High-risk loans are about to get more expensive

High-risk loans are about to get more expensive

Australia’s financial regulator, APRA, is looking to increase the number of mortgage categories that are to be penalised with an increase in regulatory capital by the banks. The higher capital requirements on these categories is likely to see riskier loans get more expensive.

APRA has continued to provide more information on the regulatory framework that will be imposed on the banks to meet the requirements of the FSI and Basel Committee updates with the release of discussions papers on the risk weighted asset calculations for authorised deposit-taking institutions (ADIs) as well as leverage ratio requirements.

Importantly, APRA has reaffirmed that the major banks will not have to increase their equity capital holdings if they meet the previously stated minimum 10.5 per cent of currently defined risk weighted assets by January 2020. This is because the 10.5 per cent minimum was determined by comparing the Australian banks to global peers using a consistent approach in measuring risk weighted assets and CET1 capital. If APRA changes the risk weights applied in Australia, it does not impact the international comparison. As such, if the change in risk weights results in an increase in risk weighted assets, and a consequential reduction in the CET1 ratio, the minimum CET1 ratio allowed will be adjusted down accordingly.

However, the risk weightings applied to certain types of loans are likely to change, requiring relatively more or less equity capital to be held by the bank. This has implications for the pricing of mortgages.

APRA has proposed that the risk weighting applied to a mortgage should differ depending on the type of mortgage. At present, there is a more limited variance in the risk weighting applied to different types of mortgages by the major banks under their advanced internal risk-based (IRB) models.

APRA is proposing significantly higher risk weights on interest only, high loan to value ratio mortgages, investment property mortgages that are materially dependent on property income to meet serviceability requirements, mortgages to SMSFs, reverse mortgages, and ‘very high’ loan to income ratio mortgages.

So, what does this mean for consumers? Over the last two years, we have seen a change in mortgage pricing with the banks charging higher standard variable rates on interest only (IO) and investment property relative to owner occupied principle and interest (P&I) mortgages. This occurred in response to APRA imposed regulations that limited the growth in these types of products.

Greater differentiation in risk weights applied to different types of mortgages will result in an increase in the number of products with separate interest rates. This is because of the impact of higher risk weights on the ROE a bank generates on a loan. The average risk weight applied to mortgages for the major Australian banks at present is just over 25 per cent. This means that the bank needs to hold equity equating to over 2.625 per cent of the principle of the mortgage to meet APRA’s minimum 10.5 per cent CET1 capital ratio requirement (i.e. 25 per cent * 10.5 per cent = 2.625 per cent).

However, if the risk weighting applied to the mortgage is increased to 50 per cent because it is classified as an investment property, then the bank would need to earn double the profit on the loan in order to generate the same ROE. This would need to be achieved through an increase in the net interest margin generated on the loan.

With the discussion paper calling for an increase in the number mortgage categories that are to be penalised with an increase in regulatory capital, there is likely to be an increase in the number of variable interest rate categories from the current four (owner occupied P&I, owner occupied IO, investment property P&I, investment property IO) to include separate rates for the other categories (high LVR, SMSF, ultra-high loan to income, investment property mortgage materially dependent on rental income). The definitively higher capital requirements on these categories is also likely to see the gap between the variable rates offered on these types of products and the standard owner occupied P&I rate widen. How significantly they increase relative to owner occupied P&I rates will depend on the final risk weight decision from APRA.