APRA sounds alarm on commercial property risks

In a letter to all Australian banks today, APRA outlined its observations from a thematic review into commercial property lending, noting that its investigations into the area will continue throughout 2017.

APRA noted that commercial property lending “has historically been a source of significant loss for banks, both in Australia and overseas.”

In response to recent market dynamics and indications that underwriting standards were under competitive pressure, APRA undertook a thematic review of commercial property lending over 2016.

As part of the review, APRA assessed the portfolio controls and underwriting standards of a number of larger domestic banks and foreign bank branches.

While the regulator observed a general tightening of underwriting standards, especially for residential development lending, it noted that this has not been uniform.

“There is a need for ADIs to exercise particular care to ensure that they are not unduly accepting greater risk as other lenders step back,” APRA said.

“The review also revealed evidence that some ADIs were justifying a particular underwriting stance based on what the ADI understood to be the criteria applied by another lender.”

APRA warned that underwriting standards should be reflective of the ADI’s own risk appetite and not based on a potentially erroneous appreciation of a competitor’s criteria.

One key finding from the review was that many banks “fell well short of expectations” regarding portfolio controls for commercial property. APRA said an underinvestment in information systems has led to challenges in extracting portfolio data.

“The identification, recording, tracking and reporting of key transaction characteristics, in a manner which can be readily aggregated, is fundamental to sound risk management,” the regulator said.

“These transaction characteristics include asset type, geographic location, construction contractor and developer concentrations and key underwriting metrics such as ICR, debt yield, loan-to-development costs (LDC), presales to debt cover and LVR.

“Analysis of these transaction drivers helps an ADI to understand its risk profile at different stages of the cycle. A large number of ADIs were unable to readily provide reasonably basic portfolio information to APRA as part of this review.”

APRA said that banks should not only be managing the risk of individual loans but also consider “build-ups in risk” at the portfolio level. In addition to an overarching sector concentration limit, the regulator believes better practice would be to also have sub-limits to control concentrations in riskier segments of the portfolio, such as lending for development or land.

The regulator also found insufficient justification for deviation from standards.

“Justifying lending decisions on the basis of ‘long-standing relationship’ or ‘good track record’ are insufficient, by themselves, to mitigate higher risk characteristics such as higher leverage or weaker presale cover, especially if these are outside approved underwriting standards,” APRA said.