APRA issues capital framework changes update

The Australian Prudential Regulation Authority (APRA) has provided an update on its proposed changes to the authorised deposit-taking institution (ADI) capital framework in a bid to help the industry plan ahead for implementation.

In December 2020, APRA published a roadmap for finalising reforms to the bank capital framework, and released a consultation package on the draft prudential standards that will underpin these reforms, which are due to come into effect from January 2023.

The aim of the bank capital reforms is to strengthen the financial resilience of the industry, and improve the ability of the framework to respond “flexibly to future stress events”, and improve the “transparency of ADI capital strength”.

APRA stated that the new framework would “embed the industry’s unquestionably strong level of capital, with higher capital buffers providing greater flexibility for periods of stress”.

Responses from industry and other stakeholders were submitted in April 2021.

Following review of these submissions, APRA has now provided an update on key policy settings to assist the industry with capital planning, including modifying the proposed capital requirements for higher risk residential mortgage lending, with changes to the definition of long-term, interest-only loans.

Interest-only residential mortgage lending

APRA has proposed two key changes to residential mortgages with an interest-only period of greater than five years.

APRA’s proposal in December 2020 categorised mortgages with an interest-only period of greater than five years as “non-standard” loans, as borrowers in this category face a longer period of higher indebtedness, which increases their risk of falling into negative equity if house prices decline.

In addition, APRA noted that these borrowers could face significant “repayment shocks” when their interest-only periods end and they are required to make repayments on a principal and interest basis.

As a result, APRA had decided that a non-standard categorisation would better represent the risks associated with long-term interest-only mortgages, and a higher risk weight of 100 per cent would be appropriate.

While APRA has still considered it appropriate to treat these mortgages as non-standard loans, it has announced that it intends to narrow the scope of the non-standard definition after considering industry feedback.

As such, it has proposed two key changes, which include:

• The five-year, interest-only period would be based on contractual length rather than an aggregation that includes prior periods. APRA has acknowledged that there is less risk if ADIs have undertaken a serviceability assessment as part of refinancing or renewal activity; and
• Exposures with a loan-to-value ratio (LVR) less than or equal to 80 per cent would be excluded. These borrowers are less vulnerable to falling into negative equity.

The revised approach will be included in Attachment A of draft APS 112 Capital Adequacy: Standardised Approach to Credit Risk (APS 112), building on APRA’s December 2020 consultation package.

It will be set out as follows: “The following exposures must also be classified as non-standard loans: (a) Interest-only loans with an LVR greater than 80 per cent and an interest-only term that is of unspecified duration or is specified in the loan contract as greater than five years.

“The non-standard treatment applies while the loan remains on interest-only repayment terms. Exposures that meet the above criteria but are predominantly for business purposes may be excluded.”

Interest-only seasoning

APRA also noted in its update that it originally proposed to treat all interest-only mortgages as “other residential mortgages” in the six months following conversion to principal and interest repayments, adding that these loans are subject to higher risk during this period, with borrowers more likely to fall into arrears or default.

However, it no longer intends to pursue this proposed seasoning requirement in draft APS 112 in order to simplify implementation and improve alignment with the treatment of other loans under the capital framework.

Mixed property collateral

APRA has announced changes to the way it intends to approach mixed collateral exposures after viewing the submissions.

APRA originally proposed that where a loan is secured by both residential and commercial property and the predominant security is residential property, the ADI must the treat the loan as a residential property exposure and only include the aggregated value of residential properties in the LVR calculation.

However, submissions pointed out that the lack of recognition of commercial property collateral in such exposures would present commercial challenges for business lending, and as such, suggested that the value of commercial property be included in the LVR calculation.

In response to these concerns, APRA said that it intends to allow ADIs to use commercial property in the LVR calculation for mixed collateral exposures, subject to a 40 per cent “haircut” on the value of the collateral.

According to APRA, this approach recognises the value of commercial property but with a haircut to reflect the greater risk of this collateral compared with residential property. This LVR would then be used to determine the risk weight for exposures where the predominant security is residential property.

SME definition

Last year, the draft APS 112 defined small-to-medium enterprise (SME) lending as “an exposure to a corporate counterparty with total consolidated annual revenue of less than or equal to $75 million”.

In response to industry feedback, APRA said that it intends to allow ADIs to include a corporate exposure as SME where its consolidated annual revenue cannot be determined but exposure size is less than $5 million.

“Further, to simplify the SME definition and achieve greater consistency between the internal ratings-based (IRB) and standardised approaches, APRA is planning to revise the SME revenue threshold to ‘less than $75 million’ across both approaches,” APRA said.

Some proposals to remain

On the other hand, APRA said that it intends to maintain other proposals as set out in the December 2020 consultation, including defining lower-risk residential mortgages as lending to owner-occupiers on a principal and interest basis, with other residential mortgages categorised as higher risk, and keeping prescribed risk weights under the standardised approach and risk-weighted assets (RWA) multipliers under the IRB approach at the levels specified in last year’s consultation.

Furthermore, lender’s mortgage insurance (LMI) will be recognised as a 20 per cent benefit, reducing capital requirements under both standardised and IRB approaches.

The mortgage risk-weight floor for the IRB approach is to be set at 5 per cent, limiting the difference in capital between the standardised and IRB approaches.

ADIs can provide further feedback on these proposed policy settings by 20 August 2021.

In a letter to ADIs, APRA general manager, policy, Gideon Holland said that APRA will also conduct a further quantitative impact study (QIS) to understand the impact of these revisions, which will be optional for ADIs and conducted on a “best-efforts” basis.

Responses for this are also due on 20 August.

APRA is aiming to release final prudential standards in November 2021, which will come into effect from 1 January 2023.