APRA's warning puts the banks on notice

The Australian Prudential Regulation Authority has a far better line of sight into the banking system than any other external party. When it publicly expresses concern about lending standards, it provides credibility for the general unease about developments in the residential property markets.

In releasing a draft prudential practice guide for residential mortgage lending, APRA’s chairman John Laker said that credit standards in residential mortgage lending had been a major focus of its supervision of authorised deposit-taking institutions, “particularly in the current environment of strong pricing pressures in some housing markets and very active competition between lenders”.

“In this environment APRA is seeing increasing evidence of lending with higher risk characteristics and it does not want this trend to continue,” he said bluntly.

“The draft prudential practice guide reinforces the importance of maintaining prudent lending standards when competitive pressures may tempt otherwise.”

The Australian banking system, including the major banks, is heavily exposed to residential property. Historically, unlike commercial property, that hasn’t been a source of credit issues with very low default and loss rates.

APRA, however, is worried that a combination of a long period of economic growth and a sustained period of rising house prices could create a sense of complacency among lenders.

While much of the discussion about residential property has focused on the sharp growth in lending for investment properties, APRA appears to have broader concerns amid anecdotal reports of higher loan-to-valuation ratios and an increase in low-doc lending.

With demand for credit from businesses large and small at relatively low levels, home loans have been the major source of volume growth for lenders, even though the competition among lenders continues to push net interest margins lower.

Home loans are a ‘capital light’ asset class for banks given their low risk-weightings, which also helps the banks both meet toughening capital adequacy requirements while maintaining returns on equity in the mid-teens.

The draft APRA practice guide is directed at the boards of authorised deposit-taking institutions and is fundamentally about them demonstrating some common sense in assessing and over-seeing the risks being taken in their mortgage books and lending practices.

It is a timely reminder, given that official interest rates are at historic lows and that any return to more normal rate settings could expose overly-aggressive risk-taking.

It is inevitable that the structural bias in the Australian system towards lending for housing will be a significant discussion point in the Financial System Inquiry being chaired by former Commonwealth Bank chief executive David Murray.

There are those who would like to see APRA using macroprudential tools to impose a counter-cyclical dampener on mortgage lending during periods when the market is seen to be over-heating.

In a submission to the inquiry, APRA responded to charges that its own capital requirements encourage an excessive concentration on housing lending and distort the competitive landscape in favour of the major banks.

Under the international regulatory regime, lending is risk-weighted; the amount of capital banks are required to hold against an asset depends on its risk-weighting.

Under the Basel capital adequacy regime, there are two approaches to determining risk-weightings. Under the ‘standardised’ approach, the weightings for particular types of home loans are mandated. Under the ‘advanced’ approach, accredited banks with sophisticated systems can use internal modelling of their portfolios to determine their risk-weightings.

In practice, in the Australian system, that means that the risk-weightings on home loans for smaller banks and non-bank lenders average about 39 per cent, while they are only about 18 per cent for the big banks.

Despite calls from the smaller institutions that either their risk-weightings should be reduced or the bigger banks should face some form of capital impost to level the competitive playing field, APRA takes the view that there are no compelling reasons to alter its approach. It said that “in the current circumstances of emerging housing price pressures, there would be no case to reduce standardised housing loan risk-weights on macroprudential grounds”.

That, of course, raises the question of whether or not APRA should tinker with the advanced approach to effectively increase the risk-weightings for home loans for the major banks that dominate lending.

‘Jawboning’ via the practice guides and in its less visible contacts with the banks and other lenders could, however, be an equally effective approach.

It’s not often talked about publicly, but APRA already imposes different minimum capital requirements on each of the major banks depending on its perceptions of their different risk profiles.

When Laker says APRA doesn’t want to see the trend towards higher-risk lending continuing, he is putting the banks on notice.  They would be very well aware that APRA has the power to discipline them (punish them) privately if they ignore the warning.