APRA consults on capital framework changes

The Australian Prudential Regulation Authority (APRA) is consulting on proposed changes to the authorised deposit-taking institution (ADI) capital framework.

The proposed “improvements” to the framework seek to enhance the ability of the framework to respond “flexibly to future stress events”, improve the “transparency of ADI capital strength”, and embed “unquestionably strong” levels of capital.

As foreshadowed in November, the proposals include changes to mortgage and SME lending risk weights.

Mortgage risk weights

APRA is recommending that banks implement more risk-sensitive risk weights, particularly for residential mortgage lending (given the extent of mortgage lending on Australian bank balance sheets).

The consultation proposes that capital for housing is more “in line with risk”, with “higher-risk loans” receiving higher capital and “lower risk loans” seeing a reduction in capital. Instead, the purpose of the loan and its repayment profile and loan-to-value ratio (LVR) will be the key determinants of capital.

As previously, APRA is targeting higher capital requirements for investor and interest-only lending, which it said was “consistent with APRA’s supervisory interventions in recent years and will result in lower capital requirements for owner-occupied principal and interest exposures, which are generally considered to be of comparatively lower risk”.

For example, standardised ADIs currently have mortgage exposure segmentation by ‘standard’ or ‘non-standard’ loans and the lowest risk weight available is 35 per cent.

Under the proposed changes, APRA is looking to amend this so that there is additional segmentation by loan purpose (e.g. owner-occupier, paying principal and interest (P&I), and other), and the lowest risk weight available would be 20 per cent.

As an example, the risk weight for an owner-occupied, P&I loan with an LVR of 50 per cent would therefore be 20 per cent, under the new framework.

In this consultation, APRA is additionally proposing:

• that lending with an interest-only period greater than five years would no longer be eligible to be included as a standard loan to reflect the heightened risk when principal is not paid down over a long period; 
• that under the standardised approach, to split the 60 to 80 per cent loan-to-valuation ratio (LVR) category into two segments (60 to 70 LVR and 70 to 80 LVR) to reflect different levels of risk and to smooth out the capital outcomes for the large amount of exposures in this segment; and
• to align the credit conversion factor for undrawn exposures under the standardised approach with the 40 per cent estimate in the Basel framework;
• providing an approximate 20 per cent discount to the risk weight for high LVR loans with LMI for both standardised and internal ratings-based approach ADIs.

The consultation document reads: “APRA’s objective is to strengthen the amount of capital held by ADIs for residential mortgage lending to enhance financial system resilience and underpin confidence that there is sufficient capital allocated to this important and material asset class. 

“While the housing portfolio has so far remained resilient in the current economic downturn, the concentration in residential mortgage lending remains a systemic vulnerability, particularly if more severe economic risks eventuate, such as a period of higher unemployment. 

“In strengthening capital requirements for residential mortgages, APRA is particularly targeting higher risk segments such as investor lending and loans with a lengthy interest-only period. This approach should also support sustainable lending in this portfolio in the longer term.”

SME lending risk weight changes

APRA is also seeking to reduce risk weights for small-business lending, in a bid to provide additional incentives for banks to lend to SMEs.

For example, under the “improvements”, risk weights for standardised ADIs would vary by level of commercial property security.

Meanwhile, SME lending, not secured by property, would see the risk weight drop from 100 per cent to 75 per cent if less than $1.5 million in size. Otherwise, it would be an 85 per cent risk weight.

APRA suggests that these changes would “achieve better risk sensitivity in this asset class”.

“These proposals are aligned with the Basel III framework and will provide some additional incentive for ADIs to lend to small businesses relative to other forms of lending,” it said.

Other proposed changes to the capital framework include: 

• providing for ADIs to hold a larger share of their required capital as buffers, enhancing the ability of the framework to respond flexibly to future stress events;
• improving the transparency of the framework by requiring all ADIs to disclose their capital ratios on a common basis, and making it easier to reconcile the Australian framework with international standards; and 
• introducing a simplified framework and reduced compliance requirements for smaller ADIs.

As a result of the changes, reported capital ratios will increase; however, APRA said it does not expect that ADIs would need to raise additional capital as a result.

APRA has said that larger buffers offsetting this would ensure the ‘unquestionably strong’ standing of the Australian banking system is not diminished. 

‘Fulfilling a critical role when confronted by the challenges of the future’

APRA chair Wayne Byres commented: “The groundwork of previous years meant that, when COVID-19 hit, the Australian banking industry had sufficient capital depth to support customers, maintain the supply of credit and help the Australian economy on its path towards recovery. 

“These proposed changes will embed the ‘unquestionably strong’ capital position that has been achieved by the banking sector into a regulatory capital framework that is more flexible and responsive at times of crisis. 

“Progressing these reforms in a timely manner will deliver a robust, competitive banking system that can continue to fulfil its critical role when our community is confronted by the challenges of the future,” Mr Byres said.

Written submissions on the draft standards are open until 1 April 2021.

The new framework is proposed to be implemented from 1 January 2023.