QBE has urged the Financial System Inquiry (FSI) to consider the role that lender's mortgage insurance (LMI) plays in the financial system and recommends that capital relief be provided to internal ratings-based (IRB) lenders that use LMI.
Under the existing Basel II arrangements there is no capital incentive for IRB lenders to use LMI on residential mortgages, according to QBE.
IRB lenders currently receive no capital benefit for the use of LMI, despite the fact that the LMI providers are required to, and do, hold significant capital for the risk that is transferred, QBE said in its FSI submission.
LMI capital in Australia is typically invested in conservative, highly liquid non-correlated assets and is used as an independent layer of capital or a buffer to pool credit default risk and the costs associated with default across time, geography and a large group of borrowers and lenders.
Following implementation of the Basel provisions, APRA required all IRB lenders to maintain a floor of 20 per cent for the Loss Given Default (LGD) on residential mortgages.
“This floor has been the adopted assumption for LGD for mortgages with and without LMI protection, giving no recognition for the use of LMI by lenders and effectively negating any capital benefits for LMI,” the submission said.
However, prior to 2008 - under Basel I - there was a significant capital incentive for the use of LMI.
“It enabled ADIs (Authorised Deposit-taking Institutions) to apply a 50 per cent risk weighting (rather than a 100 per cent weighting) to 'standard' loans with greater than 80 per cent [LVR] and 'non-standard' loans (primarily low-doc loans) with greater than 60 per cent LVR,” the submission said.
“This incentive, which halved the capital usage for the lender, reinforced the practice by lenders of insuring high LVR loans,” it said.
“The current IRB approach has proven to yield a lower regulatory capital requirement for residential mortgages than the standardised approach.”
All of the big four banks have had their IRB status approved by APRA.
A number of non-major ADIs have achieved or are seeking IRB status, while smaller ADIs - such as credit unions, building societies and various smaller lenders - will continue to apply the standardised approach.
“In practice, the vast majority of residential mortgages originated by ADIs are subject to the IRB approach,” QBE says in its submission.
“It is anticipated that this proportion will increase further due to the market dominance of the large IRB lenders and anticipating that further ADIs will achieve IRB status over time.”