Global financial regulators are continuing to ramp up pressure on banks to dial down risk in the wake of the GFC.
The regulators, and their political masters, recognise that if they are going to offer support to banks, then the quid pro quo is the banks need to knuckle down, take less risk and where they are taking on risk understand it, measure, manage and report it better.
It’s why APRA and the RBA are using macroprudential in the home loan market at the moment and also why APRA has introduced its all-encompassing APS 220 risk management framework, which has increased the level of expectations about the type of risk management capability all Australian ADIs, superannuation funds and life insurers must have.
New reforms continue and the latest missive from the Basel Committee on Banking Supervision looks at “revisions to the standardised approach for credit risk,” and could shake the very foundations of Australian finance if it is taken up by APRA in the proposed form.
The document is applicable to all banks who use the “standardised” approach to measure capital reserve requirements. That’s every Australian bank, credit union and building society, apart from the majors and Macquarie.
The BCBS says that the new standard is aimed at “reducing reliance on external credit ratings; increasing risk sensitivity; reducing national discretion; strengthening the link between the standardised approach and the internal ratings-based (IRB) approach; and enhancing comparability of capital requirements across banks.”
It’s a long document, but two things stick out that are worryingly relevant for Australia’s non-major financial sector.
The first departure from Australia’s current approach is that ADIs on the standardised model of credit risk currently have a 35% risk weighting on residential mortgages.
The BCBS plan has risk weights between “25% to 100% on the basis of two risk drivers: loan-to-value and debt-service coverage ratios.”
Already, some ADIs have told Business Insider privately that they would struggle to provide the debt service ratio on older loans, implying they need to increase the risk weight to 100%.
That is a lot of extra capital that needs to be put aside and while Australia’s smaller ADIs are capital rich, it is a major change.
The second major change the BCBS wants to institute has to do with residential properties purchased for investment, to be rented by others.
What the BCBS calls “income producing real estate” is what Australians think of as investment properties which are negatively geared.
In Australia under the negative gearing regime the borrowers non-interest related income is generally not sufficient to cover the loan servicing requirements without reference to the rental income of the property, plus any tax deductions.
In this way it is more a commercial transaction rather than a personal transaction and this aspect is what the BCBS is now wanting regulators and banks to recognise.
The proposed standard says that when a bank works out the debt service coverage ratios, and specifically the income component then “total income must be net of taxes and prudently calculated, including a conservative assessment of the borrower’s stable income and without providing any recognition to rental income derived from the property collateral.”
Read that again – it’s a potential death knell for negative gearing if APRA adopts it.
The political ramifications of such a change cannot be underestimated with negative gearing remaining a political sacred cow in Australia on both sides of politics. It would be a brave government to do away with it – despite strong views that it should go, but if negative gearing came under attack from global banking regulators then at least the government would have someone to blame (while enjoying a considerable boost to the budget bottom line from the $14 billion in tax losses currently claimed).
The standard is not clear on whether a lender can give value to other rental income from other properties for those who hold multiple properties, but what’s clear is that if the borrower cannot service the investment property loan out of “a conservative assessment of the borrower’s stable income,” the risk weighting will head higher.
Australia’s responsible lending regulations would also kick in if this is adopted.
This is one of a limited number of jurisdictions in the world that has a negative gearing regime and its clear the BCBS has it in its sights.
The BCBS is seeking feedback from affected institutions and stakeholders by March 27. They can expect an avalanche from Australia.
Here’s a link to the BCBS document.