6 lending issues on the horizon

Let’s look at 6 of the key issues that arise from the paper which will guide the industry debate and discussion over the course of 2016.

1. APRA was ahead of the game

APRA deserves some kudos for the manner in which it has implemented Basel II and III in Australia since 2008, particularly with respect to its approach to the treatment of credit risk for standardised institutions.

Specifically, the Basel Committee is following APRA’s lead in adopting a more conservative and granular approach to determining capital by LVR buckets.

Similarly, APRA in 2008 also adopted a distinction between standard and non-standard loans (based largely on the distinction between the information supplied to verify the borrower’s ability to repay the loan). Non-standard loans attract more punitive capital treatment. The Consultation Paper focuses heavily on the importance of determining the borrower’s ability to repay the loan.

Overall, APRA should be commended for the fact that the Basel Committee has largely followed their approach.

2. Investment loans

The most controversial aspect of the Consultation Paper is the Basel Committee’s proposal to levy higher capital on a subset of investment loans. Not just marginally higher; two to three times higher than for a like-for-like owner-occupied loan.

The Basel Committee has defined these loans as ones where “repayment is materially dependent on cash flow generated by the property”. Unfortunately, the Consultation Paper does not define what this phrase means in any further detail.

Currently in Australia, lending institutions use, on average, 80 per cent of the estimated rent from the investment property towards serviceability. It is likely many investment loan applications in Australia would not pass servicing without at least some portion of the rental amount having to be relied upon.

The threshold question for APRA will be to determine whether or not it wishes to adopt the Basel Committee’s proposed approach to imposing higher capital on investment loans. If APRA forms the view that it wishes to go down this path, then it will need to engage in some spirited debate with industry participants throughout the course of 2016 to provide greater clarity around the meaning of the term “materially dependent”, particularly given the proposed material difference in capital treatment between an owner-occupied loan and an investment loan.

When the Basel Committee visited Australia a couple of years ago, they did make a comment in their final report to the effect that Australia had an extremely large percentage of investment lending and that the 35 per cent risk weighting for residential mortgages in the Basel II Framework was not originally intended to apply to investment loans to the degree evidenced in Australia.

I expect it will be difficult for APRA not to follow the international agenda and adopt some form of differentiated capital treatment for investment loans.

3. Some wins for standardised lenders

The flipside of potentially higher capital treatment for investment loans is the fact that the Consultation Paper actually proposes less onerous capital treatment for most types of standard loans when compared to APRA’s current rules (APA 112). In particular, the Consultation Paper proposes much lower capital for fully documented owner-occupied loans under 60 per cent LVR and for high LVR loans between 80 per cent and 100 per cent.

If and to the extent that standardised lenders do lose the battle with respect to a subset of investment loans and are forced to hold higher capital for this (generally sizeable) segment of their portfolio, then it is likely they will leverage this section of the Consultation Paper and seek to argue for less conservative capital treatment of the majority of their portfolio. Absent any move by APRA to impose more conservative treatment on investment loans in line with the Consultation Paper, I consider it unlikely that APRA will permit a reduction in capital on system-wide capital for standardised lenders, particularly given the current risk and market environment.

4. The importance of original LVR

The Consultation Paper highlights the importance of precisely calculating the loan-to-value ratio at loan origination as the most determinative and influential risk driver influencing capital.

With respect to the denominator, the Basel Committee highlights the importance of the appraisal (valuation) being conducted independently of the bank’s mortgage acquisition, loan processing and loan decision process. The Consultation Paper also highlights the importance of the valuation process adopting “prudently conservative evaluation criteria” in arriving at the valuation at loan origination, with the valuation to exclude any expectations of future price increases.

The Consultation Paper notes that the numerator adopted by the bank must be the outstanding loan balance and any undrawn committed amount of the loan included.

In the first Consultation Paper, the Basel Committee proposed using debt servicing ratio criteria in determining the risk weights for residential mortgages. Based on feedback received after the first Consultation Paper, the Basel Committee decided against going down this path because of the challenges of defining and calibrating a debt service coverage ratio that can be equitably applied across jurisdictions.

Accordingly, LVR at origination remains the most important characteristic in determining not only initial capital allocation, but also risk appetite and assessment and as a key input into risk-based pricing strategies.

5. Key elements of a standard loan

The Consultation Paper outlines the following five key requirements that a residential mortgage loan needs to meet in order to avoid more penal capital treatment. These include:

• the loan is secured by a finished or completed property;
• the loan is secured by a first mortgage which is legally enforceable;
• the financial institution has verified the ability of the borrower to repay the loan;
• a prudent value of the collateral has been adopted; and
• the borrower has supplied all of the necessary and required documentation to enable the lending institution to verify the borrower’s ability to repay the loan, including evidence of income and employment.

If the loan does not meet these five broad criteria, then punitive capital treatment would apply. The proposals in the Consultation Paper, if adopted in Australia, would mean that the days of regulated entities originating low doc or no doc loans would be well and truly over, given the material increase in capital proposed where these operational requirements are not met.

This would suggest non-banks have an enduring opportunity to grab this niche aspect of the market.

6. The importance of validating rental income

With the material increase in the amount of investment lending in Australia over the past three to five years, it has never been more important to adopt prudent servicing standards when assessing a borrower’s capacity to repay an investment loan and the extent to which the borrower relies on rental income to do so.

Servicing standards in Australia have been tightened throughout the course of 2015, in the wake of increased focus from APRA following the large growth in investment lending over recent years.

Verifying estimated rental income from a proposed investment property is good practice in order to ensure the borrower has the ability to repay the loan without undue hardship, and can afford the loan notwithstanding some short-term fluctuations in cash flow from the rental property.

With the proposal by the Basel Committee to apply a more punitive capital regime where the repayment of the loan facility is ‘materially dependent on cash flows generated by the property’, lending institutions may need to undertake a more rigorous analysis to verify the estimated rental amount, as well as satisfy themselves that this cash flow remains stable and viable over the term of the proposed credit facility.

Conclusion

The key issue coming out of the Consultation Paper, which will attract much focus over the course of 2016, will be whether or not APRA either wishes to or feels compelled to adopt a differential capital treatment for those investment loans which are “materially dependent on cash flows generated by the property” in order to support repayment of that facility. If APRA supports this general approach, then they will need to engage in serious and detailed dialogue with the industry in order to provide more prescription around the terms “materially dependent” in order to provide clarity to impacted financial institutions, particularly given the two to three times capital differential applying to these loans. This uncertainty may well lead to a further slowdown in investment lending throughout the early part of 2016, until such time as APRA’s intentions become clearer.