Investor Loan Growth Outpaces Owner Occupied In March

The latest data from the RBA, the credit aggregates, shows that loan growth was strongest for investment home loans, at an annualised rate of 7.1% compared with owner occupied loans at 6.2%. Business lending fell again, and personal credit continues to fall.

The proportion of lending to business fell to 32.8% (a record low) and the proportion of home lending for investors sat at 34.9%

Total credit grew $9.7 billion (up 0.4%), owner occupied lending rose $6.7 billion (up 0.6%), investment loans rose $2.5 billion (up 0.4%) and lending to business up $1 billion (up 0.1%).

However, the RBA adjusts these numbers to take account of $1.2 billion restatement between owner occupied and investment loans. Overall housing rose 6.5% in the past 12 months, way above income growth, so higher household debt once again.

Comparing the RBA and APRA data, it looks like the share of non-bank investor home lending is rising, and of course these lenders are not under the APRA regulatory control, but fall under ASIC (and they are not required to hold capital, as they are not ADIs). This is a loophole.

The RBA notes:

Following the introduction of an interest rate differential between housing loans to investors and owner-occupiers in mid-2015, a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $51 billion over the period of July 2015 to March 2017, of which $1.2 billion occurred in March 2017. These changes are reflected in the level of owner-occupier and investor credit outstanding. However, growth rates for these series have been adjusted to remove the effect of loan purpose changes.

Commodities rally putting pressure on RBA

From InvestorDaily.

A commodity-driven spike in Australia’s nominal GDP is putting the Reserve Bank of Australia under increased pressure to hike interest rates, says Nikko Asset Management.

Australia has seen strong growth in nominal GDP in the past year, thanks largely to the strong rally in commodities prices, according to Nikko Asset management fixed income portfolio manager Chris Rands.

The commodities rally is likely to continue for the next two quarters, Mr Rands said – but whether it continues longer than that will be down to Chinese demand.

Either way, the bright outlook for Australian economy over the next two quarters could potentially give rise to a more hawkish RBA than the market expects, he said.

Few economists are expecting the RBA to hike interest interest rates in the near future given the bank’s fears about further stoking domestic house prices.

But the sharp divergence between nominal GDP and the official cash rate (which have traditionally moved in lockstep) suggests it will be weighing on the RBA’s mind.

“In a strong nominal GDP environment, the RBA is typically either hiking rates or keeping them on hold,” said Mr Rands.

“Over the past five years, the cash rate has been moving in only one direction, and this new information could see the RBA taking a more hawkish tone than what the market is expecting,” he said.

The question for investors (and the RBA) is whether the rally in commodities that is driving nominal GDP growth is sustainable, Mr Rands said.

“If the commodity sector has been driven by Chinese fiscal expansion, this momentum could begin to run out during the second half of this year,” he said.

RBA Minutes And Housing

The RBA released their minutes today. Whilst there is mention of housing, there is not definitive evidence in the minutes to explain the RBA’s recent shift in sentiment as contained in the recent Financial Stability Report.

Indicators of household consumption had been a little weaker than expected in early 2017. The value of retail sales had fallen slightly in February, following average growth in January, and households’ perceptions of their personal finances had declined to below-average levels. Retail price inflation had remained subdued, partly because competition had remained strong across the retail sector. Members noted that utilities prices were expected to put some upward pressure on retail costs, but that retail rents had been flat – or rising very marginally at most – across the major cities.

Conditions in the established housing market had continued to vary significantly by region. Housing price growth had been strongest in detached housing markets in Sydney and Melbourne and some indicators for the established housing markets in these cities had picked up in the preceding couple of months. In contrast, housing market conditions in Perth had remained weak, although there were signs that prices there may be stabilising. Vacancy rates had been increasing, particularly in Perth. Strong growth in the supply of new apartments was continuing to drive a wedge between price growth for apartments and detached houses in Melbourne and Brisbane. Private residential building approvals had rebounded in February; the large pipeline of work to be done was expected to support dwelling investment over the subsequent year or two.

Growth in housing credit to owner-occupiers had moderated slightly over the preceding six months, while growth in housing credit to investors had increased, although investor loan approvals had declined in February. Most of the increase in lending to investors had occurred in New South Wales and Victoria, which was consistent with the pattern of housing market activity. Members observed that the growth of housing credit to investors had initially moderated in response to the announcement by the Australian Prudential Regulation Authority (APRA) of a 10 per cent benchmark for investor credit growth in late 2014. In addition, the share of lending with high loan-to-valuation ratios had fallen. However, growth in investor credit had increased steadily since early 2016, despite the fact that banks had tightened lending standards and, on average, increased the margin between interest rates on investor housing loans and those on loans to owner-occupiers.

Risks related to household debt and the housing market more generally had increased over the preceding six months. However, the nature of those risks differed across the country, according to the varying conditions and activity in local markets. Although credit to the household sector had been growing modestly relative to history, growth had been faster than income growth and the aggregate debt-to-income ratio for households had increased.

Nevertheless, indicators of financial stress in the household sector remained contained. Low interest rates and improved lending standards over recent years had been supporting households’ ability to service debt, and households on average had continued to build repayment buffers. Members noted, however, that some households with home loans appeared to have little or no buffer of excess mortgage repayments and could be vulnerable if household income were lower than expected. This observation emphasised the importance of realistic assessments of household expenses and prudent lending standards for mitigating risks to both financial stability and macroeconomic outcomes.

Members discussed the recent actions taken by APRA and the Australian Securities and Investments Commission to support prudent lending practices. These actions had been focused particularly on interest-only lending, serviceability assessments and responsible lending practices. APRA’s guidance had included limits on the share of interest-only loans in new housing loans and a requirement that banks impose strict limits on new interest-only lending at high loan-to-valuation ratios. Members recognised that the calibration of this guidance was not precise or straightforward. Developments needed to be kept under review and, depending on how the system responds to the various measures, members noted that the Council of Financial Regulators would consider further measures if needed.

Members observed that a number of factors make interest-only loans attractive in the Australian context. In particular, interest-only loans allow investors to take greatest advantage of particular features of the tax system, while the availability of offset accounts provides some owner-occupiers with opportunities to manage liquidity risks that might be associated with irregular income, for example.

Members noted that some banks had curtailed lending to some segments of the housing market, notably the Brisbane apartment market, where the supply of apartments was expected to increase significantly, raising the risks associated with oversupply. Reports of settlement failures had remained isolated. Members also noted the higher interest rates facing most investors, especially those with interest-only loans.

Developments in commercial property markets mirrored the geographic pattern seen in residential property markets. Conditions had been strengthening in Sydney and Melbourne but were weaker elsewhere. Valuations were generally high, however, and posed some risk to leveraged investors if prices were to decline sharply. Members were briefed on APRA’s recent review of commercial property lending. This review revealed some instances of weak underwriting standards and poor monitoring of risk profiles among lenders; several Australian banks had since tightened their lending standards.

Members observed that, in contrast to the growing risks faced by the household sector, vulnerabilities in the non-financial business sector remained low. Outside Western Australia, business failure rates had declined. Profitability had been supported by higher earnings for resource-related firms, following the increase in commodity prices. Gearing ratios and other measures of the strength of businesses’ balance sheets had generally been around their historical averages.

Conditions in housing markets continued to vary considerably across the country. The established markets in Sydney and Melbourne appeared to have strengthened further, but housing prices had continued to fall in Perth. The additional supply of apartments scheduled to come on stream over the subsequent couple of years in the eastern capital cities was expected to put some downward pressure on growth in apartment prices and rents, particularly in Brisbane.

Growth in housing credit continued to outpace growth in household incomes, suggesting that the risks associated with the housing market and household balance sheets had been rising. Recently announced supervisory measures were designed to help mitigate these risks by reinforcing prudent lending standards and ensuring that loan serviceability was appropriate for current conditions. Less reliance on interest-only housing loans was also expected to increase the resilience of household balance sheets. However, it would take some time to assess fully the effects of the recent pricing changes and the increased supervisory attention.

Reserve Bank governor Philip Lowe zeroes in on bank lending

From The Australian Financial Review.

The Reserve Bank of Australia under governor Philip Lowe has backed the concerns of regulators about bank lending standards, seizing on the rising number of households who are a month away from missing a mortgage payment in his first major review of the financial system.

Dr Lowe has zeroed in on a rise in the percentage of households who have a buffer of less than one month’s mortgage payments, in contrast with the last review conducted under his predecessor which saw risks abating.

The RBA has put the spotlight firmly bank on the banks in its twice yearly report by noting “one-third of borrowers have either no accrued buffer or a buffer of less than one month’s payments”.

This latest study of the financial architecture adds more detail to the worrying picture emerging about the unbalanced housing market. It follows concerns from the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority about a build up of risks and warnings from credit ratings agencies that the property market could face an orderly unwinding of prices.

The RBA also noted that these risks would have consequences for the banks themselves, pointing to the prospect of additional losses on mortgage portfolios for banks with exposures to the mining sector.

Significant pivot

The focus on households and the state of their balance sheets marks a significant pivot from the previous Financial Stability Review released one month before Dr Lowe was made governor and found that risks to households had lessened.

Founder of boutique research house Digital Finance Analytics Martin North said it was about time the Reserve Bank woke up to the risks posed by higher levels of household debt and stagnant incomes.

“This situation hasn’t fundamentally worsened in six months so it stands to reason what has changed is the RBA’s perception of the world,” Mr North said.

Statistics from Digital Finance Analytics show the percentage of Australian households that are cutting back expenditure, dipping into savings or using credit facilities to meet mortgage payments has risen to 22 per cent following a series of out-of-cycle rate rises from the banks.

Mr North said the number of households experiencing some level of financial stress would rise to 26 per cent in the case of a 50 basis-point rise. If they were to rise by another 100 basis points the percentage would rise to 31.1 per cent.

Big four data supports warning

Data published by the big four banks supports the warning from the RBA with anywhere between 20 and 40 per cent of big four bank mortgage holders just a misstep away from missing a mortgage payment.

ANZ and NAB, which measure the percentage of mortgage holders who do not have buffers of one month or more, count 61 per cent and 27.7 per cent of their customers respectively in the non-buffer bracket.

Commonwealth Bank and Westpac, which use a less stringent buffer measure to include any additional repayment and factor in offset accounts, put 23 per cent and 28 per cent of customers in the RBA’s danger zone.

Annual result data from the banks shows that the percentage of customers who do not have sufficient buffers have worsened by between 2 per cent and 3 per cent over the last 12 months alone.

The worsening position of households has been attributed to rising healthcare and energy costs combined with out-of-cycle rate rises and flat incomes.

Mr North noted that much of the data on households was predicated on the HILDA data which had a lag of several years.

“We have always had households that struggle to make mortgage payments,” Mr North said. “So the intriguing question for me is why have they woken up now? It could be that the governor has taken a different view on household debt.”

Tracing The Rise Of Mortgage Stress

We updated our mortgage stress models recently, which showed that around 669,000 households are in stress, which represents 21.8% of borrowing households.  Those results are a point in time view of households finances. The RBA also said that one third of households have no mortgage buffer.

Today we take a longer term view of the rise of mortgage stress, which is driven by a combination of larger mortgages, flat incomes, higher living costs and rising debt.

The first chart tracks household debt to disposable income from the RBA, as well as mortgage rates, the cash rate and both CPI and wage growth.

Stress levels rose consistently through the  early 2000’s as debt and mortgage rates rose, to reach a peak of 19%, when the cash rate was 7.25%, the average variable mortgage rate was 9.35% and the household debt to disposable income sat at around 170. Those with a long memory may remember that we were warning about this trend in the 2000’s.

But then the GFC hit, rates were cut, and mortgages rates fell sharply to 5.8%. However the debt to disposable income ratio only fell a little to 168.

Lower rates stoked demand for property, so prices started to rise, and mortgage rates moved higher, then lower as the RBA used housing to try to fill the gap left by the mining sector moving into the production phases.  Household debt to disposable income has since moved higher to a new high of 189 and is still rising.

During more recent times, mortgage stress and household debt has been moving up – and the latest stress data shows an acceleration as income growth all but stalls, and costs of living keep going, mortgage rates are rising.

To look at this in more detail, here is the same data, but with CPI and wage growth now mapped to stress and the cash rate. The fall in wage growth is significant, and this has now become one of the main drivers of stress.

My point is, nothing has suddenly changed. The inexorable rise in household debt, especially in a low wage growth scenario was obviously going to lead to issues (see our posts from 3 years back!) and so the RBA’s apparent volte-face is a welcome paradigm shift, but late to the party. Perhaps the New Governor had a different perspective from the previous incumbant!

Of course the question now is, can this be managed without a property correction?  Probably not.  Read our definitive guide to mortgage stress here.

One final point. In the recent Financial Stability report, the RBA used HILDA data to argue that household financial stress was not too bad.  But the data is not that recent, latest from 2014 and 2015, and since then our surveys highlight that some more affluent households are also being squeezed, especially as mortgage rates rise, and their incomes stall; they are highly leveraged.

The HILDA Survey also includes questions on financial stress experienced by households over the previous year.  There was a broad-based decline in the share of households experiencing episodes of financial stress between 2001 and 2015 (the time span available in the HILDA Survey). Nonetheless, households that were highly indebted in a particular year had a greater
propensity to experience financial stress. For instance, households that were highly indebted in 2002 were more likely to experience at least one incidence of financial stress in all other years compared with households that were less indebted in 2002 (Graph C5, right panel). The result also holds true for other cohorts. This suggests that a greater share of highly indebted households face financial difficulties and are more likely to be vulnerable to events that affect their ability to repay their debt, such as income declines or increases in interest rates.

Overall, these data highlight that highly indebted households can be more vulnerable to negative economic shocks and pose risks to financial stability. In particular, highly indebted households are less likely to be ahead of schedule on their mortgage repayments and they are more likely to experience financial stress, hence could be more vulnerable to adverse macroeconomic shocks. The consequent effects of this stress on the broader economy may be exacerbated by the disproportionately large share of investor housing debt owed by highly indebted households. Hightened investor demand can contribute to the amplification of the cycles in borrowing and housing prices, particularly when this investment is highly leveraged. Nonetheless, HILDA data also show that much of the debt held by highly indebted households is owed by households with high income and wealth, who are typically better placed to service larger amounts of debt.


One In Three Households Have No Mortgage Buffer – RBA

The latest Financial Stability Review from the RBA has a different tone to it, compared with previous edition, because whereas they have previously played up the “cushion” some households have by paying their mortgages ahead, now they say one third of households have no buffer and are exposed to potential interest rate rises. What has changed is not the underlying data, but how it is being presented. Here are some key extracts.

In Australia, vulnerabilities related to household debt and the housing market more generally have increased, though the nature of the risks differs across the country. Household indebtedness has continued to rise and some riskier types of borrowing, such as interest-only lending, remain prevalent. Investor activity and housing price growth have picked up strongly in Sydney and Melbourne. A large pipeline of new supply is weighing on apartment prices and rents in Brisbane, while housing market conditions remain weak in Perth.

Nonetheless, indicators of household financial stress currently remain contained and low interest rates are supporting households’ ability to service their debt and build repayment buffers.

The Council of Financial Regulators (CFR) has been monitoring and evaluating the risks to household balance sheets, focusing in particular on interest-only and high loan-to‑valuation lending, investor credit growth and lending standards. In an environment of heightened risks, the Australian Prudential Regulation Authority (APRA) has recently taken additional supervisory measures to reinforce sound residential mortgage lending practices. The Australian Securities and Investments Commission has also announced further steps to ensure that interest-only loans are appropriate for borrowers’ circumstances and that remediation can be provided to borrowers who suffer financial distress as a consequence of past poor lending practices. The CFR will continue to monitor developments carefully and consider further measures if necessary.

Investor credit has also risen noticeably over the past six months, with investor demand particularly strong in Sydney and Melbourne (Graph 2.3).

Overall household indebtedness has increased while income growth has remained weak. Some types of higher-risk mortgage lending, such as IO loans, also remain prevalent and have increased of late.

The risks associated with strong investor credit growth and increased household indebtedness are primarily macroeconomic in nature rather than direct risks to the stability of financial institutions. Indeed, some evidence suggests that investor housing debt has historically performed better than owner-occupier housing debt in Australia, though this has not been tested in a severe downturn. Rather, the concern is that investors are likely to contribute to the amplification of the cycles in borrowing and housing prices, generating additional risks to the future health of the economy. Periods of rapidly rising prices can create the expectation of further price rises, drawing more households into the market, increasing the willingness to pay more for a given property, and leading to an overall increase in household indebtedness. While it is not possible to know what level of overall household indebtedness is sustainable, a highly indebted household sector is likely to be more sensitive to declines in income and wealth and may respond by reducing consumption sharply.

A further risk during periods of strong price growth is that it may be accompanied by an increase in construction that could result in a future overhang of supply for some types of properties or in some locations. In this environment, as well as amplifying the upswing for such properties, any subsequent downswing is likely to be larger and more likely to see prices and rents fall if the vacancy rate rises. This poses risks to the whole housing market and household sector, not just to the recent investors.

While the financial position of households has been fairly resilient, vulnerabilities persist for some highly indebted households, especially those located in the resource-rich states. Household indebtedness (as measured by the ratio of debt to disposable income) has increased further, primarily due to rising levels of housing debt, although weak income growth is also contributing. Rising indebtedness can make households more vulnerable to potential income declines and higher interest rates. This is of most concern for households that have very high levels of debt.

Low interest rates are helping to offset the cost of servicing larger amounts of debt and hence total mortgage servicing costs remain around their recent lows (Graph 2.5). In this regard, lenders have tightened mortgage serviceability assessments in recent years to include larger interest rate buffers, which should provide some protection against the potential effects of higher interest rates.

Prepayments on mortgages increase the resilience of household balance sheets. Aggregate mortgage buffers – balances in offset accounts and redraw facilities – are high, at around 17 per cent of outstanding loan balances or around 2½ years of scheduled repayments at current interest rates. However, these aggregate figures mask significant variation across borrowers, with available data suggesting that around one-third of borrowers have either no accrued buffer or a buffer of less than one month’s repayments. Those with minimal buffers tend to have newer mortgages, or to be lower-income or lower-wealth households.

Interest-only (IO) loans account for a sizeable and growing share of total housing credit in Australia, now representing around 23 per cent of owner‑occupier lending and 64 per cent of investor lending (Graph B1). IO lending has the potential to increase households’ vulnerability in part due to the higher average level of indebtedness over the life of an IO loan compared with a regular principal-and-interest (P&I) loan.

For some time regulators have highlighted the potential risks associated with IO compared with P&I loans. Because IO loans allow borrowers to remain more indebted for longer, there may be greater credit risks associated with such loans. When loan balances stay high, there is an increased risk of borrowers falling into negative equity should housing prices decline.

Another risk is that borrowers may find it difficult to service higher required payments at the end of the IO period, which increases the chance of default. For example, repayments on a $400 000 loan with a 4 per cent interest rate and a five-year IO period would typically increase by around 60 per cent at the end of the IO period. While some borrowers may have planned to refinance into another IO loan at the end of the IO period, this may be difficult if circumstances have changed.

Borrowers who anticipate future price rises can use IO loans to maintain a higher level of leverage for a given servicing payment, thereby magnifying their returns from rising housing prices but also magnifying any losses. More generally, at an aggregate level this behaviour could induce a more pronounced cycle in housing prices than would otherwise occur, amplifying the size of any subsequent downswing in housing prices.

Why The Gap Between Bank Serviceability And Real Life?

Following the recent coverage of our mortgage stress analysis (light it seems is now dawning on regulators, industry commentators and others that household debt is a real and growing issue), one question we get asked is – yes, but surely the banks have guidelines on affordability and serviceability, minimum assumed rate 2%+ above current rates, or 7%+?

So surely, households should have buffers as rates rise?

This is a great question, with a long history attached to it. A couple of years ago the regulators got a shock when them looked at bank practice, and started putting out more specific expectations on lending standards. Back in 2015, Wayne Byres made this point in a speech on lending standards.  At its core was the observation that borrowers appeared to be able to get very different loan amounts from a selection of lenders, using the same base financial profile.

One significant factor behind differences in serviceability assessments, particularly for owner occupiers, was how ADIs measured the borrower’s living expenses (Chart 2a and 2b). As a regulator, it is hard to understand the rationale for large differences in what should be a relatively objective, and extremely critical, metric.4

Chart 2a: Minimum living expense assumptions shows percentage of owner-occupier borrower pre-tax salary income between 20%-35%
Chart 2b: Minimum living expense assumptions shows percentage of investor borrower pre-tax salary income between 0%-25%

Of major concern were a few ADIs who opted to make their credit assessment based on a lower level of living expenses than that declared by the borrower. That is obviously a practice that should not continue, and ADIs should be making reasonable inquiries about a borrower’s living expenses. In fact, best practice (and intuition) would be to apply minimum living expense assumptions that increase with borrower incomes; this was a practice adopted by only a minority of ADIs in our survey.

In 2014, the RBA made this statement in their Financial Stability Report.

Although aggregate bank lending to these higher-risk segments has not increased, it is noteworthy that a number of banks are currently expanding their new housing lending at a relatively fast pace in certain borrower, loan and geographic segments. There are also indications that some lenders are using less conservative serviceability assessments when determining the amount they will lend to selected borrowers. In addition to the general risks associated with rapid loan growth, banks should be mindful that faster-growing loan segments may pose higher risks than average, especially if they are increasing their lending to marginal borrowers or building up concentrated exposures to borrowers posing correlated risks. As noted above, the investor segment is one area where some banks are growing their lending at a relatively strong pace. Even though banks’ lending to investors has historically performed broadly in line with their lending to owner-occupiers, it cannot be assumed that this will always be the case. Furthermore, strong investor lending may contribute to a build-up in risk in banks’ mortgage portfolios by funding additional speculative demand that  increases the chance of a sharp housing market downturn in the future.”

“A build-up in investor activity may also imply a changing risk profile in lenders’ mortgage exposures. Because the tax deductibility of interest expenses on investment property reduces an investor’s incentive to pay down loans more quickly than required, investor housing loans tend to amortise  more slowly than owner-occupier loans. They are also more likely to be taken out on interest-only terms. While these factors increase the chance of investors experiencing negative equity, and thus generating loan losses for lenders if they default, the lower share of investors than owner-occupiers who have high initial loan-to-valuation ratios (LVRs; that is an LVR of 90 per cent or higher) potentially offsets this. Indeed, the performance of investor housing loans has historically been in line with that of owner-occupier housing loans.

The trouble is that the basis on which banks have been assessing available income has been too optimistic. This is because they are based their calculations on historic mortgage book performance, when incomes were rising strongly, and loan losses were very low.

But we are now in a new normal. We have flat incomes. We have rising costs. We have underemployment. We have low growth. But costs of living are rising (and higher for many than the ABS CPI figure would suggest).  Affordability is not what it was. Lenders need to adjust, hard to do when home prices are so high.

Combined, many households are stretched, and the prospect of rising interest rates in these conditions are making things harder.

In addition, households have been willing to gear up with the prospect of future capital growth, so reach for the largest mortgage they can get. Perhaps sometimes they exaggerate their incomes, and understate their costs. This is true we think for households with larger incomes, and lifestyles. Some of these are now under pressure.

So, the root cause of the gap between theoretical affordability and real life is a serious one. Banks often set and forget loans, so do not revisit households finances unless there is a reset or a crisis.  But for many, available incomes are falling (and bracket creep is not helping).  Ongoing financial health-checks might be in order.

ASIC is rightly looking at this issue anew, but we fear the horse may have already bolted. APRA will tighten capital. Both will put upward pressure on mortgage rates, and test affordability further. This is a paradigm shift.

Capital Flows to the Banking Sector

Deputy RBA Governor Guy Debelle, spoke at the Australian Financial Review Banking & Wealth Summit on “Recent Trends in Australian Capital Flows“. He highlights that Australian banks are still reliant on US funding sources, and this includes exposure to US commercial paper.

We therefore highlight that events there will impact banks here, especially changes in market rates (which are likely to be impacted by FED policy as we discussed earlier).

For more than a century, Australia’s high level of investment relative to saving has been supported by capital inflows from the rest of the world. These net capital inflows are the financial counterpart to Australia’s current account deficit. Foreign investment has been instrumental in expanding our domestic productive capacity and has been attracted by the favourable risk-adjusted returns on offer here.

Although net capital inflows have been a consistent feature of Australia’s balance of payments, the composition of both the inflows, as well as the outflows when Australians invest offshore, has varied substantially over time.

When I spoke about capital flows a few years ago, I discussed the significant changes in the composition of capital flows that had taken place since 2007. At that time, I highlighted three noteworthy developments: a marked increase in foreign direct investment in the mining sector associated with the mining investment boom; the significant change in flows to the Australian banking sector from sizeable inflows pre-crisis to around zero; and a substantial increase in foreigners’ purchases of Australian government debt.

Graph 1: Net Capital Inflows


To a large degree, these trends have continued over the past three years. But under the surface, there have been some significant changes in the composition of these flows in recent years.

The aggregate pattern of capital flows to the banking sector has not changed materially since I last spoke on this topic. Since 2014 – and indeed over the period since the financial crisis – there have been minimal net capital flows to or from the banking sector. Following the shift away from offshore wholesale debt towards domestic deposits that took place in the wake of the global financial crisis, the funding composition of banks has remained relatively stable. But notwithstanding this stability, recently there have been two noteworthy developments relating to short-term debt, both stemming from regulatory reforms.

Firstly, over the past year or so, Australian banks have reduced their short-term debt issuance in preparation for the introduction of the Net Stable Funding Ratio (NSFR) next year. The NSFR provides an incentive for banks to shift to sources of funding considered to be more stable and away from sources such as short-term wholesale liabilities.

Graph 3: Net Foreign Purchases of Australian Bank Debt


Secondly, the composition of Australian banks’ short-term offshore funding has also changed following the implementation of US Money Market Fund (MMF) reforms by the Securities and Exchange Commission in October 2016. As a result of these reforms, the value of assets under management of prime MMFs (those that lend to banks) has fallen by US$1 trillion or around 70 per cent over the past couple of years. Some prime funds have switched to become government-only funds, that is, funds that invest only in US government debt. At the same time, investors have allocated away from prime funds to government-only funds. Although prime MMFs have maintained their exposure to Australian banks relative to banks globally (at around 8 per cent of total MMF exposures to banks), their holdings of Australian bank debt have declined from around US$100 billion to under US$30 billion currently.

However, in aggregate, Australian banks have continued to raise almost as much short-term funding from US commercial paper markets, despite the decline in MMFs. They have been able to tap other investors, in particular US corporates with large cash holdings, such as those in the technology sector.

The RBA on Housing and Debt

Remarks at tonights Reserve Bank Board Dinner by Philip Lowe, RBA Governor included the level of household debt and the housing market.

This is something we have been focused on for some time. The level of household debt in Australia is high and it is rising. Over the past year the value of housing-related debt outstanding increased by 6½ per cent. This compares with growth of around 3 per cent in aggregate household income. The result has been a further rise in the ratio of household debt to income, from an already high level.

In aggregate, households are coping reasonably well with the higher debt levels. Arrears rates remain low and many households have built up sizeable buffers in mortgage offset accounts. At the same time, though, slow growth in wages is making it harder for some households to pay down their debt. For many people, the high debt levels and low wage growth are a sobering combination.

In the housing market, conditions continue to vary considerably across the country. The Melbourne and Sydney markets are very strong and prices are increasing briskly. In contrast, conditions are more subdued in most other cities and, in some areas, most notably Perth, prices have declined. Nationally, growth in rents is the lowest for some decades.

So it’s a complex picture and there is not a single story that applies across the country. But, as is often the case in economics, it largely comes down to supply and demand. On the demand side, population growth in Australia – especially in our largest cities – picked up unexpectedly in the mid 2000s and it is only in the past couple of years that the rate of home building has responded. This imbalance was compounded by insufficient investment in the transport infrastructure needed to support our growing population. Nothing increases the supply of well-located land like good transport links. Underinvestment in this area is one of the factors that has pushed housing prices up. Put simply, the supply side simply did not keep pace with the stronger demand side. The result has been higher prices.

Not surprisingly, the rising prices have encouraged people to buy residential property as an investment in the hope of ongoing capital gains. With global interest rates so low, many investors have found it attractive to borrow money to invest in appreciating residential property. This has reinforced the upward pressure on prices.

This configuration of ongoing increases in indebtedness and rising housing prices has been discussed at length by the Council of Financial Regulators. This council, which I chair, brings together the heads of the RBA, APRA, ASIC and the Australian Treasury. The concern has not been that these developments have posed a risk to the stability of our financial system. Our banks are resilient and they are soundly capitalised. Instead, the concern has been that the longer the recent trends continued, the greater the risk to the future health of the Australian economy. Stretched balance sheets make for more volatility when things turn down.

Given this, over the past couple of years there has been a concerted effort by APRA to encourage lenders to strengthen their lending standards. This followed deterioration in these standards a few years ago. Also, at the end of 2014, when growth in investor lending was accelerating, APRA announced that it would pay very close attention to lenders whose investor loan portfolios were growing faster than 10 per cent. It did so with the full support of the RBA. This guidance helped pull the whole system back and has made a positive contribution to overall financial stability. So too has ASIC’s focus on responsible lending. These measures constrained some higher-risk lending and reinforced the message to lenders that they need to take a system-wide focus in their risk assessments.

Notwithstanding this, given recent trends and the heightened risk environment, APRA announced some further measures last Friday. Again, it did this with the full support of the Council of Financial Regulators.

There are two parts of APRA’s announcements that I would like to draw your attention to.

The first is the need for lenders to have a very strong focus on serviceability assessments. Despite the focus on this area over recent times, too many loans are still made where the borrower has the skinniest of income buffers after interest payments. In some cases, lenders are assuming that people can live more frugally than in practice they can, leaving little buffer if things go wrong. So APRA quite rightly has said that lenders can expect a strong supervisory focus on loans with a very low net income surplus.

The second area is interest-only lending. Over the past year, close to 40 per cent of the housing loans made in Australia have not required the scheduled repayment of even one dollar of principal at least in the first years of the life of the loan; only interest payments are required. This is unusual by international standards. In some countries, repayment of at least some principal is required on all housing loans for the entire life of the loan. In other countries, interest-only loans are available only if the borrower has already contributed a fair degree of equity. So this is one area where Australia stands out. We are not unique in this area, but we are unusual.

There are a couple of factors that help explain the popularity of interest-only loans in Australia. One is the flexible nature of Australian mortgages. Many people with interest-only loans make significant payments into offset accounts rather than explicitly paying down principal. This flexibility, which is of value to many people, isn’t available in most countries. A second factor is the taxation arrangements that apply to investment in residential property in Australia.

Last week APRA stated that it expected that new interest-only loans should account for no more than 30 per cent of the flow of new loans. It also stated that institutions should place strict limits on interest-only loans with high loan-to-valuation ratios.

Like the earlier ‘speed limits’ on investor lending, these new requirements should help the whole system pull back to a more sustainable position. A reduced reliance on interest-only loans in Australia would be a positive development and would help improve our resilience. With interest rates so low, now is a good time for us to move in this direction. Hopefully, the changes might encourage a few more people to think about the merit of taking out very large interest-only loans when interest rates are near historical lows.

So the RBA welcomes these latest changes.

It is important, though, that we are all realistic about what these and other prudential measures can achieve. As I said before, the underlying driver in our housing market is the balance between supply and demand. The availability of credit is undoubtedly a factor that can amplify demand, but it is not the root cause. This assessment is consistent with the observation that housing market dynamics currently differ significantly across the country, despite Australia having nationwide financial institutions and the level of interest rates being the same across the country. It is hard to escape the conclusion that we need to address the supply side if we are to avoid ever-rising housing costs relative to our incomes and to avoid the attendant incentive to borrow that is created by rising housing prices.

The various prudential measures do not address the underlying supply-demand issues. But they can reduce the risk from the financial side of the housing market while the underlying issues are addressed. These prudential measures help lessen the amplification of the cycle we get from borrowing and reduce the risk of developments on the financial side weakening the resilience that our economy has exhibited for many years. Ideally, this would be achieved by financial institutions acting themselves, without the need for prudential guidance. But sometimes prudential guidance can help the whole system adjust.

The calibration of this guidance is not precise or straightforward so we need to keep matters under review. The Council of Financial Regulators will continue to assess how the system responds to the various measures so far. It would consider further measures if needed. As I have said, though, in the end addressing the supply side of the housing market is likely to prove a more durable way of dealing with the concerns that people have about debt and housing prices than detailed supervisory guidance.

So that is enough on debt and housing.