APRA makes move on home loan buffers

The Australian Prudential Regulation Authority (APRA) has announced changes to mortgage lending rules for banks.

As flagged by the Reserve Bank on Tuesday (5 October), it is increasing the minimum interest rate buffer it expects banks to use when assessing the serviceability of home loan applications. 

In a letter to authorised deposit-taking institutions (ADIs), APRA told lenders it expects they will assess new borrowers’ ability to meet their loan repayments at an interest rate that is at least 3.0 percentage points above the loan product rate.

This compares to a buffer of 2.5 percentage points that are commonly used by ADIs today (CBA had already pre-emptively moved its serviceability floor rate earlier this year and its chief executive recently stated that he believed other banks should do the same).

The increase in the interest rate buffer applies to all new borrowers, however it is likely to have a larger impact on investors than owner-occupiers.

APRA suggests that, when putting aside the impact from other aspects of serviceability assessment, a 50 basis points increase in the serviceability buffer would reduce maximum borrowing capacity for the typical borrower by around 5 per cent. 

ADIs will need to start using the higher buffer rate from the end of October 2021. If they continue to approve loans using a lower buffer rate after this time, APRA said it would "adjust individual prudential capital requirements to reflect higher credit risk inherent in new lending". 

It suggested that it expects "prudent" banks would keep the level of the buffer under review to "assess whether it remains appropriate in relation to the broader risk environment".

Why make the move?

APRA’s decision comes amid growing scrutiny of “growing financial stability risks” from banks’ residential mortgage lending. (APRA said it was closely monitoring trends in non-ADI lending, but “did not consider there to be a basis for a policy response in relation to non-ADI lenders at this point in time”, noting that non-banks account for less than 5 per cent of total housing lending). 

Figures for the June quarter show that more than 20 per cent of ADIs’ new lending was to borrowers that had borrowed more than six times their pre-tax income.

APRA has noted that this is high by both historical and international standards – and without action, is likely to increase further (particularly once lockdowns lift in Victoria and NSW, the two most populous states). 

This has been largely brought about by record-low interest rates and rapidly rising house prices, which have placed pressure on household indebtedness. Given that household credit growth is expected to exceed household income growth for the forseeable future (and that rates will eventually rise), it is expected that household indebtedness will only rise, which “presents risks to the future financial stability,” APRA suggested.

Why not debt-to-income limits?

There had been speculation that APRA was set to introduce debt-to-income limits, however many commentators had suggested increasing buffers was a less blunt tool to use, while others were mindful that such an approach may have impacted smaller lenders.

Indeed, APRA has stated that it believes changing the interest rate serviceability buffer was “the most appropriate tool to use” as it “acts as a cap on leverage, is relatively easy to implement, and will not have any impact on mortgage interest rates”.

It flagged that changing interest rate floors would have been “more restrictive on owner-occupiers and have a lesser impact on investors” while debt-to-income limits would be “more operationally complex to deploy consistently, and may lead to higher interest rates for some borrowers as lenders effectively seek to ration credit to this cohort”.

However, it added that this move does not rule out that the other measures might be used in the future.

The change has been supported by other members of the Council of Financial Regulators (CFR), comprising the Reserve Bank of Australia, the Treasury and the Australian Securities and Investments Commission (ASIC) and was made in consultation with the Australian Competition and Consumer Commission (ACCC). The group had met last month to discuss what measures could be taken to curb financial risks given growing levels of high debt-to-income lending.

APRA chair Wayne Byres said this is a targeted and judicious action designed to reinforce the stability of the financial system. 

“In taking action, APRA is focused on ensuring the financial system remains safe, and that banks are lending to borrowers who can afford the level of debt they are taking on – both today and into the future,” he said.

“While the banking system is well capitalised and lending standards overall have held up, increases in the share of heavily indebted borrowers, and leverage in the household sector more broadly, mean that medium-term risks to financial stability are building.

“More than one in five new loans approved in the June quarter were at more than six times the borrowers’ income, and at an aggregate level the expectation is that housing credit growth will run ahead of household income growth in the period ahead. With the economy expected to bounce back as lockdowns begin to be lifted around the country, the balance of risks is such that stronger serviceability standards are warranted.”

Together with other members of the CFR, APRA said it would “continue to closely monitor risks in residential mortgage lending, and can take further steps if necessary”. 

APRA will soon release information setting out how it will use macroprudential controls.

[Related: Regulators to tread lightly on macro changes: ANZ]