The Australian Prudential Regulatory Authority today (APRA) today declared that:
APRA Chairman Dr John Laker says credit standards in residential mortgage lending have been a major focus of APRA’s prudential supervision of ADIs, particularly in the current environment of strong pricing pressures in some housing markets and very active competition between lenders.
‘In this environment, APRA is seeing increasing evidence of lending with higher risk characteristics and it does not want this trend to continue. The draft prudential practice guide reinforces the importance of maintaining prudent lending standards when competitive pressures may tempt otherwise’, Dr Laker said.
In response to the problem, APRA released not a comprehensive framework for macroprudential policy, but rather, a piece of paper, summarised below by Martin North’s DFA blog:
APRA has today released today released a draft Prudential Practice Guide 223 Residential Mortgage Lending that provides guidance to authorised deposit-taking institutions (ADIs) on sound risk management practices for residential mortgage lending, including owner-occupied and investment properties. This provide guidance on APRA’s view of sound practice in particular areas and frequently discuss legal requirements from legislation, regulations or APRA’s prudential standards, but do not themselves create enforceable requirements.
According to APRA, this PPG aims to outline prudent practices in the management of risks arising from lending secured by mortgages over residential properties, including owner-occupied and investment properties. It applies to authorised deposit-taking institutions (ADIs) as well as to other APRA-regulated institutions that may have exposures to residential mortgages. This PPG summarises prudent lending practices in residential mortgage lending in Australia, including the need to address credit risk within the ADI’s risk management framework, sound loan origination criteria, appropriate security valuation practices, the management of hardship loans and a robust stress-testing framework.
Interestingly, it underscores the responsibilities of an ADI Board:
“Where residential mortgage lending forms a material proportion of an ADI’s lending portfolio and therefore a risk that may have a material impact on the ADI, APRA expects that the Board would take reasonable steps to satisfy itself about the level of risk in the ADI’s residential mortgage lending portfolio and the effectiveness of its risk management framework. This would, at the very least, include:
(a) specifically addressing residential mortgage lending in the ADI’s risk appetite, risk management strategy and business plans;
(b) seeking assurances from senior management that the approved risk appetite is communicated to relevant persons involved in residential mortgage lending and is appropriately reflected in the ADI’s policies and procedures; and
(c) seeking assurances from senior management that there is a robust management information and monitoring system in place that:
(i) tracks material risks against risk appetite;
(ii) provides periodic reporting on compliance with policies and procedures, reasons for significant breaches or material deviations and updates on actions being taken to rectify breaches or deviations; and
(iii) provides accurate, timely and relevant information on the performance of the residential mortgage lending portfolio.”
ADI’s according to APRA require an overarching statement expressing the level of credit risk an ADI is willing to accept. They also highlight the necessity for processes relating to the oversight and review and supporting management information processes. I highlight a number of potentially significant observations:
- A history of low defaults does not justify under-investment in management information systems.
- MIS reporting needs to include exception reporting including overrides, key drivers for overrides and delinquency performance for loans approved by override, and reports on broker relationships and performance
- In Australia, it is standard market practice to pay brokers either an upfront commission or a trailing commission, or both. Experience has shown that commissions paid upfront tend to encourage less rigorous attention to loan application quality. Trailing commissions are more likely to provide incentives for brokers to retain and monitor customers. A prudent approach to the use of third parties for residential mortgage lending would include appropriate compensation measures for brokers. Such measures include the ADI being able to end or claw back commissions where there are high levels of delinquency or process failures on loans originated by third parties.
- Good practice would be for an ADI, rather than a third party, to perform income verification. However, if a third party does perform such a role, an ADI would be expected to implement appropriate oversight processes covering income verification.
- When an ADI is increasing its residential mortgage lending at a rate materially faster than its competitors, either across the portfolio or in particular segments or geographies, a prudent Board would seek explanation as to why this is the case. Rapid relative growth could be due to an unintended deterioration in the ADI’s loan origination practices, in which case APRA expects that an ADI’s risk management framework would facilitate rapid and effective measures to mitigate any consequences.
- Loan serviceability policies would include a set of consistent serviceability criteria across all mortgage products. A single set of serviceability criteria would promote consistency by applying the same interest rate buffers, serviceability calculation and override framework across different products offered by an ADI. Where an ADI uses different serviceability criteria for different products or across different ‘brands’, APRA expects the ADI to be able to articulate and be aware of commercial and other reasons for these differences, and any implications for the ADI’s risk profile and risk appetite.
- A prudent ADI would include various buffers and adjustments in its serviceability assessment model to reflect potential increases in mortgage loan interest rates, increases in a borrower’s living expenses and decreases in the borrower’s income available to service the debt. APRA’s expectation is that the combination of buffers and other adjustments in these models would seek to ensure that an individual borrower, and the portfolio in aggregate, would be able to absorb substantial stress, such as in an economic downturn, without producing unexpectedly high loan default losses for the lender.
- Self-employed borrowers are generally more difficult to assess for borrowing capacity, as their income tends to be less certain. Accordingly, a prudent ADI would make reasonable inquiries and take reasonable steps to verify a self-employed borrower’s available income.
- In the case of investment property, industry practice is to include expected rent on a residential property as part of a borrower’s income when making a loan origination decision. However, it would be prudent to make allowances to reflect periods of non-occupancy and other costs.
- it would be prudent for an ADI to retain complete documentation of the information supporting a residential mortgage approval, including paper or digital copies of documentation on income and expenses and the steps taken to verify these items. This documentation would be retained for a reasonable number of years after origination.
- There are varying industry practices with respect to defining, approving, reporting and monitoring overrides. APRA expects an ADI to have a framework that clearly defines overrides. For example, a sound framework may clarify that overrides include escalation to a higher delegated lending authority (DLA), where standard policy requirements are not being met in a loan application.
- APRA expects that an ADI would only approve interest-only loans for owner-occupiers where there is a sound economic basis for such an arrangement and not based on inability of a borrower to qualify for a loan on a principal and interest basis.
- APRA expects that an ADI will recognise, in its risk appetite, portfolio limits for loans that may be more vulnerable to serviceability stress and possible material decreases in property value in a housing market downturn, and may therefore generate higher losses.
- Techniques such as desk-top assessments, kerbside valuations, automated valuation models (AVMs) and reviews of contracts of sale are all acceptable valuation assessments, in the appropriate context. As the risk associated with collateral increases, or the coverage of a given loan by collateral decreases, the need for specialist valuation also increases.
- A prudent ADI would monitor exposures by LVR bands over time. Significant increases in high LVR lending would typically be a trigger for the Board and senior management to review risk targets and internal controls over high LVR lending. APRA has no formal definition for high LVR lending, but experience shows that LVRs above 90 per cent (including capitalised LMI premium or other fees) clearly expose an ADI to a higher risk of loss. Lending at low LVRs does not remove the need for an ADI to adhere to sound credit practice or consumer lending obligations.
- APRA expects that an ADI, as part of its credit risk appetite framework, will define its approach to resolving troubled loans, both individually and under conditions where an unusually large number of borrowers are distressed at the same time.
- In addition to enterprise-wide stress tests, portfolio-level and risk-specific stress tests of residential mortgage lending portfolios are considered good practice.
- A prudent ADI would, notwithstanding the presence of LMI coverage, conduct its own due diligence, including comprehensive and independent assessment of a borrower’s capacity to repay, verification of minimum initial equity by borrowers, reasonable debt service coverage, and assessment of the value of the property. LMI is not an alternative to loan origination due diligence.
This document offers good advice to ADI’s and APRA’s stance is welcomed. From our industry experience, whilst many ADI’s will be mostly compliant, some of the smaller organisations, and non-banks would not be. We expect there will be some industry reaction, and we will be watching to see whether this changes lending habits in the market. The interesting question is, why has APRA issued these draft guidelines now? Is this a reaction to the recent warnings from the RBA, or are they aware of more specific risks and issues? Because supervision is not transparent, we probably won’t know. What we really need is public data by ADI as to level of compliance as highlighted by the recent Financial Stability Board review.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
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