The prudential regulator will target investor and interest-only loans under its proposed capital framework after finding that these products create “potential systemic vulnerabilities” to the financial system.
On Wednesday, APRA released its discussion paper on revisions to the capital framework for ADIs.
In the paper, APRA outlines that over the past two decades, residential mortgages in Australia as a share of ADIs’ total loans have increased significantly, from just under half to more than 60 per cent.
“While losses incurred on residential mortgage portfolios in this period have been limited, this level of structural concentration poses prudential and financial stability risks, particularly in an environment of high household debt, high property prices, weak income growth and strong competitive pressures among lenders,” the regulator said. “In such circumstances, households, individual ADIs and the broader banking sector are vulnerable to economic shocks.”
APRA’s latest paper is a further step to finalising capital rules for Australian banks. In addition to promoting stronger underwriting practices and increasing the amount of capital held by IRB ADIs for residential mortgage exposures, the regulator has established benchmarks to moderate investor and interest-only lending.
“A key focus is the appropriate capital requirement for investment and interest-only mortgage loans,” the regulator said.
“Although, as a class, investment loans have typically performed well under normal economic conditions in Australia, this segment has not been tested in a nationwide downturn.
“Further, an increasing proportion of highly indebted households own investment property, relative to past economic cycles. Experience in the United Kingdom and Ireland during the global financial crisis, for example, showed that previously better performing investment loans can fall into arrears in higher volumes than loans to owner-occupiers in times of stress.”
APRA warns that the the significant share of interest-only housing lending, including to owner-occupiers, is a structural feature that “increases the risk profile of the Australian banking system”.
APRA has proposed to segment bank mortgage portfolios by risk, with ADIs required to hold more capital for higher risk mortgages such as interest-only, investor loans and loans to SMEs secured by residential property.
To incorporate Basel III reforms, APRA is proposing that an updated version of its mortgage lending guide (APG 223) would require ADIs to designate eligible mortgages as non-standard where the ADI:
• did not include an interest rate buffer of at least 2 percentage points and a minimum floor assessment interest rate of at least 7 per cent in the serviceability methodology used to approve the loan;
• did not verify that a borrower is able to service the loan on an ongoing basis (i.e. positive net income surplus); and
• approved the loan outside the ADI’s loan serviceability policy.
APRA is also considering whether exposures to individuals with a large investment portfolio (such as those with more than four residential properties) would be treated as non-standard residential mortgage loans or as loans secured by commercial property.
In addition, the regulator is proposing that reverse mortgages, SMSF loans and other categories of loans considered higher risk from the definition of standard eligible mortgages, such as those with very high multiples of a borrower’s income, are considered non-standard.
“Subject to final calibration, APRA proposes that all non-standard eligible mortgages would be subject to a risk weight of 100 per cent,” the regulator said.
APRA chairman Wayne Byres said that the proposed changes are designed to lock in the strengthening of ADI capital positions that has occurred in recent years.
“These changes to the capital framework will ensure the strong capital position of the ADI industry is sustained by better aligning capital requirements with underlying risks,” Mr Byres said.
“However, given the ADI industry is on track to meet the ‘unquestionably strong’ benchmarks set out by APRA last year, today’s announcement should not require the industry to hold additional capital overall.”