APRA – Page 33 – Digital Finance Analytics (DFA) Blog

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

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.

APRA On Risk Culture, and ABA’s Response

APRA has released a series of documents on the risk culture within financial services organisations. They will be looking at the risk culture of entities, as well as remuneration and its linkage to risky behaviour.

They are also seeking to harmonise prudential standards across APRA-regulated industries where appropriate and practical. This ensures that like risks are treated in a like manner so that no significant differences arise in the regulatory treatment of entities with similar risks operating in different industries.

The 2008 financial crisis revealed major shortcomings in the way the global financial sector managed risk. This was not solely an issue of poor risk measurement, or weaknesses in internal control structures. It also reflected deficiencies in institutions’ attitudes towards risk. In combination, a poor risk culture and weak risk management (the former often being the root cause of the latter) led to unbalanced and ill-considered risk-taking, to significant losses and, in some cases, to institutional failures. The impact on the financial stability of affected countries was significant.

Although APRA-regulated institutions avoided the worst of the financial crisis, Australia has not been without its own examples of poor risk culture. The failure of HIH Insurance in 2001, for example, highlighted the central role that a weak organisational culture, and a dismissive attitude to risk management, had in the demise of the insurer. Similarly, foreign currency trading losses at a major bank in 2004 identified the link between the risk culture of its trading area and the scant regard given by the business to the underlying risk and management risk limits.

More recently, APRA highlighted the emergence of increased risk-taking within the life insurance industry with respect to the underwriting and pricing of, in particular, group insurance business. At its heart, this stemmed from a focus on growth without, in a number of institutions, adequate regard to the risks that came with it. Similarly, in the past few years, APRA observed that sound market practices for the origination of residential mortgage loans had, in some instances, been sacrificed to considerations of preserving market share and growth.

Unlike the earlier episodes highlighted above, which affected individual institutions, the more recent issues in group risk insurance and mortgage lending have manifested in a deterioration in general industry practices. There is nothing wrong with an institution or an industry pursuing a higher risk strategy, provided it does so consciously, and with appropriate risk management capabilities and financial capacity. In some of these cases, though, hindsight and supervisory scrutiny would suggest that the decision was not a conscious one: considerations of risk were not always front of mind in a highly competitive environment.

It is also interesting to juxtapose these recent experiences with the assertion made by most institutions that they believe they have a good, if not strong, risk culture; to the extent there are deficiencies in the industry, most institutions consider they exist within their peers. And where there have been specific problems identified within their own businesses, ‘bad apples’ are typically seen as the cause. Yet in the case of mortgage lending standards, for example, there were few lenders who could claim their risk culture was sufficient to prevent them succumbing to the weak practices that eroded industry standards.

Unfortunately, a poor risk culture can persist for some time without detection, or immediate damage. Typically, it will be when a poor risk culture is combined with adverse market conditions and/or other stresses that there is greater potential for a build-up of unbalanced and ill-considered decisions to result in significantly adverse, and potentially crippling, financial outcomes. Good times will often mask poor practices. In an Australian context, where the domestic economy has enjoyed 25 years without a serious recession, this should sound a clear note of caution against complacency.

As well as setting out global developments in risk culture, APRA highlighted the following key areas of focus.

Continue to encourage APRA-regulated institutions to focus on risk culture

APRA’s initiatives that will help maintain the prominence of risk culture within regulated institutions include:

engaging with the broader APRA-regulated financial sector – through, for example, speeches and publications such as this one – to reinforce the need for continued focus on risk culture and, where needed, highlighting any areas of concern;

providing information and guidance to industry, where appropriate, on approaches that can be used to assess and strengthen risk cultures;

bilateral discussions with institutions’ senior executives and directors to highlight and seek remediation for any specific concerns that are identified through routine supervision activities; and

conducting pilot on-site reviews at individual institutions focussing specifically on risk culture.

A more anticipatory supervisory approach to risk culture

Although APRA already considers risk culture as part of its ongoing supervisory activities, APRA intends to refine and sharpen its approach to assessing risk culture. Conducting pilot risk culture reviews will form a key component of this work.

APRA expects that this more intensive review will enable it to better anticipate potential risk issues, and strengthen its forward-looking supervisory approach. For example, where a regulated institution is found to have indicators of a poor risk culture, supervisory attention will correspondingly increase. As with APRA’s more general approach to supervision, which focusses on the prevention of problems before they materialise, the goal of these risk culture reviews will be to promote prompt corrective action to any shortcomings identified, or establish mitigating actions. In doing so, the potential for loss from unbalanced and ill-considered risk decisions is reduced, potentially adverse outcomes for depositors, policyholders and superannuation fund members can be avoided, and (in the extreme case) threats to financial stability are eliminated.

Reviewing industry remuneration practices

The remuneration requirements contained in CPS 510 were introduced in 2010 for ADIs and insurers. Requirements for superannuation were introduced in Prudential Standard SPS 510 Governance22 in 2012. The fundamental principle underlying these requirements is that performance-based components of remuneration must be designed to encourage behaviour that supports:

the regulated institution’s long-term financial soundness; and

the risk management framework of the institution.

Remuneration frameworks, and the outcomes they produce, are therefore important barometers and influencers of risk culture.

APRA intends to conduct a stocktake of current industry remuneration practices to gauge how well existing requirements are being implemented, and how they are interacting with the risk cultures of regulated institutions. This will include reviewing the remuneration arrangements and outcomes for some senior executives, risk and control staff, and material risk-takers at a sample of institutions.

APRA will also use this opportunity to compare its remuneration requirements with more recent international regulatory developments and supervisory practices.

This work will commence in 2016 and will continue into 2017. APRA will engage with industry participants, as well as relevant industry experts, throughout this period as it formulates its views.

The Australian Bankers Association welcomed APRA’s announcement.

The Australian Bankers’ Association has welcomed today’s release of an information paper by the Australian Prudential Regulation Authority on the risk culture of financial institutions.

“A lender’s risk culture impacts every decision it makes and is the cornerstone of a stable financial system,” ABA Chief Executive Steven Münchenberg said.

“We welcome initiatives that help banks understand and manage their own risk culture, and we are pleased that APRA has noted an improvement in how directors focus on the risk culture in their organisation,” he said.

“It is important that the tone is set from the top and employees have a clear framework to make decisions that appropriately balance the potential gain with any potential loss.”

APRA’s paper looks at how different organisations approach risk culture and how this relates to company values. It also outlines APRA’s future plans to encourage institutions to focus on risk culture.

Mr Münchenberg said the ABA agreed on the need to build on the work that had already been done.

“There are many elements to a strong risk culture, including having clear business objectives, values and understanding of risk appetite.

“Banks recognise that demonstrating a strong risk culture will increase the public’s trust in the financial sector. We look forward to working with APRA on how risk culture can be strengthened to ensure banks have the right practices and behaviours,” he said.

APRA On Derivatives Margin Rules

APRA has released final requirements for margining and risk mitigation for non-centrally cleared derivatives. APRA has made some changes to the requirements, based on feedback to the earlier consultation process. This is one of the risk mitigation elements brought to the fore post the GFC. APRA has not yet set a commencement date.

The release, CPS 226, provides clarity on the final requirements and it will allow APRA regulated institutions with material levels of non-centrally cleared derivatives to actively continue their preparations. APRA will advise an implementation date and phase-in timetable in due course. APRA says they “continue to support internationally harmonised implementation of the requirements and is monitoring the progress of implementation in other jurisdictions”.

There are two tests to determine whether the rules apply.

First the entity has to be a financial services organisation (authorised deposit-taking institutions (ADIs), general insurers, life companies and registrable superannuation entities (RSE) licensees). However entities such as central banks and certain special purpose vehicles are excluded. These entities must post and collect variation margin and initial margin when it trades with covered counterparties.

Second, there is a threshold which must be met first. APRA has kept the AUD 3 billion threshold for the application of variation margin requirement based on the entity’s group’s aggregate month-end average notional amount of non-centrally cleared derivative transactions.

Both the covered entity AND the covered counterparty has to meet this threshold, else the transactions between them will not be caught by the margin requirements.

There were some significant changes from the earlier drafts, which generally have weakened the requirements.

For example, physically settled foreign exchange forwards and swaps, and the fixed physically settled FX transactions associated with the exchange of principal in cross-currency swaps, have been excluded from the requirement to exchange variation margin. In addition, real estate and infrastructure special purpose vehicles and collective investment vehicles are excluded from the scope of the rules if they enter into derivatives for the sole purpose of hedging. Similarly, non-financial institutions are no longer included as covered counterparties. There are others. You will need to read the fine print to see all the changes.

APRA Highlights Cyber Security

APRA has released the results from their 2016 Cyber Security Survey which ran from October 2015 to March 2016 to gather information on cyber security incidents and their management within APRA-regulated sectors. Respondents to the survey included 37 regulated entities and four significant service providers, covering all APRA-regulated industries, with the exception of private health insurance.

Just over half of all survey respondents – 20 regulated entities and one service provider – experienced at least one cyber security incident in the 12 months leading up to the survey that was sufficiently material to warrant executive management involvement.

Superannuation industry respondents reported a higher occurrence of incidents that warranted reporting to executive management as compared to other industries. While the underlying cause of this was not apparent in the survey results, possible explanations are that the superannuation industry is a more attractive target to perpetrators due to the relatively high customer account balances, and/or variances in reporting thresholds between the industries.

Incidents reported by survey respondents included:

potentially high impact incidents such as advanced persistent threats (APTs), distributed denial of service (DDoS) attacks and compromises of highly privileged access. These were experienced by a number of respondents (21 per cent) and reinforce the value of preparedness (prevention, detection and response controls) in the face of sophisticated
attacks which cannot always be prevented;
ransomware attacks, which represent an increasing threat. The reported incidence of these attacks (14 per cent of respondents) reinforces the importance of frequent system and data back-ups as a last resort mitigation;
potentially reputation damaging incidents such as website defacement and social media account misuse, which were experienced by approximately 1 in 8 entities (12 per cent of respondents). Whilst these incidents have had a low impact and frequency to date, the potential reputational impact necessitates continued vigilance with respect to the management of public facing channels and services; and
other incidents with low impact such as compromise of client accounts, internet banking fraud, phishing and malware attacks. These were experienced by almost 1 in 4 respondents (24 per cent).

They conclude:

To date, no APRA regulated entity has suffered material losses from a cyber incident, and security controls have held up against past attacks. However, this should not provide grounds for complacency. As a result of the expanding sophistication, frequency and impact of cyber attacks, APRA-regulated entities should expect to experience significant cyber security incidents and be prepared for an evolving range of threats. APRA intends to lift the supervisory and regulatory expectations for regulated entities to not only secure themselves against cyber attacks, but to implement improved mechanisms to quickly identify and remediate successful attacks when they occur.

They rightly highlight the cultural dimensions to effective Cyber Security as we discussed recently.

Where Has APRA Gone?

An amusing snip-it. On the day the banks are starting to appear before the economics committee, I noticed the APRA web site was down. Yes, the ADI regulator had disappeared! I wanted to grab some information for analysis I was running. Normal service was resumed just before 11:00 this morning.

Thinking it might be my end, I tried this. Nope, the site was down.

At 8:55am, local time it came back, then went again. At 9:34, we are getting an HTTP Error 503 from APRA. A quick lookup says of 503:

HTTP Error 503 – Service unavailable

Introduction

The Web server (running the Web site) is currently unable to handle the HTTP request due to a temporary overloading or maintenance of the server. The implication is that this is a temporary condition which will be alleviated after some delay. Some servers in this state may also simply refuse the socket connection, in which case a different error may be generated because the socket creation timed out.

Fixing 503 errors

The Web server is effectively ‘closed for repair’. It is still functioning minimally because it can at least respond with a 503 status code, but full service is impossible i.e. the Web site is simply unavailable. There are a myriad possible reasons for this, but generally it is because of some human intervention by the operators of the Web server machine. You can usually expect that someone is working on the problem, and normal service will resume as soon as possible.

Home Lending Continues Higher

The latest APRA monthly banking stats to end August 2016 shows that total lending for housing rose 0.53%, equivalent to an annualised rate of 6.41%, well ahead of inflation and wage growth. Total loans are now $1.487 trillion, up another $7.9 billion in the month.

Within that, owner occupied loans rose 0.63% (up $6bn) and investment loans rose 0.35% (up $1.8bn). Investment loans comprise 35.55% of loans on book, down just a little from last month.

Looking at the individual banks, Westpac grew their portfolio the largest, up $2.5 billion, followed by CBA. ANZ reduced their investment portfolio – perhaps thanks to restatement of loan purpose? Bendigo dropped their portfolio of owner occupied loans in the month.

Here are the current relative shares.

Finally, here is the investment growth, by lender, which is running on a 3 month annualised basis at 2.6%. We see some of the majors growing their investment loans faster than system but below the theoretical 10% speed limit, which has little use currently. A couple of players are running well over however.

The RBA data, out soon will tell use more about the overall portfolio, including non-banks, and also about the restatement adjustments.

Bank Profits Down 27%, Provisions Up To June 2016 – APRA

APRA has released the quarterly ADI performance statistics. On a consolidated group basis, there were 156 ADIs operating in Australia as at 30 June 2016, the same as a year before, despite some changes.

Here is a summary chart for the combined four majors to June 2016.

We see a rise in gross advances, and higher tier 1 capital, though CET1 fell a little. Shareholder capital relative to the lending book rose slightly, but at 5.45% in June, the big banks remain highly leveraged businesses.

Looking more broadly across all ADI’s, the net profit after tax was $27.7 billion to 30 June 2016. This is a decrease of $10.4 billion (27.3 per cent) on the year ending 30 June 2015.

The cost-to-income ratio for all ADIs was 50.7 per cent for the year ending 30 June 2016, compared to 47.4 per cent for the year ending 30 June 2015 while the return on equity for all ADIs was 10.3 per cent for the year ending 30 June 2016, compared to 15.2 per cent for the year ending 30 June 2015.

The total assets for all ADIs was $4.64 trillion at 30 June 2016. This is an increase of $225.3 billion (5.1 per cent) on 30 June 2015. The total gross loans and advances for all ADIs was $2.98 trillion as at 30 June 2016. This is an increase of $139.0 billion (4.9 per cent) on 30 June 2015.

The total capital ratio for all ADIs was 14.1 per cent at 30 June 2016, an increase from 13.1 per cent on 30 June 2015. The common equity tier 1 ratio for all ADIs was 10.2 per cent at 30 June 2016, an increase from 9.5 per cent on 30 June 2015.

The risk-weighted assets (RWA) for all ADIs was $1.84 trillion at 30 June 2016, an increase of $31.1 billion (1.7 per cent) on 30 June 2015. Impaired facilities were $15.0 billion as at 30 June 2016. This is an increase of $0.6 billion (4.2 per cent) on 30 June 2015.

Past due items were $13.0 billion as at 30 June 2016. This is an increase of $0.7 billion (6.0 per cent) on 30 June 2015; Impaired facilities and past due items as a proportion of gross loans and advances was 0.94 per cent at 30 June 2016, unchanged from 0.94 per cent at 30 June 2015; Specific provisions were $7.1 billion at 30 June 2016. This is an increase of $0.6 billion (8.6 per cent) on 30 June 2015; and Specific provisions as a proportion of gross loans and advances was 0.24 per cent at 30 June 2016, an increase from 0.23 per cent at 30 June 2015.

Home Lending Higher In July 2016, But Slowing

The latest monthly banking stats from APRA shows that total lending for home loans by the ADI’s (banks, building societies, credit unions etc.) rose 0.5% in July, down slightly from the previous month. Within that loans for owner occupied loans rose 0.64% to reach $952.5 billion, and investment lending rose 0.3% to $527 billion. Loans for investment property now comprise 35.6% of outstanding loans. So the rate of loan growth is slowing, but the overall level of household debt continues to rise and investment loans are back in favour. Remember too that these numbers are still messed up with ongoing loan reclassification with $43 billion over the period of July 2015 to July 2016, of which $1.0 billion occurred in July.

Looking at individual lender movements, CBA lent more on both the owner occupied and investment side of the ledger.

As a result we see CBA lifting its market share, though Westpac still has a greater share of investment loans.

If we examine the relative growth of loan portfolios against the APRA 10% speed limit, most major players remain within the 10% target.

We will look at the RBA financial aggregates next, which gives us the view of all loans across the market, including the non-bank sector.