APRA to raise capital required against interest-only mortgages

In its new bank capital requirements framework, which comes into effect from January 2023, APRA has increased capital requirements for higher risk mortgages, through enhanced risk sensitivity measures.

As outlined in an information paper summarising the changes, the banks will require more capital to engage in higher risk lending, and vice versa with lower requirements for lower risk.

APRA has hoped to incentivise the banks to lend prudently, by requiring more capital to be held for riskier loans with a higher probability and impact of loss.

APRA has also zeroed in on residential mortgage lending, as its stress testing has shown mortgages typically account for around a third of aggregate bad debts.

Loans to owner-occupiers repaying principal and interest have been classified as lower risk, while investor and interest-only loans have been deemed higher risk.

For smaller, less complex, standardised banks, more capital will be required for riskier loans, varying by loan-to-valuation ratios (LVRs).

At larger, advanced banks, risk weights will be determined by approved internal models, subject to APRA multipliers and floors.

“Under the new framework, APRA has increased capital for residential mortgages relative to other asset classes, and better distinguished higher and lower risk lending,” the regulator explained in its information paper.

Mortgages with both an interest-only period of five years or more and an LVR above 80 per cent will also be classified as non-standard loans (those with the highest risk) and will require a higher risk weight of 100 per cent.

There had been protests against the non-standard classification from industry stakeholders, with respondents in a consultation stating it would be unduly conservative and not reflect the risk profile of long-term interest-only loans.

“Submissions provided information on the inherent risk associated with long-term interest-only lending, noting the arrears and default rates have steadily decreased over time as ADIs have improved serviceability assessments and tightened underwriting criteria,” APRA had noted in its response paper.

“Some respondents also noted that the proposal may push interest-only lending to the unregulated non-ADI sector.”

As a result, the regulator had shifted the non-standard criteria to interest-only loans with a five-year period based on contractual length, rather than an aggregation including prior periods – acknowledging there is less risk if banks undertake a serviceability assessment as part of refinancing or renewal.

Further, interest-only loans with an LVR less than or equal to 80 per cent would be excluded, with borrowers being less vulnerable to falling into negative equity.

Business lending considered less risky

Meanwhile, APRA has reduced capital required against small-business lending, with lower risk weights under the standardised approach.

For standardised banks, small businesses have been classified as those with revenue under $75 million, with capital required depending on their collateral and credit rating.

A similar approach will apply for advanced banks, where risk weights will be determined by approved internal models.

The threshold for defining retail SME has also been raised from $1 million to $1.5 million in loan size, increasing the volume of loans eligible for lower risk weights.

The regulator has also aimed to support competition and to introduce simpler capital requirements for smaller, less complex banks, compared to significant financial institutions.

Smaller banks, which will operate under the standardised approach, have reduced requirements for lower risk mortgage lending.

Advanced banks on the other hand, will be required to hold higher capital buffers and to apply multipliers to risk weights for higher risk loan types.

“Standardised risk weights are intentionally simple and conservative, to cater for a variety of banks and portfolios, whereas advanced approaches are based on more risk sensitive models, and as such are able to identify additional risk characteristics of loans that the simpler standardised approach cannot,” the information paper stated.

“APRA believes that there should be an incentive to invest in advanced modelling, given the benefits to risk management that this brings.”

Major banks are expected to operate with common equity tier 1 (CET1) ratios above 11 per cent from 2023, compared to the 10.5 per cent average calculated that would be needed to achieve “unquestionably strong” capital ratios in July 2017.

APRA has expanded its use of buffers, with a significantly larger proportion of capital to be reserved for periods of stress.

The new required capital has included a releasable buffer of 100 basis points through a baseline setting for the countercyclical capital buffer, which may be varied, in the range of 0-350 points, and additional useable buffers of 250-475 basis points, through the capital conservation buffer, which will vary depending on the type of bank.

“Capital buffers are designed to allow for banks to operate within the regulatory buffer range in periods of stress, to absorb losses and continue lending without breaching minimum requirements: this is the intent of the capital framework,” APRA’s information paper explained.

“Regulatory buffers can be used if needed, and APRA does not expect banks to maintain targets above the buffer range in a severe stress.”

[Related: RBNZ eyes DTI, serviceability limits]