APRA warns banks about overusing lending exceptions

The chair of the Australian Prudential Regulation Authority (APRA), John Lonsdale, has written to banks to remind them of the regulator’s expectations when it comes to managing exceptions to housing lending policy and to warn them that any banks reporting large volumes of policy exceptions will be subject to “heightened supervisory attention”.

In a letter to regulated authorised deposit-taking institutions (ADIs), the APRA chair noted that some banks have recently announced changes to their exception processes to support borrowers experiencing serviceability challenges.

For example, this may include borrowers who are rolling off super-low fixed rates onto interest rates that are around three times higher — and whom may now be subject to the higher 3 percentage point buffer (previously 2.5 per cent). Added to this are higher cost-of-living pressures, which — when combined with higher rates and serviceability tests — may be creating ‘mortgage prisoners’ who are unable to refinance.

Given these constraints, several lenders — including Westpac and its subsidiaries Bank of Melbourne, St.George Bank, and BankSA — have begun tweaking their serviceability tests.

While applications to refinance an existing consumer mortgage will continue to be assessed under standard serviceability criteria and document verification requirements, Westpac has said that if certain customers are unable to meet serviceability under the standard assessment criteria, a “modified serviceability assessment rate” may be applied. This rate would be applied as a credit exception to new and existing consumer mortgage commitments.

However, APRA has warned banks about the frequency with which it applies these exceptions.

The regulator reiterated that banks must apply a 3 per cent minimum serviceability buffer above the housing loan interest rate when assessing borrowing capacity, stating this “provides a contingency for rises in interest rates over the life of the loan, as well as for any unforeseen changes in a borrower’s income or expenses”.

“With the potential for interest rates to rise further, inflation still high and the possibility of weaker labour market outcomes, the buffer is an important risk mitigant,” the chair said in its letter to banks.

Exceptions should be limited, higher volumes will attract ‘heightened supervisory attention’

He added that while APRA’s prudential framework enables banks to use exceptions to policy to approve a loan that does not meet standard loan criteria (such as a reduced serviceability buffer or additional indicators of repayment capacity), these should be “managed prudently and limited”.

The letter read: “APRA requires banks to have prudent policies and processes for dealing with exceptions to policy. Large volumes of exceptions can create risks by weakening banks’ risk profiles and increasing the vulnerability of their loan books to future shocks. Historically, serviceability policy exceptions have accounted for a small share of banks’ total housing lending, at between 2 and 3 per cent...

“It is important that exceptions are used in a prudent and limited manner, so as not to undermine the intent of the core policy. In using exceptions, APRA expects banks to make a prudent assessment of repayment capacity so that there is a good outcome for borrowers and the financial system.

“Prudent banks would have acceptable reasons and clear justifications for loans written outside policy,” flagging that banks should also consider their responsible lending obligations.

“Loans written as exceptions must be regularly reported to the relevant internal governance bodies of the bank and monitored against risk appetite limits. Prudent boards would assess the impact of any proposed changes to exceptions processes on the bank’s risk profile and risk appetite. This includes understanding the types of loans that are being written outside policy, such as like-for-like refinancing.”

In conclusion, the prudential regulator requested that banks notify their supervisor ahead of material changes to their exceptions process.

“APRA will be monitoring exceptions trends closely and may request additional information to assess how banks are managing risks,” it said.

“Banks reporting large volumes of policy exceptions will be subject to heightened supervisory attention.”

While some lenders have announced that they will apply reduced serviceability in some instances, other banks have been hesitant to do so.

Indeed, AMP Bank’s head of credit, Shane Scott, recently said that the non-major bank would be “sticking with a 3 per cent buffer” on its loans as it considers it to be “very risky” to ignore APRA’s serviceability expectations.

“Our position, at the moment, is it would be very risky to ignore APRA’s mandated 3 per cent [buffer],” he said during a credit webinar earlier this month.

“So we’re sticking with 3 per cent at the moment, but are looking at other concessions that we can make in terms of assessment of income loan terms, etc to help those customers that are facing difficulty in repayments because of the significant rise in interest rates we’ve seen over the last 12 months.”

[Related: Serviceability buffers to cushion banks from credit losses]