APRA’s supervisory activities in 2005/06
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Authorised deposit-taking institutions
Strong domestic economic activity and robust credit growth, particularly in the second half of 2005/06, underpinned the continued sound performance of authorised deposit-taking institutions (ADIs). Business credit grew at its fastest pace since the late 1980s and housing lending growth, which had been slowing over the previous two years, picked up as the housing market regained momentum. The higher lending volumes again offset pressures on interest margins from more intense competition in both lending and retail deposit markets, and from increasing reliance by larger ADIs on relatively more expensive wholesale (often offshore) funding. Benefiting as well from growing non-interest income, particularly from wealth management activities, the ADI sector has for some time now enjoyed strong and stable profitability, comfortable capital buffers, and impaired assets that are at historically low levels. As a possible harbinger of future problems, however, the value of ‘past due’ loans has been edging up. Reflecting the competitive operating environment, the pronounced trend of consolidation among smaller ADIs has continued.
Credit standards
APRA’s concerns about slippages in credit standards in housing lending are well documented. ADIs are venturing more actively into non-traditional mortgage products — such as ‘low-doc’ loans, reverse mortgages and interest-only mortgages — and into higher-risk business lending, including complex structured finance transactions. In this changing credit environment, APRA has been working closely with ADIs to review their credit policies and assess the robustness of their internal controls. In 2005/06, in the context of its tripartite arrangements with external auditors, APRA requested that a subset of ADIs commission reviews by their external auditors of their mortgage lending practices. Though some areas for improvement were identified — particularly in the verification of critical loan application data and in documentation — the internal control frameworks were assessed as broadly adequate and effective. APRA’s attention is now switching increasingly to business lending, where strong competition and pursuit of market share have been putting pressure on lending standards and risk margins. Commercial property lending, a risky area for ADIs in the past, has also been growing strongly and APRA is keeping this development under watch.
During 2005/06, APRA undertook a survey of debt-serviceability criteria used by ADIs in approving loans. This has confirmed that ADIs have materially increased the maximum amount they are prepared to lend to any given borrower. The increase has come about via an industry shift from traditional debt-serviceability ratios, under which debt-servicing is constrained by gross income, toward income surplus models, in which borrowers are assumed to be willing to continue repaying their mortgages until they reach minimum ‘subsistence’ levels of family consumption. The survey has indicated a wide dispersion in maximum loan amounts across institutions, with the most aggressive ADIs typically being willing to lend almost twice as much as the most conservative ADIs to a hypothetical borrower with the same basic characteristics. APRA’s assessment is now focusing on how much of the current ADI housing lending portfolio involves loans with very high debt-servicing ratios. The results of this assessment are expected to provide useful benchmarks on industry practice and enable APRA to direct its scrutiny to institutions pursuing more aggressive strategies.
Pricing for risk
Sustained good times create the danger that investors and financial intermediaries underestimate and underprice risk. This is a global issue: solid global growth and a benign credit environment over recent years have seen credit spreads fall to their lowest levels in a decade. For APRA, a particular focus has been developments in pricing for risk in the low-doc loan market. Although originally championed by lenders outside the ADI sector, low-doc loans — where borrowers self-certify their income because they lack the necessary documentation — are now offered by all the large ADIs and, aggressively in some cases, by a number of smaller ADIs. Experience in overseas markets indicates that low-doc loans are much more likely to default than conventional loans and this experience may yet assert itself in Australia, where the arrears rate for securitised low-doc loans is currently around three times as high as for conventional loans. From a prudential perspective, the concern is whether the higher risk of default of low-doc loans is being factored into their pricing. Low-doc loans are now being advertised at rates comparable to the ‘headline’ rate for mortgages with fully verified documentation and the spread between actual rates paid on low-doc and conventional loans has halved over the past few years. Time and an adverse turn in Australia’s economic circumstances will tell whether this margin for risk is adequate...........