UBS analysts Jonathan Mott and Rachel Bentvelzen (alongside economists George Tharenou and Carlos Cacho) have released their latest Australian Banking Sector Update, which outlines that they believe the banks will soon “move further to tighten underwriting standards to ensure they fully comply with the National Credit Act regarding responsible lending”.
The assessment comes off the back of hearings held by the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, which criticised several lenders for failing to “take positive steps to verify the customer’s expenses”.
During one of the hearings earlier this month, Rowena Orr, the senior counsel assisting the commission, highlighted a guide by the Australian Securities and Investments Commission (ASIC) that tells banks they are “obliged to take reasonable steps to verify consumers financial situation”.
When it was revealed that ANZ did not undertake verification of expenses in some instanes, Ms Orr said: “ “I want to put to you that your processes, or your lack of processes in relation to the verification of a customer’s expenses, are non-compliant with the National Credit Act, responsible lending obligations and with this regulatory guide issued by ASIC.”
While the interim findings of the royal commission will not be released until September (with a final report next year), UBS has said it believes the banks will “continue to act to address irresponsible lending”.
It highlighted that ANZ has already said it will suspend new asset finance loans for retail customers, while CBA has suspended credit card and personal loan insurance, adding that it believes the banks’ boards and management will “move further to tighten underwriting standards to ensure they fully comply with the National Credit Act regarding responsible lending”.
Suggesting that mortgage underwriting standards seem to have been “lax for some period of time”, UBS said that the evidence given at the royal commission hearing leads its analysts to believe that there is “a material way to go” to ensure adherence to NCCP.
“While a tightening of mortgage underwriting standards is prudent, especially as the banks move to fully complying with responsible lending, it has a material impact on the economy,” the update reads.
“It must be remembered that house prices are determined by the demand and supply of credit (not the demand for and supply of housing).”
As a result, UBS’ analysts said they believe there are two potential scenarios:
(1) As the banks tighten underwriting standards assessed household income is reduced. The banks will need to undertake more detailed analysis of customers' individual living costs and the Household Expenditure Measure (HEM) benchmark is increased slowly over time. “As the banks gradually move towards fully complying with the responsible lending laws the flow of credit is steadily constrained and the housing market slowly deflates”; or
(2) The Royal Commission sets a strict definition of the "reasonable inquiries" and lenders are required to immediately comply with Responsible Lending obligations (eliminating 'predatory lending'). Income assessment is tightened, the banks are required to undertake a full review of each borrower's living costs. The back-up HEM benchmark is increased to realistic levels which borrowers could be expected to live off during the full life of the loan (including 'lumpy' items). “This leads to a sharp reduction in the Net Income Surplus and false applications are largely eliminated. However, in this scenario fully complying with responsible lending laws would result in a sharp reduction in credit availability ie a 'Credit Crunch' especially for lower income households. RBA rate cuts would not help credit availability as borrowers are assessed using the 7.25 per cent interest rate floor. This could potentially result in a significant economic downturn.”
While the investment bank suggests that its base case economic outlook “assumes only a slow and modest tightening of credit conditions”, it is “more concerned about the possibility of a 'tighter credit' scenario”.
The latter could lead to a “credit crunch scenario”, the analysts warn, which could lead to potential economic downturn.
“Under a credit crunch scenario, house prices would likely fall over a prolonged period across a few years,” the update reads. “This is because the price of money (i.e. ~record low interest rates) becomes less relevant compared with the supply of money (i.e. credit availability) or demand for money (i.e. employment, income, population) – particularly for the marginal new borrower (especially on lower incomes) which sets the price of the stock of existing housing.
“There is a great deal of uncertainty over how 'bad' this could become, simply because Australia has never had a fall in house prices of 10 per cent + (even during the GFC prices 'only' fell to -8 per cent year-on-year, but the RBA slashed rates by 425bp and reflated the housing market), and neither have we had a domestic recession in almost three decades,” the analysts write.
However, UBS concludes that should a credit crunch feed through to the broader economy and result in rising unemployment, this could see the RBA consider cutting the cash rate further should they become concerned the slow-down was “turning into a recession”.
UBS states: “In this scenario there is a risk of a pick-up in arrears as existing borrowers become financially stressed, and could precipitate a broad-based credit event.”