIs’ own internal information management systems. For example, the definitions of an owner-occupied loan and an investor loan have been updated. These changes should make it easier to report and therefore reduce the ongoing reporting burden.

More detail about problem loans will be required than is currently reported on ARF 220.0. ADIs will be required to report past-due loans according to risk characteristics (such as loan type, origination channel and LVR), mortgage loans with hardship arrangements, mortgagee in possession loans, loans less than 90 days past due and new non-performing loans in the quarter.

2.2 Details of new loans
In addition to portfolio metrics, information on the risk profile of new loans is essential for analysis of ADIs’ credit risk.

ADIs currently report limited information on new loan approvals on ARF 320.8, including breakdowns on purpose, some loan features and LVRs. Revolving credit is not captured on ARF 320.8.

ARF 223.0 will require ADIs to report loans originated during the quarter, rather than loans approved, as this is a better and more reliable measure of loans affecting an ADI’s risk profile. Details on new loan originated to trusts operated by households, such as family trusts and SMSFs, will be included in reporting, as well as loans to non-residents. Originations of revolving credit facilities will also be reported.

ADIs will be required to report more detailed data on loans originated during the quarter than is required on ARF 320.8, including information on borrowers, loan-to-income ratios, collateral type and location and a more granular breakdown by LVR. Most of the existing detail on loan approvals reported on ARF 320.8 will continue to be reported for originations on ARF 223.0, such as loan purpose and loan features.
ADIs will also be required to report information on the average variable interest rate and average loan serviceability assessment rate of loans originated during the quarter. These data will be used to analyse changes in serviceability parameters.

2.3 Use of ARF 320.8
APRA’s needs for regular statistics on mortgage lending activity will be largely met by the proposed ARF 223.0.

However, the RBA relies on the information reported on ARF 320.8 to perform its role. The RBA will become the primary user of ARF 320.8 and has requested that APRA continue to collect the form on its behalf from ADIs with over $1 billion of residential mortgage term loans each quarter.
The RBA is currently reviewing ARF 320.8 and intends to consult ADIs on revised reporting requirements in late-2016. Both APRA and the RBA are working together to minimise reporting burden by limiting the overlap between collections, and by streamlining concepts and definitions.

Risks within the housing and residential development markets remain elevated – APRA

APRA Chairman, Wayne Byres in his Opening statement to the Senate Economics Legislation Committee highlighted again the regulators views that there are elevated risks in the housing sector, despite tightening of underwriting rules in the past year. They are looking at additional ways to embed better and sticky lending standards into the banks. Some would say better late than never!

Our supervisory work on housing lending standards continues. Given the environment of heightened risks, our objective has been to reinforce sound lending standards, particularly in relation to the manner in which lenders assess the capacity of borrowers to service their loans. Over the past year, we believe the industry has appreciably improved its lending standards. But risks within the housing and residential development markets remain elevated. We are therefore giving thought to how best to have improved standards firmly embedded into industry practice, such that they are not eroded away again over time.

He also discussed the risk culture information paper which we featured yesterday.

Earlier this week, APRA published an information paper on risk culture – a topic that we have given greater attention to over the past few years. The paper focusses, amongst other things, on how Boards of regulated institutions have gone about the task of assessing the risk culture within their organisations, given the introduction of specific prudential requirements in this area from January 2015. Assessing risk culture is no easy task. But, as the global financial crisis showed, if an organisation has a poor attitude to risk-taking and risk management, it can ultimately threaten an institution’s financial viability. So one of our key messages is the need for continued investment of time and attention by senior leaders on this issue.Just as regulated institutions will refine and improve their own practices, we will continue to refine our approach and methodologies for making assessments of risk culture within regulated institutions. We will also, in particular, be looking more closely at the influence of remuneration arrangements on that culture.

As the Committee knows well, there have been some serious allegations of inappropriate and unfair treatment of life insurance claimants by The Colonial Mutual Life Assurance Society Limited, trading as CommInsure. While ASIC has been dealing with the specific customer cases, APRA takes an interest in what these cases tell us about the strength of an institution’s governance, risk management and risk culture.Our work with CommInsure has targeted two main issues. First, APRA has engaged with the Board and senior management of CommInsure to gain assurance over the robustness and completeness of the independent reviews commissioned to investigate the allegations, and ensure to stakeholder and community expectations are considered through this process. We have also met with the whistleblower who brought the issues to light, and are considering whether the whistleblowing provisions in the Life Insurance Act designed to prevent the identification and victimisation of whistleblowers have been adhered to.

Earlier this year, APRA also wrote to the Boards of all active life insurers, as well as to a selection of superannuation trustees, seeking information on the effectiveness of their governance and oversight mechanisms for matters such as claims handling, benefit definitions, rejected claims and customer complaints. Based on the responses received, we issued a report last week identifying areas in which insurers and trustees can improve their management of life insurance claims.

APRA and ASIC have been working closely on all of these matters, which remain ongoing.