The Rise of Microprudential

APRA’s revised mortgage guidance released yesterday, on the surface may look benign but if you look at the detail there are a number of changes which together do change the game in terms of risk analysis during underwriting, and through the life of the mortgage. We think this will slow credit growth through 2017 and beyond.

We suggest this is imposing significant micro-management on the portfolio, which will force some lenders to change their current practices.

Investment Property Underwriting Tightened.

APRA says a minimum haircut of 20% on expected rental income, and larger discounts on properties where there is a higher risk of non-occupancy should be applied. They also need to taking into account a borrower’s investment property-related fees and expenses. Also, APRA highlights that an ADI should ideally “place no reliance on a borrower’s potential ability to access future tax benefits from operating a rental property at a loss”, but if an ADI chooses to do so, it “would be prudent to assess it at the current interest rate rather than one with a buffer applied”.

Serviceability Tests Strengthened

APRA reaffirmed the interest rate buffer of at least 2% and minimum lending floor rate of at least 7% for mortgages. But now APRA says ADIs should apply these buffers a borrower’s new and existing debt commitments. To do this, banks will need to have more detailed knowledge of a borrower’s existing debt commitments and history of  delinquency.

Expenses Assessment Tightened

APRA wants ADIs to use the greater of a borrower’s declared living expenses or an appropriately income scaled version of the Household Expenditure Measure (HEM) or Henderson Poverty Index (HPI). They cannot rely fully on HEM or HPI to assess living expenses. They suggest expenses should be more correlated to income.

Income Assessment Tightened

APRA says banks should apply discounts of at least 20% (instead of being calculated at the ADIs’ discretion) to be applied to most types of non-salary income (rental income on investment properties, bonuses, child benefits etc.). A larger discount should sometimes be used where income is more variable over time – “an ADI may choose to use the lowest documented value of such income over the last several years, or apply a 20 per cent discount to the average amount received over a similar period”.

Interest Only Loans More Restricted

APRA expects interest-only periods offered on residential mortgage loans to be of limited duration, particularly for owner-occupiers. Interest-only loans may carry higher credit risk in some cases, and may not be appropriate for all borrowers. This should be reflected in the ADI’s risk management framework, including its risk appetite statement, and also in the ADI’s responsible lending compliance program. APRA expects that an ADI would only approve interest-only loans for owner-occupiers where there is a sound and documented economic basis for such an arrangement and not based on inability to service a loan on a principal and interest basis.

SMSF Property Loans Require More Examination

The nature of loans to SMSFs gives rise to unique operational, legal and reputational risks that differ from those of a traditional mortgage loan. Legal recourse in the event of default may differ from a standard mortgage, even with guarantees in place from other parties. Customer objectives and suitability may be more difficult to determine. In performing a serviceability assessment, ADIs would need to consider what regular income, subject to haircuts as discussed above, is available to service the loan and what expenses should be reflected in addition to the loan servicing. APRA expects that a prudent ADI would identify the additional risks relevant to this type of lending and implement loan application assessment processes and criteria that adequately reflect these risks.

LVR Is Not A Good Risk Indicator

Although mortgage lending risk cannot be fully mitigated through conservative LVRs, prudent LVR limits help to minimise the risk that the property serving as collateral will be insufficient to cover any repayment shortfall. Consequently, prudent LVR limits serve as an important element of portfolio risk management. APRA emphasises, however, that loan origination policies would not be expected to be solely reliant on LVR as a risk-mitigating mechanism.

Genuine Savings To Be Tested

ADIs typically require a borrower to provide an initial deposit primarily drawn from the borrower’s own funds. Imposing a minimum ‘genuine savings’ requirement as part of this initial deposit is considered an important means of reducing default risk. A prudent ADI would have limited appetite for taking into account non-genuine savings, such as gifts from a family member. In such cases, it would be prudent for an ADI to take all reasonable steps to determine whether non-genuine savings are to be repaid by the borrower and, if so, to incorporate these repayments in the serviceability assessment.

Granular and Ongoing Portfolio Management Required

Where residential mortgage lending forms a material proportion of an ADI’s lending portfolio and therefore represents a risk that may have a material impact on the ADI, the accepted level of credit risk would be expected to specifically address the risk in the residential mortgage portfolio. Further, in order to assist senior management and lending staff to operate within the accepted level of credit risk, quantifiable risk limits would be set for various aspects of the residential mortgage portfolio.

A robust management information system would be able to provide good quality information on residential mortgage lending risks. This would typically include:

a) the composition and quality of the residential mortgage lending portfolio, e.g. by type of customer (first home buyer, owner-occupied, investment etc), product line, distribution channel, loan vintage, geographic concentration, LVR bands at origination, loans on the watch list and impaired;
b) portfolio performance reporting, including trend analysis, peer comparisons where possible, other risk-adjusted profitability and economic capital measures and results from stress tests;
c) compliance against risk limits and trigger levels at which action is required;
d) reports on broker relationships and performance;
e) exception reporting including overrides, key drivers for overrides and delinquency performance for loans approved by override;
f) reports on loan breaches and other issues arising from annual reviews;
g) prepayment rates and mortgage prepayment buffers;
h) serviceability buffers including trends, performance, recent changes to buffers and adjustments and rationale for changes;
i) missed payments, hardship concessions and restructurings, cure rates and 30-, 60- and 90-days arrears levels across, for example, different segments of the portfolio, loan vintage, geographic region, borrower type, distribution channel and product type;
j) changes to valuation methodologies, types and location of collateral held and analysis relating to any current or expected changes in collateral values;
k) findings from valuer reviews or other hindsight reviews undertaken by the ADI;
l) reporting against key metrics to measure collections performance;
m) tracking of loans insured by LMI providers, including claims made and adverse findings by such providers;
n) provisioning trends and write-offs;
o) internal and external audit findings and tracking of unresolved issues and closure;
p) issues of contention with third-parties including service providers, valuation firms, etc; and
q) risk drivers and other components that form part of scorecard or models used for loan origination as well as risk indicators for new lending.

When setting risk limits for the residential mortgage portfolio, a prudent ADI would consider the following areas:

a) loans with differing risk profiles (e.g. interest-only loans, owner-occupied, investment property, reverse mortgages, home equity lines-of-credit (HELOCs), foreign currency loans and loans with non-standard/alternative documentation);
b) loans originated through various channels (e.g. mobile lenders, brokers, branches and online);
c) geographic concentrations;
d) serviceability criteria (e.g. limits on loan size relative to income, (stressed) mortgage repayments to income, net income surplus and other debt servicing measures);
e) loan-to-valuation ratios (LVRs), including limits on high LVR loans for new originations and for the overall portfolio;
f) use of lenders mortgage insurance (LMI) and associated concentration risks;
g) special circumstance loans, such as reliance on guarantors, loans to retired or soon-to–be-retired persons, loans to non-residents, loans with non-typical features such as trusts or self-managed superannuation funds (SMSFs);
h) frequency and types of overrides to lending policies, guidelines and loan origination standards;
i) maximum expected or tolerable portfolio default, arrears and write-off rates; and
j) non-lending losses such as operational breakdowns or adverse reputational events related to consumer lending practices.

Good practice would be for the risk management framework to clearly specify whether particular risk limits are ‘hard’ limits, where any breach is escalated for action as soon as practicable, or ‘soft’ limits, where occasional or temporary breaches are tolerated.

 

APRA Updates Mortgage Lending Practices

APRA has updated the mortgage lending guidance, to include more specific guidance on gifts for deposits, off-the-plan lending, allowance for vacant periods on rental proprieties, allowance for irregular income and confirmation of interest rate floor and buffers. There are also important comments relating to brokers, portfolio analysis and management responsibility. For example, banks will need to have ongoing awareness of households finances, rather than making a point-in-time, set-and-forget assessment. Whilst they say these changes are not material, in practice they are significant, and it suggests a more detailed “micro” analytical approach to lending scrutiny, rather than generic portfolio analytics. This is important and will impact. We think the costs of managing a mortgage portfolio just went up!

The Australian Prudential Regulation Authority (APRA) has updated its expectations for sound residential mortgage lending practices for authorised deposit-taking institutions (ADIs) following consultation with industry and other stakeholders.

APRA released for consultation a revised draft of Prudential Practice Guide APG 223 Residential Mortgage Lending in October 2016 to incorporate measures previously announced by APRA in 2014 or communicated to ADIs since that time.

The revisions to APG 223 are designed to ensure that the sound lending practices that have been implemented across the industry since late 2014 are maintained and reinforced.

As a result of the consultation, APRA has made a small number of refinements to the prudential practice guide, which are explained in a letter to ADIs released today. APRA does not expect these refinements to result in material changes to existing lending practices across the industry as a whole.

APRA is continuing to maintain its close monitoring and supervision of residential mortgage lending practices, including growth in investor lending, as part of its broader mandate to build resilience in the financial sector and promote financial system stability.

There are a few important comments which may trouble some lenders. For example:

Where residential mortgage lending forms a material proportion of an ADI’s lending portfolio and therefore represents a risk that may have a material impact on the ADI, the accepted level of credit risk would be expected to specifically address the risk in the residential mortgage portfolio.

In order to establish robust oversight, the Board and senior management would receive regular, concise and meaningful assessment of actual risks relative to the ADI’s risk appetite and of the operation and effectiveness of internal controls. The information would be provided in a timely manner to facilitate early corrective action.

A robust management information system would be able to provide good quality information on residential mortgage lending risks.

In Australia, it is standard market practice to pay brokers either an upfront commission or a trailing commission, or both. A prudent approach to the use of third parties for residential mortgage lending would include appropriate measures to ensure that commission-based compensation does not create adverse incentives.

When an ADI is increasing its residential mortgage lending rapidly or at a rate materially faster than its competitors, either across the portfolio or in particular segments or geographical areas, a prudent Board would seek explanation as to why this is the case.

Where an ADI uses different serviceability criteria for different products or across different ‘brands’, APRA expects the ADI to be able to articulate and be aware of commercial and other reasons for these differences, and any implications for the ADI’s risk profile and risk appetite.

Good practice would apply a buffer over the loan’s interest rate to assess the serviceability of the borrower (interest rate buffer). This approach would seek to ensure that potential increases in interest rates do not adversely impact on a borrower’s capacity to repay a loan. The buffer would reflect the potential for interest rates to change over several years. APRA expects that ADI serviceability policies should incorporate an interest rate buffer of at least two percentage points. A prudent ADI would use a buffer comfortably above this level.

In addition, a prudent ADI would use the interest rate buffer in conjunction with an interest rate floor, to ensure that the interest rate buffer used is adequate when the ADI is operating in a low interest rate environment. Prudent serviceability policies should incorporate a minimum floor assessment interest rate of at least seven per cent. Again, a prudent ADI would implement a minimum floor rate comfortably above this level.

When assessing a borrower’s income, a prudent ADI would discount or disregard temporarily high or uncertain income. Similarly, it would apply appropriate adjustments when assessing seasonal or variable income sources. For example, significant discounts are generally applied to reported bonuses, overtime, rental income on investment properties, other types of investment income and variable commissions; in some cases, they may be applied to child support or other social security payments, pensions and superannuation income. Prudent practice is to apply discounts of at least 20 per cent on most types of non-salary income; in some cases, a higher discount would be appropriate. In some circumstances, an ADI may choose to use the lowest documented value of such income over the last several years, or apply a 20 per cent discount to the average amount received over a similar period.

In APRA’s view, prudent serviceability policies incorporate a minimum haircut of 20 per cent on expected rental income, with larger haircuts appropriate for properties where there is a higher risk of non-occupancy.

Good practice would be for an ADI to place no reliance on a borrower’s potential ability to access future tax benefits from operating a rental property at a loss. Where an ADI chooses to include such a tax benefit, it would be prudent to assess it at the current interest rate rather than one with a buffer applied.

Good practice would be for an ADI, rather than a third party, to perform income verification

Some ADIs use rules-based scorecards or quantitative models in the residential mortgage loan evaluation process. In such cases, good practice would include close oversight and governance of the credit scoring processes. Where decisions suggested by a scorecard are overridden, it is good practice to document the reasons for the override.

Interest-only loans may carry higher credit risk in some cases, and may not be appropriate for all borrowers. This should be reflected in the ADI’s risk management framework, including its risk appetite statement, and also in the ADI’s responsible lending compliance program. APRA expects that an ADI would only approve interest-only loans for owner-occupiers where there is a sound and documented economic basis for such an arrangement and not based on inability to service a loan on a principal and interest basis. APRA expects interest-only periods offered on residential mortgage loans to be of limited duration, particularly for owner-occupiers.

The nature of loans to SMSFs gives rise to unique operational, legal and reputational risks that differ from those of a traditional mortgage loan. Legal recourse in the event of default may differ from a standard mortgage, even with guarantees in place from other parties. Customer objectives and suitability may be more difficult to determine. In performing a serviceability assessment, ADIs would need to consider what regular income, subject to haircuts as discussed above, is available to service the loan and what expenses should be reflected in addition to the loan servicing. APRA expects that a prudent ADI would identify the additional risks relevant to this type of lending and implement loan application assessment processes and criteria that adequately reflect these risks.

Although mortgage lending risk cannot be fully mitigated through conservative LVRs, prudent LVR limits help to minimise the risk that the property serving as collateral will be insufficient to cover any repayment shortfall. Consequently, prudent LVR limits serve as an important element of portfolio risk management. APRA emphasises, however, that loan origination policies would not be expected to be solely reliant on LVR as a risk-mitigating mechanism.

ADIs typically require a borrower to provide an initial deposit primarily drawn from the borrower’s own funds. Imposing a minimum ‘genuine savings’ requirement as part of this initial deposit is considered an important means of reducing default risk. A prudent ADI would have limited appetite for taking into account non-genuine savings, such as gifts from a family member. In such cases, it would be prudent for an ADI to take all reasonable steps to determine whether non-genuine savings are to be repaid by the borrower and, if so, to incorporate these repayments in the serviceability assessment.

In the case of valuation of off-the-plan sales, developer prices might not represent a sustainable resale value. Consequently, in such circumstances, a prudent ADI would make appropriate reductions in the off-the-plan prices in determining LVRs or seek independent professional valuations.

A prudent ADI would regularly stress test its residential mortgage lending portfolio under a range of scenarios. Scenarios used for stress testing would include severe but plausible adverse conditions

LMI is not an alternative to loan origination due diligence. A prudent ADI would, notwithstanding the presence of LMI coverage, conduct its own due diligence, including comprehensive and independent assessment of a borrower’s capacity to repay, verification of minimum initial equity by borrowers, reasonable debt service coverage, and assessment of the value of the property.

 

 

APRA fiddles on bank risk while Rome burns

From The Conversation.

Australian Prudential Regulation Authority (APRA) chairman Wayne Byers has made it clear the bank regulator will be cracking down on bank capital levels this year.

Bank capital reserves are a loss-absorber, designed to protect creditors if banks suffer significant losses. That protection, in turn, will – ostensibly – prevent panicked withdrawals by depositors, thereby preventing financial contagion and financial crises.

[DFA notes, its the Council of Financial Regulators that is the coordinating body for Australia’s main financial regulatory agencies. Its membership comprises the Reserve Bank of Australia (RBA), which chairs the CFR; the Australian Prudential Regulation Authority (APRA); the Australian Securities and Investments Commission (ASIC); and The Treasury — so APRA is just part of the problem!]

Byers has decided that Australian banks’ capital levels must be “unquestionably strong” in keeping with the findings of the Financial System Inquiry. But how much capital equals “unquestionably strong”? We don’t know.

What we do know is that the inquiry handed down that finding in November 2014. More than two years have passed and only now is APRA getting a wriggle on.

The problem is that, according to the IMF, when it comes to Tier 1 bank capital, this time last year Australia was ranked 91st in the world. That puts us close to the bottom of the G20, the OECD and the G8. Our position has fluctuated, but at no time during the preceding four quarters have we risen above 60th.

Ranked above Australia were Swaziland, Afghanistan and even Greece. That sounds like, at best, unquestionably ordinary. Maybe even unquestionably weak. But definitely not “unquestionably strong”.

The global financial crisis could’ve led to change

Some argue, determinedly and erroneously, that when functioning correctly bank capital levels are almost magical things. As former US Federal Reserve chair Alan Greenspan once said:

The reason I raise the capital issue so often is that … it solves every problem.

Greenspan, as Fed chair, was ultimately responsible for the health of the US financial system. Having touted capital levels, his tenure ended just before the sub-prime disaster turned into the global financial crisis. This earned Greenspan Time Magazine’s moniker as one of the 25 people most to blame for the crisis.

However, bank capital levels were in place before the crisis hit. The Basel Committee – a sort-of UN for Reserve Bank governors and bank regulators – introduced global standards for bank capital as far back as 1988.

Back then, it set the capital level at 8%. In other words, for every $100 in liabilities, banks had to retain $8 in cash (or close to cash). But this level was simply a reflection of the average of the day.

Codifying the average into a global standard was an excellent trick. No-one was made to feel left out, or inadequate.

Then came the global financial crisis. It resulted in an output loss of somewhere between US$6 trillion and US$14 trillion in the US alone.

The Basel Committee said it was going to raise bank capital levels in response to the crisis. This meant it was going to do more of the thing (bolster capital levels) that had been meant to prevent such a crisis from occurring in the first place, but had failed.

What now?

The Basel Committee’s latest attempt to take action on capital levels involves curbing “internal risk-based models”. These models allow banks to determine how risky their assets are, and therefore how much expensive and unusable capital they have to set aside for loss-absorption, to match the risk profile of their assets.

That’s like you or I determining how risky we are as borrowers, and therefore deciding how much interest we should be charged on the money we borrow.

European banks have pushed back against curbing internal risk-based models. They resent not being able to have absolutely everything their own way. And the Basel Committee has proven to be a push-over.

Australian banks have pushed back too, with a not-so-subtle threat that customers will bear the costs of higher capital levels. If Byers and APRA do what they are supposed to, and what the government told them to do in late 2015, Australia’s banks will need to raise A$15 billion or more to rectify their thin capital position.

That’s $15 billion not earning returns or bringing in bonuses. No wonder our bankers aren’t happy.

And while APRA and Byers have fiddled on this issue and effectively ignored government instructions, and Australian banks remained capital-thin, conditions have arisen that economist John Adams argues may result in an “economic Armageddon” for Australia.

If that happens, guess who will be bailing out the banks? You, the taxpayer.

Author: Andrew Schmulow , Senior Lecturer, Faculty of Law, University of Western Australia

APRA Reaffirms 10% Investor Loan Growth Cap

Speaking today at the A50 Australian Economic Forum in Sydney, APRA Chairman Wayne Byres reaffirmed the 10% speed limit for investor loans.

Sort of makes sense given the CBA slowing of investor loans we discussed yesterday, but 10% is, in our view too high, given current salary growth and inflation rates. This is what he said:

Let me start with a warm welcome to everyone who has travelled here to be part of this event.  A little over two hundred years ago this beautiful location was seen as an ideal place for a penal colony.  Thankfully, Sydney is no longer regarded as a hardship destination, but as someone who does a reasonable amount of international travel, I know it is still quite some distance from wherever you have journeyed from.  I hope you are finding the travel to be worth it.

A few quick words about APRA. We are Australia’s prudential regulator, responsible for the prudential oversight of deposit-taking institutions; life, general, and private health insurers; and most of Australia’s superannuation assets. All up, we have coverage of just under $6 trillion in assets, which represents around 3-and-a-half times Australian GDP.

That broad coverage of the financial sector means we inevitably have a large agenda of issues on our plate, but we also have the relative luxury of working with a financial system that is fundamentally sound. To the extent we are grappling with current issues and policy questions, they don’t reflect an impaired system that needs urgent remedial attention, but rather a desire to make the system stronger and more resilient while it is in good shape to do so.

Our mission is to achieve safety within a stable, open, efficient and competitive financial system. We don’t pursue a safety-at-all-costs strategy. But it is also pretty clear the Australian financial system has benefited over the long run from operating with fairly conservative policy and financial settings.

To give you an example, the headline capital ratios of the major  Australian banks might seem low relative to international peers – collectively, they have a CET1 ratio of a touch over 9-and-a-half per cent, whereas a more normal expectation in this day and age might be something comfortably in double digits. But the Australian ratios reflect a set of conservative policy decisions that produce a lower headline capital ratio, but give us a much greater level of confidence in the financial health of the banking system.

One result of that approach is that, even though the major Australian banks are either just inside, or just outside, the top 50 banks in the world when ranked by asset size, they are amongst the small number who have retained AA credit ratings, and we have one bank in the top 10, and the remainder in or around the top 20, when ranked by market capitalisation. Clearly, investors – both debt and equity – understand their underlying quality, and the Australian community gets great benefit from the market access that provides.

The Financial System Inquiry held a couple of years ago endorsed our approach, as did the Government in its response to the Inquiry’s recommendations.

So with that background, let me turn to a few of the important issues on our plate.

The main policy item we have on our agenda in 2017 is the first recommendation of the Financial System Inquiry: that we should set capital standards so that the capital ratios of our deposit-takers are ‘unquestionably strong.’ We have been doing quite a bit of thinking on this issue, but had held off taking action until the international work in Basel on the bank capital regime had been completed.
Unfortunately, the timetable for that Basel work now seems less certain, so it would be remiss of us to wait any longer.

We will have more to say in the coming months about how we propose to give effect to the concept of unquestionably strong, but in the meantime the banking industry has been assiduously building its capital strength in anticipation. Looking through the effects of policy changes, the major banks have added in the order of 150 basis points to their CET1 ratios over the past couple of years. Assuming the industry continues to steadily build its capital, we expect it will be well placed to respond to future policy changes in an orderly manner.

If capital for the banking system is our main policy item, then housing is our main supervisory focus. I know there is always a great deal of interest in the Australian housing market, so it is probably something I should say a few words about.

It should not be surprising we have been paying particular attention to the quality of housing portfolios for some time – and particularly the quality of new lending – given housing represents the largest asset class on the banking industry’s balance sheet.

We have lifted our supervisory intensity in a number of ways – collecting more data from lenders, putting the matter on the agenda of Boards, establishing stronger lending standards that will serve to mitigate some of the risks from the current environment, and seeking in particular to moderate the rapid growth in lending to investors. These efforts are often tagged ‘macroprudential’, but in an environment of historically low interest rates, high household debt, relatively subdued wage growth, and strong competitive pressures, we see our role – in simple terms, seeking to make sure lenders continue to make sound loans to borrowers who can afford to pay them back – as really pretty basic bank supervision.

And just to be clear about it, we are not predicting whether house prices will go up or down or sideways (as the Governor of the Reserve Bank said last night, they are doing all these things in different parts of the country), but simply seeking to make sure that bank balance sheets are well equipped to handle whatever scenarios eventuate.

As things stand today, our recent efforts have generated a moderation in investor lending, which was accelerating at double digit rates of growth but has now come back into single figures. We can also be more confident in the quality of mortgage lending decisions today relative to a few years ago.

We are not complacent, however, as recent months have seen a pick-up in the rate of new lending to investors. That pick-up in itself is not necessarily surprising – with so much construction activity being completed and the resulting settlement of purchases, some pick-up in the rate of growth might be expected. But, at least for the time being, the benchmarks that we communicated – including the 10 per cent benchmark for annual growth in investor lending – remain in place and lenders that choose to operate beyond these benchmarks are under no illusions that supervisory intervention, probably in the form of higher capital requirements, is a possible consequence. If that is encouraging them to direct their competitive instincts elsewhere, then that’s probably a good thing for the system as a whole.

I have focussed very much on banking in my remarks thus far, so before my time is up I thought I would also comment on an issue that is relevant right across the financial system: the need to continue investment in existing technology platforms while at the same time putting money into new technology which may well replace it. This conundrum exists for all firms we supervise, and the issue is going to rise in importance as time goes by.

The Australian financial sector is, on the whole, pretty quick to adapt new technology as it emerges. And we have some important new infrastructure currently being built, like the New Payments Platform that will facilitate payments 24/7. But we also face the challenge that, like many parts of the world, large parts of financial firms’ core operating platforms are still based on technology that is increasingly dated, and not as integrated as it needs to be.

Particularly with the rise of fintech and potential disruptors, the temptation in the current environment is to devote a larger proportion of any investment budget to shiny new toys at the front end that excite the customer, and perhaps defer a bit of maintenance on the back office functions that make sure the customers’ transactions actually get processed and recorded correctly. As a supervisor, we are very keen to see investment in new technology by financial firms, because we think it offers considerable benefit to the soundness, efficiency and competitiveness of the financial system. The important thing for us is to make sure investment budgets are expanding to accommodate that, and it is not simply funded by a diversion of resources from other essential tasks.

I’ll conclude here and give the floor to my other panellists. I will, of course, be happy to take any questions you might have once they have had a chance to make their remarks.

Super assets reaches $2.1 trillion

From InvestorDaily.

Australia’s retirement savings system grew to $2.1 trillion by the middle of 2016, according to new statistics published by APRA

In its Annual Superannuation Bulletin, released yesterday, APRA revealed total assets hit $2.1 trillion as at 30 June 2016.

Of that total, $621.7 billion (29.6 per cent) was held in SMSFs and $1.29 trillion was held by APRA regulated superannuation entities.

The remaining $185.5 billion comprised exempt public sector superannuation schemes ($132.2 billion) and the balance of life statutory funds ($53.3 billion).

Retail funds held 26 per cent of the total $2.1 trillion; industry funds held 22.2 per cent; public sector funds held 17 per cent and corporate funds held 2.6 per cent.

As at 30 June 2016, there were 144 APRA-regulated RSE licensees responsible for managing funds with more than four members.

Of the funds with more than four members, the annual rate of return for the year ended June 2016 was 2.9 per cent. The five-year average annualised rate of return to June 2016 was 7.4 per cent and the 10-year rate of return was 4.6 per cent.

Australian superannuation members paid $11.72 billion in fees for the 12 months to 30 June 2016, according to APRA.

APRA Says Banks Home Lending Up In December … But

APRA has released their monthly banking statistics, which shows the portfolio movements of the major banks. Total lending for housing was up 0.68% to $1.52 trillion, with owner occupied lending up 1% to $987 billion and investment lending up 0.06% to $537 trillion. But there are adjustments in these numbers which make them pretty useless, especially when looking at the mix between investment and owner occupied loans.

The trend here is quite different from the RBA data also out today, which showed growth of 0.8% for investment loans and 0.4% for owner occupied loans (and includes non-banks in these totals). A quick look at the monthly movements shows that there was a significant ($3bn+) adjustment at ING, which distorts the overall picture. No explanation from APRA, and this movement is much bigger than the $0.9 billion net figure the RBA mentioned in their release.

For what it is worth, here is the sorted 12 month growth trend by lending, showing the 10% “hurdle”. ING is to the right of the chart thanks to their adjustment.

But the point is, we really do not know where we stand as i) data quality from the banks is still poor, and ii) the regulators are unable to provide a reconciled and transparent picture of lending. Given the debate about housing affordability, we need better and consistent data to aid the debate.

APRA On The Countercyclical Capital Buffer

APRA released a brief update to support their zero Countercylical Capital Buffer setting. As they say “the countercyclical capital buffer is designed to be used to raise banking sector capital requirements in periods where excess credit growth is judged to be associated with the build-up of systemic risk. This additional buffer can then be reduced or removed during subsequent periods of stress, to reduce the risk of the supply of credit being impacted by regulatory capital requirements”.

APRA may set a countercyclical capital buffer within a range of 0 to 2.5 per cent of risk weighted assets. On 17 December 2015, APRA announced that the countercyclical capital buffer applying to the Australian exposures of authorised deposit-taking institutions (ADIs) from 1 January 2016 would be set at zero per cent. An announcement to increase the buffer may have up to 12 months’ notice before the new buffer comes into effect; a decision to reduce the buffer will generally be effective immediately.

APRA reviews the level of the countercyclical capital buffer on a quarterly basis, based on forward looking judgements around credit growth, asset price growth, and lending conditions, as well as evidence of financial stress. APRA takes into consideration the levels of a set of core financial indicators, prudential measures in place, and a range of other supplementary metrics and information, including findings from its supervisory activities. APRA also seeks input on the level of the buffer from other agencies on the Council of Financial Regulators.

A range of core indicators are used to justify their position. Here are their main data-points.

Credit growth

Credit-to-GDP ratio (level, trend and gap)

The credit-to-GDP gap is defined as the difference between the credit-to-GDP ratio and its long-run trend. The long-run trend is calculated using a one sided Hodrick-Prescott filter, a tool used in macroeconomics to establish the trend of a variable over time. The credit-to-GDP gap for Australia is currently negative at -3.9. The Basel Committee suggests that a gap level between 2 and 10 percentage points could equate to a countercyclical capital buffer of between 0 and 2.5 percent of risk-weighted assets.

Housing credit growth

The pace of housing credit growth has slowed this year, growing at 6.4 per cent year on year as at September 2016, down from 7.5 per cent at the time the buffer was initially set. Investor housing credit growth fell from 10 per cent to 4.9 per cent over the same period, however the pace of growth has been increasing again more recently. APRA has identified strong growth in lending to property investors (portfolio growth above a threshold of 10 per cent) as an important risk indicator for APRA supervisors.

Business credit growth

Business credit growth increased marginally in the first half of 2016. However, business credit growth has fallen over recent quarters; annual growth in business credit was 4.8 per cent over the year to end September 2016, down from 6.3 per cent as at September 2015. Notwithstanding the lower overall rate of growth, commercial property lending growth (not shown) has remained strong, growing 10.5 per cent year on year as at September 2016.

Asset Prices

National housing price growth remains strong, but has slowed relative to 2015 peaks, growing nationally at around 3.5 per cent over the 12 months to September 2016. However, over a shorter horizon, prices have been reaccelerating recently with six month-ended annualised price growth of 7.2 per cent nationally as at September 2016 (albeit still a slower pace than 2015 peaks). Conversely, rental growth and household income growth have been relatively weak. Looking beyond the national averages, conditions vary significantly across individual cities and regions. In particular, housing price growth has strengthened in Sydney and Melbourne over recent months with six month-ended annualised growth rates of 11.4 per cent and 9.0 per cent respectively.

Non-residential commercial property has also been exhibiting strong price growth, though this has moderated somewhat in recent months (not shown).

Lending indicators

APRA monitors a range of data and qualitative information on lending standards. For residential mortgages, the proportion of higher-risk lending is a key metric. Over the past few years, APRA has heightened its regulatory focus on the mortgage lending practices of ADIs in order to reinforce sound lending practices. This has included, but not been limited to, the introduction of benchmarks on loan serviceability and investor lending growth, and the issuance of a prudential practice guide on sound risk management practices for residential mortgage lending.

In general, higher-risk mortgage lending has been falling recently with the share of new lending at loan-to-valuation ratios greater than 90 per cent falling from 9.5 per cent to 8.1 per cent over the year to September 2016. Other forms of higher-risk mortgage lending including high loan-to-income and interest-only lending (not shown) have also moderated from 2015 peaks, although there has been some pick-up in the share of interest-only lending recently.

In business lending, banks have showed some evidence of tightening lending standards more recently, in particular for commercial property lending, with the lowering of loan-to-valuation and loan-to-cost ratios on certain development transactions (not shown).

Lending rates had been steadily falling for both housing and business lending to historical lows. More recently however, lending rates have fallen by less than the cash rate, with banks passing on around half of the August cash rate reduction. Lending rates have also risen in recent weeks in response to higher costs in wholesale funding markets. In particular, a number of ADIs have recently announced increases to their mortgage lending rates with some ADIs specifically targeting investor and interest-only loans.

APRA’s confidential quarterly survey of credit conditions and lending standards provides qualitative information on whether conditions are tightening or loosening in the industry.

Financial Stress

Indicators of financial stress are used in informing decisions to release any countercyclical capital buffer. While a wide range of indicators could signify a deterioration in conditions, APRA has identified non-performing loans as its core indicator of financial stress.

The share of non-performing loans remains low, though it has increased moderately over 2016, to 0.93 per cent as at September 2016, largely driven by increases in regions and sectors with exposures to mining.

So, everything is looking rosy, in their view. However, the high household debt to income ratio and the fact that debt servicing is supported by ultra low interest rates is not included adequately in their assessment – seems myopic in my view, but then this continues the regulatory group-think.  In addition the use of “confidential quarterly survey data” highlights the lack of industry disclosure.

Bank Home Loan Portfolio Now Up To $1.51 Trillion

APRA released their monthly banking stats for November 2016.  The total loan portfolio rose 0.65% in the month to a new high of $1.51 trillion. Within that, owner occupied lending rose 0.69% by $6.7 billion, to $977 billion and investment lending rose 0.58%, by $3.1 billion to $536 billion; accounting for 35.44% of all loans. We see investment lending still accelerating (as expected, based on our household surveys).

Looking at the individual lenders, CBA wrote more investment loans than WBC in the month, though WBC just holds on to its prime position for investment loans.

Overall WBC wrote the most new business, $2.48 billion. compared with CBA’s $2.26 billion.

The 12 month system investment portfolio movement is 3.5%, but has accelerated in recent months. Testing against the 10% APRA speed limit, we see that most lenders are well below this threshold. We think the limit should be dropped, as investment loan momentum is too strong, and well above inflation and wage growth. APRA never really explained why they picked 10% – time for more macro-prudential action!

The RBA data will be out soon, so we will see if the market – including the non-banks moved the same way.

APRA releases final standard on the Net Stable Funding Ratio

The Australian Prudential Regulation Authority (APRA) has today released the final revised Prudential Standard APS 210 Liquidity (APS 210) and Prudential Practice Guide APG 210 Liquidity (APG 210) which incorporates, among other things, the Net Stable Funding Ratio (NSFR) requirements for some authorised deposit-taking institutions (ADIs).

APRA’s objective in implementing the NSFR in Australia for ADIs that are subject to the Liquidity Coverage Ratio (LCR), implemented in 2015, is to strengthen the funding and liquidity resilience of these ADIs.

The NSFR encourages ADIs to fund their activities with more stable sources of funding on an ongoing basis, and thereby promotes greater balance sheet resilience. In particular, the NSFR should lead to reduced reliance on less-stable sources of funding, such as short-term wholesale funding, that proved problematic during the global financial crisis.

The release of the final prudential standard and prudential practice guide on liquidity follows submissions received on APRA’s September response paper: Basel III liquidity – the Net Stable Funding Ratio and the liquid assets requirement for foreign ADIs. APRA has released today a letter addressing the issues raised in these submissions, while APRA’s final position also takes account of comments received in submissions to the initial March 2016 discussion paper on these matters.

APRA Chairman Wayne Byres said ‘the final policy settings will reinforce the steps that ADIs have taken to strengthen their funding profiles in recent years, and ensure that strengthening is sustained over the long term.’

In addition to addressing the Net Stable Funding Ratio requirements, the final APS and APG 210 released today also address a number of other changes noted in the September response paper. The new APS 210 will commence on 1 January 2018, while the new APG 210 replaces the existing APG 210 from today.

Liquid assets requirement for foreign ADIs
As noted in the September 2016 response paper, APRA will retain the 40 per cent LCR as the default liquid assets requirement for foreign ADIs, but allow foreign ADIs with simpler business activities to apply to use the alternative Minimum Liquidity Holdings (MLH) approach.

Background information

Q: What is the Net Stable Funding Ratio (NSFR)?
A: The NSFR is a quantitative global liquidity standard established by the Basel Committee on Banking Supervision that seeks to promote more stable funding of banks’ balance sheets. The standard establishes a minimum stable funding requirement based on the liquidity characteristics of an ADI’s assets and off-balance sheet activities over a one-year time horizon, and aims to ensure that long-term assets are financed with at least a minimum amount of stable funding.

Q: Why is APRA introducing the NSFR?
A: The NSFR seeks to promote more stable funding of banks’ balance sheets. As the Basel Committee on Banking Supervision noted, when announcing its new international liquidity framework in 2009, throughout the global financial crisis many banks had failed to operate with adequate liquidity and unprecedented levels of liquidity support were required in order to sustain the financial system. The crisis illustrated how quickly and severely liquidity risks can crystallise and certain unstable sources of funding can evaporate, compounding concerns related to the valuation of assets and capital adequacy.

Q: Which ADIs will the NSFR apply to?
A: The NSFR will apply to those locally-incorporated ADIs that are also subject to the Liquidity Coverage Ratio (LCR). There are currently 15 LCR ADIs:  AMP Bank; Arab Bank; Australia and New Zealand Banking Group; Bendigo and Adelaide Bank; Bank of China; Bank of Queensland; Citigroup; Commonwealth Bank of Australia; HSBC Bank; ING Bank; Macquarie Bank; National Australia Bank; Rabobank Australia; Suncorp-Metway; and Westpac Banking Corporation.

Q: Why is APRA only applying the NSFR to ADIs with the Liquidity Coverage Ratio (LCR)?
A: Non-LCR ADIs typically have simpler funding models with most of their balance sheet funded by their deposit base which is considered to be a more stable source of funding. Given the balance sheets of these ADIs will already be financed with significant amounts of stable funding, APRA does not consider there would be any additional benefits from the imposition of the formal NSFR framework for these ADIs.

Caution as interest-only mortgages continue to rise

From News.com.au.

Has Australia gotten too swept up in our great love affair with property?

And they have been consistently rising for close to a decade, since the Australian Prudential Regulation Authority (APRA) started releasing this data in 2008.

According to APRA’s latest quarterly property exposure statistics, released last week, interest-only home loans increased by almost $8 billion in the September 2016 quarter. These types of mortgages now make up 39 per cent of all residential home loans.

But with evidence that house price growth is easing — capital gains recorded over November were the softest they have been since December 2015 — and with mortgage rates on the way back up, the rise in interest-only lending is beginning to ring alarm bells.

“In slow growth markets, which most markets in Australia currently are, if you’re not paying down the principal loan amount and there is a market event that leads to a drop in property prices, a homeowner with an interest-only loan could be left dangerously exposed,” the CEO of HomeStart Finance, John Oliver said.

“Even in current high-growth markets such as Melbourne and Sydney, there is speculation about a potential bursting of the property bubble. If this happens, it could lead to a lot of homeowners losing their properties.

“Australia’s property market is littered with periods when the value of properties actually fell, such as the Sydney market between 2004 — 2007 where prices fell by 8 per cent and Adelaide between 2010 — 2013 where prices fell by 4 per cent.”

CoreLogic figures showed Melbourne house prices dropped by 1.5 per cent in November while Sydney prices rose by just 0.8 per cent. The combined capital city index grew by just 0.2 per cent over the month.

A SLEEPING PROBLEM

Interest-only home loans have typically been popular among property investors because it minimises mortgage repayments in the short-term while investors bank on capital growth in the long-term. So with property investors such a strong force in the Australian property market, Martin North, Principal of Digital Finance Analytics said the increasing popularity of interest-only isn’t surprising.

“We need to understand who are getting those interest-only loans. There is a very strong correlation between interest-only loans and greater investment lending,” Mr North told news.com.au.

“In the last three or four months we have seen investors come back and investor loans are driving the market again.”

But this love affair with property investment, and the subsequent rise in interest-only lending, could now start to cause real headaches at a time when interest rates are starting to rise.

“We have got two issues. The first issue is we have got this continued growth with investor loans and my research tells me investors are still pretty keen on the market … and therefore interest-only loans are being sold,” Mr North said.

“The second issue is we have got interest-only loans with people currently and when they come up for renewal, with interest rates rising, the bank will be asking harder questions about whether they can refinance and repay the capital. And some of those [investors], from my surveys, would indicate they don’t have a plan to repay the capital. That means there is a sleeping problem for those with interest-only loans currently.”

Research from Digital Finance Analytics shows more than eight in ten existing interest-only loan holders expect to refinance their loan to another interest-only loan and more than a quarter had no firm plans as to how they were going to repay if they couldn’t enter another interest-only agreement. Banks, who don’t want borrowers on interest-only terms for long periods, offer fixed-terms on interest-only mortgages, with the average term lasting five years.

This leaves us with a significant amount of investors who have taken advantage of interest-only mortgages, and are “ill-prepared” to switch to principal-and-interest.

They have assumed that price growth will continue at stratospherical levels so they will be able to sell their property and repay the loan, said Mr North, or they have assumed they will be able to continue to roll their loan over on interest-only terms. But house price growth is cooling and banks are tightening interest rates and loan approvals.

“It creates a series of small earthquakes. Those might be tremors that don’t go anywhere but if you think about it in the context of interest rates rising, house price growth slowing going forward, and people who own investment properties who are already underwater in terms of rental yields, and they now find they can’t actually refinance the loan under interest-only terms …

What I’m feeling is people are going to have a nasty shock,” Mr North said.

“If [investors] do run to the exit, they still have got to repay the loan they have got on the property … But if you have a situation where there is a significant downturn, and property prices drop dramatically, then you could be in a situation where some of the interest-only borrowers won’t be able to repay their loans and that could be a significant downward force on the market.”

A WIDER PROBLEM

APRA’s data shows the concern extends beyond property investors. While interest-only home loans are mostly used by investors, owner-occupiers are resorting to this type of structure too, at higher levels than ever.

At the end of the September 2016 quarter, the value of interest-only loans exceeded the value of investment loans by almost $60 billion, compared to just $18 billion a year earlier. At the end of the September 2014 quarter, two years ago, the value of interest-only mortgages was $26 billion less than the value of mortgages to investors. That’s a turnaround of $86 billion in two years.

“At a time when living costs continue to rise there’s no doubt that home buyers, and in particular first-time buyers, see interest-only loans as a quick fix to get into their own home sooner, while also managing everyday costs,” Mr Oliver said.

A sobering thought given a fifth of young borrowers already can’t make their mortgage repayments when rates are at record lows.

So if the market does drop and rates rise, it is not just investors who are headed for trouble.

“If they are not paying any money off the home, no headway is being made on the overall mortgage. By paying off the interest for up to 10 years, no equity will be built up in the home if property prices aren’t rising,” Mr Oliver said.

“If housing prices drop or there is a downturn in the economy then they could be forced to sell the property at a loss, or the banks may repossess the property.”