There has been much debate in recent years about the need for macro prudential regulations in the Australian housing loan market as the growth in house prices scared many to believe this sector of the economy is becoming unstable.
Such calls, which put specific limits on the type of lending that can be done by banks, have intensified since the Reserve Bank of New Zealand implemented its own macro prudential rules with temporary limits on high loan-to-valuation (LVR) lending, in order to foster greater financial stability.
High LVR loans and other loans that are considered in some way “risky” are targeted because they generally have a higher probability of default (where the borrower gets into trouble and can’t pay the loan back) and loss to the bank if a default occurs. So, if there are too many of these types of loans being extended in an economy, the banking system is perceived to be unstable, or – as was the case in the US before the sub-prime crisis lead to the GFC – is actually unstable.
In Australia however demands for macro prudential regulation have so far fallen on deaf ears – until today, with the release of a consultation paper from the Australian Prudential Regulatory Authority (APRA) APG 223 Residential Mortgage Lending.
This guidance note addresses “risky” lending by increasing APRA’s expectation of risk management oversight by the boards of Australia’s banking sector including Credit Unions and Building Societies.
Under CPG 223 Apra is requiring Australia’s regulated banking sector to:
- Give boards a better understanding of the level of risk in its mortgage book and the effectiveness of its risk management framework;
- Require boards to fully understand and articulate their risk “appetite” and “tolerance” around credit risk in mortgages. This includes very granular details such as the type of loan, serviceability, geographic concentration, LVRs, use of Lenders mortgage Insurance (LMI), “special” loans, policy overrides and maximum expected or tolerable losses;
- A functional separate overview process from a senior manager who is both “independent” and “competent” such as a chief risk officer (CRO);
- Management information systems (MIS) that not only allow the reporting of exposures but also testing and stress testing of assumptions under a host of scenarios including those which are “plausible adverse conditions” which seems code for the 35% fall in prices that John Laker head of APRA as articulated over the years; and
- remuneration practices including “clawback” of “brokers commissions where there are high levels of delinquency or process failures on loans originated by third parties.
This practice guide feeds on the obligations for all APRA regulated entities to lift capabilities with regard to organisation wide risk management under APRA’s CPS 220 which comes into force in January 2015 and on my reading it is the closest that we are going to get to macro prudential regulations in Australia as APRA is explicitly putting the onus, and implicitly the liability, on bank directors to provide a higher oversight of management.
Equally however these regulations seem to reinforce views put by CBA Chairman David Turner last week that the new rules from both APRA and ASIC are muddying the water between board oversight and day-to-day management.
Either way, the result will be boards of Australia’s banking sector will be under no uncertainty about where the buck stops if their institution gets into trouble.
In forcing that recognition APRA is likely to succeed in restricting a slide toward the more risky end of the lending spectrum in a way that perhaps macro prudential rules could not.
Nothing like self-preservation as a motivating tool.
Disclaimer: Greg McKenna is a Director of Police Bank. The views shared here are his own.