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<p>In making serviceability assessments of borrowers, most ADIs currently use a methodology in which they calculate the borrower’s Net Income Surplus (NIS).</p>
<p>Computing NIS is a multi-faceted calculation, with a number of different inputs, and for which the relative importance of each input is not always clear.</p>
<p>Assessing the relative prudence of NIS assessments across ADIs can therefore be problematic, as it can be difficult to determine the extent to which one conservative assumption outweighs another less- conservative assumption, and apparent minor differences in methodology can sometimes have a significant impact on the overall outcome.</p>
<p>To assess and compare lending standards across ADIs, one technique used by APRA has been a Hypothetical Borrower Exercise (HBE).</p>
<p>In early 2015, APRA asked a number of the larger ADIs to provide their serviceability assessments for four hypothetical mortgage borrowers — two owner-occupiers and two investors — using their policies in place as at 31 December 2014. This allowed APRA to compare the lending decisions of ADIs based on identical borrower characteristics. Importantly, it also allowed APRA to disassemble assessments into their component parts. In May 2015, APRA outlined some results and conclusions from the first HBE.<sup id="mortgagefn1back"><a href="https://www.apra.gov.au/Insight/Pages/insight-issue1-2016#mortgagefn1"><br></a></sup></p>
<p>To test how lending policies had changed in response to APRA’s scrutiny, APRA ran a second HBE in late 2015, based on the policies ADIs had in place as at 30 September 2015. By asking the same population of ADIs to assess the same four hypothetical borrowers, not only could APRA compare across ADIs, it could also compare the same ADI at two different points in time.</p>
<p>The four charts below relate to the four calculation components for one of the hypothetical borrowers — in this case, a ‘typical’ investor. The blue bars show the results for December 2014, while the red dots show the September 2015 results for the same lender. Each chart is sorted with the most conservative lender for that particular component (as at September 2015) on the left, and the least conservative on the right.</p>
<div id="chart" class="resize">
<h4>Chart A - Income recognised (less tax and haircuts)</h4>
<p>Percentage of gross pre-tax income</p>
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<div class="resize"><a href="/images/2016/03/23/2016-insight-issue1-mort-chart1.gif" target="_blank">Click to enlarge</a></div>
<div class="resize"><img src="/images/2016/03/23/2016-insight-issue1-mort-chart1.gif" alt=""></div>
<div class="resize"> </div>
<div class="resize"><sup>Bars represent individual lender data </sup></div>
<div id="chart">
<h4>Chart B - Minimum living expense assumptions</h4>
<p>Percentage of borrower pre-tax salary income </p>
</div>
<div><a href="/images/2016/03/23/2016-insight-issue1-mort-chart2.gif" target="_blank">Click to enlarge</a></div>
<div><img src="/images/2016/03/23/2016-insight-issue1-mort-chart2.gif" alt=""></div>
<div> </div>
<div><sup>Bars represent individual lender data</sup></div>
<div class="clr"> </div>
<div id="chart">
<h4>Chart C - New mortgage</h4>
<p>Interest rate used in serviceability assessment</p>
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<div><a href="/images/2016/03/23/2016-insight-issue1-mort-chart3.gif" target="_blank">Click to enlarge</a></div>
<div><img src="/images/2016/03/23/2016-insight-issue1-mort-chart3.gif" alt=""></div>
<div><sup>Bars represent individual lender data (Click to enlarge image)</sup></div>
<div id="chart">
<h4>Chart D - Existing mortgage</h4>
<p>Interest rate used in serviceability assessment</p>
<p><a href="/images/2016/03/23/2016-insight-issue1-mort-chart4.gif" target="_blank">Click to enlarge</a></p>
<p><img src="/images/2016/03/23/2016-insight-issue1-mort-chart4.gif" alt=""></p>
<sup>Bars represent individual lender data<br>The current interest rate on the existing mortgage debt is 5.2%</sup>
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<div class="clr"> </div>
<p>Chart A shows income recognised, as a percentage of gross pre-tax income.  While the assessment of PAYG salary income has usually remained the same between the two periods, a number of lenders have applied larger haircuts (i.e. discounts) to less stable sources of income such as overtime, bonuses, commissions, investment dividends and rental income.</p>
<p>Chart B shows minimum living expense assumptions as a percentage of pre-tax salary income.  Some lenders have made quite large changes to this component of their NIS assessment.  This impact has typically arisen from two main sources:</p>
<ul>
<li>considering borrower-declared expenses where these are greater than calculated benchmarks; and/or</li>
<li>scaling living expense assumptions in line with income.</li>
</ul>
<p>Chart C shows the interest rate used in the serviceability assessment for this new mortgage. Various lenders have increased that rate in response to APRA’s December 2014 letter, in which APRA stated that prudent serviceability policies should incorporate a ‘serviceability buffer of at least 2 percent above the loan product rate, with a minimum floor assessment rate of 7 percent.</p>
<p>Chart D shows the interest rate used in the serviceability assessment for an existing mortgage commitment. Here, the changes are even more dramatic than for Chart C, as at the time of the first HBE a number of ADIs were not using any serviceability buffer on existing debt.</p>
<p>These four components combine to calculate NIS. Whilst there was little overall change in NIS for the lenders that were already relatively conservative in December 2014, lenders that were the least conservative in December 2014 generally reported a significant drop in calculated NIS using their September 2015 policies. These changes had the effect of tightening the spread of calculated NIS from the most to the least conservative ADI. Overall, the maximum loan sizes reported by ADIs for the four hypothetical borrowers declined by, on average, around 12 per cent for investors and 6 per cent for owner-occupiers. (Note that this does not imply actual loan sizes are falling across the board; indeed the average size of loans continues to rise.)  </p>
<h3>Conclusion</h3>
<p>APRA’s HBEs have proven a simple but effective tool for examining the impact of changes to residential mortgage lending policies during 2015.  </p>
<p>Overall, debt serviceability assessments now appear to be both more prudent and more consistent across ADIs, relative to December 2014.  APRA will continue to engage ADIs on this issue in 2016 to assess whether the observed improvements in sound underwriting practices are maintained. APRA will also be examining the extent to which loans are able to be approved outside an ADI’s own (tightened) policy parameters.</p>
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<p><sup id="mortgagefn1"><span style="font-size: 12px; line-height: 1.3em;"> </span></sup></p>
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Property 101: APRA's loan serviceability methodologies 

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<p>Over the course of 2016, APRA expects to release several policy consultation packages. These will, for the most part, primarily affect authorised deposit-taking institutions (ADIs) and the superannuation industry.</p>
<p>The consultations will reflect both domestic policy initiatives - largely driven by the Government’s response to the Financial System Inquiry (FSI) – and, for ADIs, the implementation of internationally-agreed reforms. Insurers will chiefly be impacted by a limited number of cross-industry policy proposals, as well as a review of the role of actuaries.</p>
<p>APRA will also begin engagement with private health insurers during 2016 on the future direction of the prudential framework for their industry. Responsibility for prudential regulation of the private health insurance industry passed to APRA on 1 July 2015 and, consistent with APRA’s undertakings during the transition, no substantive changes will be made to the prudential framework for private health insurers prior to 1 July 2016.</p>
<p>In conducting policy consultations, APRA follows an open and transparent process where public and industry feedback is actively encouraged, and final policy positions are formed after giving due consideration to feedback received.</p>
<h3>International developments</h3>
<p>The Basel Committee on Banking Supervision (Basel Committee) – the global standard-setter for banking - is committed to finalise in 2016 its remaining post-global financial crisis (GFC) reforms. This includes new standardised approaches to credit risk and operational risk; reducing risk-weight variability when ADIs use internal models for capital adequacy purposes; new capital floors; and the leverage ratio. This follows from the recently-finalised review of capital requirements for trading book exposures.</p>
<p>APRA intends to take a measured approach towards implementing these changes, with suitable adjustments for the Australian context. Whilst these reforms have the potential to affect all ADIs, it is likely the impact will be more noticeable for the largest ADIs. However, given the international work is unlikely to conclude before end 2016, and with many implementation dates yet to be agreed, APRA’s domestic consultation is unlikely to begin before 2017, with local implementation of these reforms following over a number of years.</p>
<p>Derivative markets have also been an area of intense international reform in the post-GFC period. APRA has begun the implementation process in Australia with the recent release of a cross-industry consultation package on margining and risk mitigation standards for non-centrally cleared derivatives; a separate (but related) consultation on ADI capital requirements for counterparty credit risk will follow in the near future. These reforms generally only affect the larger APRA-regulated entities in each impacted industry.</p>
<h3>Domestic developments</h3>
<p>The final report of the FSI includes a number of recommendations that are directly relevant to APRA’s prudential framework. The Government’s response to the FSI, <em>Improving Australia’s Financial System</em>, endorsed APRA to implement a number of these recommendations. APRA’s plans in this regard are set out below.</p>
<p><strong>FSI Recommendation 1: Capital Levels</strong> – the FSI highlighted that the stability of the banking sector is of paramount importance to Australia’s economic well-being. With that in mind, the FSI recommended that ADIs have capital ratios that are ‘unquestionably strong’. In settling a final prudential framework to deliver on this recommendation, APRA needs to have regard to the ongoing work of international standard-setters such as the Basel Committee, as well as give thought to how other measure of resilience (for example, with respect to liquidity and funding) can assist in achieving the FSI’s objective. With this in mind, APRA will shortly begin consultation on the implementation of the Net Stable Funding Ratio, which is designed to improve the stability of bank funding profiles.</p>
<p><strong>FSI Recommendation 2: Narrow mortgage risk weight differences</strong> – in July 2015, APRA announced an interim measure to increase the average residential mortgage risk weights for ADIs using the Internal Ratings-based (IRB) approach to capital adequacy, from approximately 16 percent to at least 25 percent. This change takes effect from 1 July 2016. Whilst this step materially addresses the FSI recommendation in the short term, APRA will need to consider whether further changes are necessary after the Basel Committee’s broad review of the capital framework is complete later this year.</p>
<p><strong>FSI Recommendation 3: Loss absorbing and recapitalisation capacity</strong> – consistent with the FSI’s recommendation of not moving ahead of international developments, this is an issue that APRA intends to address over the medium term. In the meantime, APRA is monitoring initiatives being taken by overseas regulators in this area, and has begun limited engagement with industry participants on this issue.</p>
<p><strong>FSI Recommendation 4: Transparent reporting</strong> – larger ADIs have begun disclosing ‘internationally comparable’ capital ratios, informed by the methodology developed by APRA for its <em>International capital comparison study</em> (July 2015). Although not strictly aligned with the FSI’s recommendation for reporting capital ratios that are ‘transparent against the minimum Basel capital framework’, APRA’s study and the larger ADIs’ reporting have addressed this issue to a large degree. APRA will continue to monitor international comparisons during the course of the year, and then consider whether further work is needed on this recommendation.</p>
<p><strong>FSI Recommendation 7: Leverage ratio</strong> – the Basel Committee is finalising its proposals for the introduction of a leverage ratio as part of its reforms to the Basel capital framework. Leverage ratio disclosure requirements for the largest ADIs have been implemented, but at this stage APRA is likely to follow the international timeframe for the introduction of a minimum leverage ratio requirement (currently scheduled for 2018).</p>
<p>Also of importance to ADIs are revisions to the prudential framework for securitisation. The consultation period on these proposals closed earlier this month, and APRA intends to finalise these revisions in 2016.</p>
<p>In the superannuation industry, APRA will participate where relevant in further Government policy consultation on post-retirement outcomes and governance of superannuation trustees (FSI Recommendations 11 and 13), and initiatives related to the objectives and efficiency of the superannuation system (FSI Recommendations 9 and 10). APRA is also be closely involved in the Government’s consultation on measures to improve the transparency of the superannuation industry, including reforms to the product dashboard requirements for MySuper products and choice investment options.</p>
<p>In general insurance and life insurance, APRA is progressing its review of the role of the Appointed Actuary, and anticipates commencing a public consultation in mid-2016. Across all industry sectors, APRA will continue to refine and clarify its governance requirements, particularly in relation to the important role played by Boards in APRA-regulated entities. APRA will also announce the next steps on our approach to the supervision of conglomerate groups in the near future.</p>
<p>More generally, APRA’s mandate is to balance the objectives of financial safety and efficiency, competition, contestability and competitive neutrality; and to promote financial stability. The FSI noted that regulators should, while remaining consistent with their mandate, increase their focus on competition in the financial system (Recommendation 30).</p>
<p>APRA will be looking to provide more information on how it balances financial safety with these other objectives, and more actively seek industry input on these issues so that policy choices are best able to balance these considerations without undermining prudential outcomes.</p>
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