Basel 4 is coming for property investors

By Martin North, cross-posted from the Digital Finance Analytics Blog:

The second consultative document on Revisions to the Standardised Approach for credit risk has been released for discussion.

There are a number of significant changes to residential property risk calculations . These guidelines will eventually become part of “Basel IV”, and will apply to banks not using their internal assessments (which are also being reviewed separately).

First, risk will be assessed by loan to value ratios, with higher LVR’s having higher risk weights. Second, investment property will have a separate a higher set of LVR related risk-weights. Third, debt servicing ratios will not directly be used for risk weights, but will still figure in the underwriting assessments.

There are also tweaks to loans to SME’s.

These proposals differ in several ways from an initial set of proposals published by the Committee in December 2014. That earlier proposal set out an approach that removed all references to external credit ratings and assigned risk weights based on a limited number of alternative risk drivers. Respondents to the first consultative document expressed concerns, suggesting that the complete removal of references to ratings was unnecessary and undesirable. The Committee has decided to reintroduce the use of ratings, in a non-mechanistic manner, for exposures to banks and corporates. The revised proposal also includes alternative approaches for jurisdictions that do not allow the use of external ratings for regulatory purposes.

The proposed risk weighting of real estate loans has also been modified, with the loan-to-value ratio as the main risk driver. The Committee has decided not to use a debt service coverage ratio as a risk driver given the challenges of defining and calibrating a global measure that can be consistently applied across jurisdictions. The Committee instead proposes requiring the assessment of a borrower’s ability to pay as a key underwriting criterion. It also proposes to categorise all exposures related to real estate, including specialised lending exposures, under the same asset class, and apply higher risk weights to real estate exposures where repayment is materially dependent on the cash flows generated by the property securing the exposure.

This consultative document also includes proposals for exposures to multilateral development banks, retail and defaulted exposures, and off-balance sheet items.The credit risk standardised approach treatment for sovereigns, central banks and public sector entities are not within the scope of these proposals. The Committee is considering these exposures as part of a broader and holistic review of sovereign-related risks.

Comments on the proposals should be made by Friday 11 March 2016.

Looking in more detail at the property-related proposals, the following risk weights will be applied to loans against real property:

  • which are finished properties
  • covered by a legal mortgage
  • with a valid claim over the property in case of default
  • where the borrower has proven ability to repay – including defined DSR’s
  • with a prudent valuation (and in a falling market, a revised valuation), to derive a valid LVR
  • all documentation held

If all criteria a met the following risk weights are proposed.

BIS-Dec-12-01For residential real estate exposures to individuals with an LTV ratio higher than 100% the risk weight applied will be 75%. For residential real estate exposures to SMEs with an LTV ratio higher than 100% the risk weight applied will be 85%. If criteria are not met, then 150% will apply.

Turning to investment property, where cash flow from the property is the primary source of income to service the loan

BIS-Sec-12-02Commercial property will have different ratios, based on counter party risk weight.

BIS-Dec-12-03 But again, those properties serviced by cash flow have higher weightings.

BIS-Dec-15-04Development projects will be rated at 150%.

Bearing in mind that residential property today has a standard weight of 35%, it is clear that more capital will be required for high LVR and investment loans. As a result, if these proposals were to be adopted, then borrowers can expect to pay more for investment loans, and higher LVR loans.

It will also increase the burden of compliance on banks, and this will  likely increase underwriting costs. Finally, whilst ongoing data on DSR will not be required, there is still a need to market-to-market in a falling market to ensure the LVR’s are up to date. This means, that if property valuations fall significantly, higher risk weights will start to apply, the further they fall, the larger the risk weights.

Finally, it continues the divergence between the relative risks of investment and owner occupied loans, the former demanding more capital, thus increasing the differential pricing of investment loans.

The Committee notes that the SA is a global minimum standard and that it is not possible to take into account all national characteristics in a simple approach. As such, national supervisors should require a more conservative treatment if they consider it necessary to reflect jurisdictional specificities. Furthermore, the SA is a methodology for calculating minimum risk-based capital requirements and should in no way be seen as a substitute for prudent risk management by banks.

Comments

  1. What a marvelous method of indenture.

    Have all the oldies takes all the future earnings of the young with high property prices and oldtitlements, encourage the oldies ro leverage up, then slowly wilt away the equity of indebted oldies.

    All whilst assuring your periodic installment. A captured government will always work to favour the means to meet coupon payments, even if at the expense of savers and entrepreneurs.

    Jubilee at the end of a guillotine looks to be the only way to fix this.

    • Another solution is potentially land sales ie parts of Antarctica; resources; full states
      Wipe out, switch some land; start again.
      The question being who wipes out first and how.

  2. Basel is actually a nice city. Stayed there for a week in 2002 when I was racing on a semi-pro cycling team.
    Having their name on a banking related covenant is probably not the greatest marketing tool. However I may be wrong.
    All of these changes are great and keep some smart bankers in jobs working out how to tread water somewhere. I wish I had a crystal ball to see what will be happening by the time we are at Basel 6. I can’t see that far ahead unfortunately.

  3. I suggest we forget Basel 4.

    Instead when it comes to home lending we should go “back to the future” and require that

    1. Banks adopt a “loanable funds” approach to residential mortgage lending – which means they must raise every dollar of deposits required for home lending and not simply “create” the loan entries.

    2. Prohibit them from raising the required deposits from off shore depositors (or local nominees)

    Certainly this would have the effect of turning our bank home loan lending into “building society” style lending where the making of a home loan depends on the bank acquiring already existing deposits, but so what?

    If the poor banks find this concept outrageous an even simpler solution is to prohibit banks from home lending altogether and limit home lending to old style building societies who lend after first attracting deposits.

    And yes it is likely to mean the banks/building societies will have to offer higher TD rates in order to attract the required deposits when they cannot leverage up on deposits secured from “carry trade” foreign depositors.

    But that issue can be readily addressed by the govt if they see fit. The govt is more than capable of increasing the supply of money that can be placed on deposit by running a fiscal deficit, with more money available to be placed on deposit the rates that need to be offered to attract them will fall.

    Here is an interesting reminder of how we managed to maintain a reasonable relationship between house prices and household (mostly single) incomes until home finance was turned into a massive money creation / debt / leverage profit centre.

    https://news.google.com/newspapers?nid=lL5f5cZgq8MC&dat=19700503&printsec=frontpage&hl=en

    How novel – home lenders limited in their capacity to extend credit to the deposits they have been able to attract.

    If there is any role for the endogenous creation of money (deposits) by banks (aka bank money printing) – home lending is not it.

    • It is novel, and likely to remain within the domain of historical or fiction novels. As Rusty Penny above says, this sort of embedded corruption of the system used to be resolved via the guillotine. These times, proactive gassing of citizen insurgencies is the preferred response.

    • 100% reserve banking huh.
      It’s a thought, probably not a great one as it transfers the money creation mechanism to where exactly?

      I’d think that by simply not bailing banks out there would be no issue.
      By asking them to pay for their Deposits insurance to 250k, you would have a fair transfer back.
      ie the premium for their deposit goes up in step with the risks of their bank book.
      In this case, the taxpayer would be reaping >30b a year in insurance fees from the banks.

      • Young One, the cost of the insurance will likely be borne by depositors (via lower rates) rather than by borrowers. Unintended consequence perhaps?
        Unfortunately this would further encourage our ingrained cultural tendency to seek to increase wealth by taking out the biggest home loan rather than saving. I.E. Infesting instead of investing!

      • Raymond, yes – there is no incentive to deposit and save money.
        That’s unfortunate.
        This is why we are seeing peer to peer lending alternatives and other mechanisms which are disrupting the model.
        I know many first home buyers now who are taking their deposit and lending it out to their parents or siblings with a full claim on the property in case things go ass up.
        there is no free lunch, unless you are a bank…

      • Young OK

        “….transfers the money creation mechanism to where exactly?…”

        Every year the government spends about $420B. While there is plenty of pork (travel allowances etc) and some reduction on that amount is possible, there is still a lot of money being spent by the government that would be available for deposits if not collected by taxes.

        Reduce taxes by increasing the tax free threshold and then let the banks attract that additional money that stays in wallets with more attractive TD rates.

        That will get people thinking clearly once more about their consumption v saving decisions.

        Considering the total outstanding amount of housing debt is only about $1.4T and the amount required for new home lending each year is only a fraction of that – there is no difficulty in creating the necessary deposits. Especially if the charade of issuing govt bonds via the AOFM is dispensed with. Or alternatively issue a 0% 10 year bond to the RBA and ask them to credit the Treasury ES account.

        http://www.australiandebtclock.com.au/

        Sure it is no magic pudding and inflation will be the limiting factor but it certainly beats the crazy situation we currently have where money creation is located with private banks and results from the process of driving massive debt into the market for 50 year old fibro shacks and shackling people to 30 year contracts of debt servitude.

      • No complaints from me if we did this… I’m struggling not only because I am subsidizing the Ponzi of earlier generations, yet also because I am getting taxed at an effective rate of >55% earnings if you include my income tax, GST payments and excise on all things big and small.

        Stealing from the commons is a no-no
        Yet it is ok if it is a man created commons

        Maybe just issue every citizen with X$ of credit per year which they can trade or do whatever… many solutions out there, just don’t think that handing the creation decisions to a committee would be a great idea.

      • When it comes to fiat there is always a creation decision.

        What we have now is a process that is so well concealed most of the people who work in the FIRE sector dont even understand it.

        The committee will have a boring task maintaining currency stability. Read a few guages and metrics and tell the govt how much of a deficit is required to avoid deflation or inflation. The govt is then free to decide how the deficit will be acheived and whether to ignore the advice.

        We can boot the govt if they ignore the committee and inflation or deflation results.

        Likewise the committe gets the boot if their advice is followed and is wrong.

        But that is likely to be much better than the procyclical money creation pumping we get from a bunch of bonus hunting taxpayer guaranteed bankers.

      • yes agreed. my only comment was that it becomes a very ‘command’ type mechanism.
        If there would be a formula that was transparent it takes out the risk that people can hijack it as they have any institution that ever existed

    • Another idea is to turn Aussie Post into a government backed bank and then grandfather the deposit insurance away from private banks if they don’t pay for it. The transition would be great to watch.

      • Current Post CEO Ahmed Fahour, got the multi million gig as a merchant banker years back and it was thought the peoples bank may be on the agenda again. Sadly, he couldn’t organise a root in a brothel and the dreams of a viable ,efficient Post and a no frills peoples bank are long gone.

    • Just make interest payments to offshore bondholders no longer tax deductible.

      Then the access to money will still be there, but it will be more expensive. Someone paying 3% for their 100% Australian money and lending at 5% will have a 2% gross margin, but another bank with 50% offshore funding paying 3% will have to charge an interest rate of about 5.6% to achieve the same gross margin.

  4. Meh…. these proposals do not apply to our big banks. They do not and will not use the Standardised Approach. Only forced changes to their internal assessment models will effect a change. I wait with bated breath for the proposals with regard to this.

      • yes, I see your point – only tier 2’s going to be impacted by this.
        Do you know why it is that big 4 and Macquarie get away with their own risk models? TBTF..?/

      • Because the big banks are sooo smart and all, they know what’s best (for them at least)! They’re special so the rules don’t apply to them. This is just another rung on the ladder for them to be able to maximise their profits (with obscene leverage), while socialising any losses through the government guarantee.

    • Basel is expected to release another paper looking at risk modelling in the big banks that use their own internal models in January.

      Under the Basel 4 proposals, big banks will be prevented from deviating too far from the risk weightings that would be required should they be governed by standardised model via the use of a “capital floor”. It is understood that this will be set until later next year. Until it is set, it will remain unclear how the big banks will be effected by the changes released overnight.

      “There is going to be a consultation on changing the [big bank] approaches across all assets, and a floor will be put in place between the IRB and standardised banks,” said Deloitte partner Kevin Nixon.

      “So IRB banks have a big stake in the outcome of this consultation. Not least because of the operation of the floor, which means every bank will need to use the standardised model to see what capital looks like.”

      Read more: http://www.smh.com.au/business/banking-and-finance/basel-4-plan-to-free-up-capital-for-regional-banks-20151210-glkaez.html#ixzz3ty7IzVUU
      Follow us: @smh on Twitter | sydneymorningherald on Facebook

  5. Note the following in the Committee’s paper relating to risk weighting of banks:

    The Committee believes that banks’ external ratings as used for regulatory capital purposes should exclude government support. This is in line with the objective of breaking the link between banks and their sovereigns (which is also achieved by eliminating from the current framework the option of risk-weighting bank exposures based on their sovereigns’ ratings).

    This is serious stuff, and almost more important, given the current link between Australia’s AAA rating and bank funding costs. The Committee is reviewing how to assess sovereigns and the impact of sovereigns on risk weighting of assets.

    Note, too, that there is a large push in the Committee to reduce reliance on external ratings to assess risk, which may result in minimum rules that no longer cause the continued access to a AAA rating such a critical issue for the Australian government. Indeed, it could free up the capacity of the Commonwealth to take on greater liabilities (Debt-to-GDP) to buffer the upcoming issues we will face.

  6. all of this is so complicated and ultimately pointless.
    we should remove 50% discount on PPOR and introduce speculative capital gain tax – e.g. 75% CGT on all investment properties sold within 10 years of date of purchase (it should be classified as IP if it was rented out for more than 20% of ownership tenure) – that would reduce house prices to around 15 times gross rental income (half of current prices), prevent any future price spaculation and problem solved.

  7. Note, too, that none of these changes above will apply to the Big 4 / Macquarie – they use an Internal-Rating Based approach. Wait for the proposed revisions to the IRB model to come out in the next few weeks – depending on the contents, that should build a massive bun-fight between regulators and the largest banks.

  8. These don’t seem to address the problem of rapidly rising markets where values keep rising so the loans get bigger because the price is higher so the same LVR allows a bigger laon so the borrower can bid more…
    LVR’s ought be measured against the price from 2 years ago or now whichever is the lower. Then the mortgage boom would be much slower at raising prices.