APRA is in the process of finalising the Standardised Approach to Credit Risk standard under the finalised Basel III framework (often also referred to as "Basel IV"). APRA finalised its QIS in early April 2021 and will release the final standards in the second half of 2021, with the new standard coming into force on 1 January 2023.
In this post, we focus on the proposed revisions to Risk Weighting the Residential Property Exposures. We cover the key changes that will impact the bank’s policy-driven decision making and the additional data requirements to enable Risk Weighted Asset computations for the asset class.
To derive the prescribed risk-weights for residential property, similar to the existing standard, the residential property exposures are further segregated into Standard and Non-Standard loans. The majority of the conventional residential property mortgage loans fall under the Standard loan category with some exception being loans to SMSF, loans with interest only repayment period of over 5 years and some reverse mortgages/shared equity type loans. Any residential property loan that does not qualify for Standard Loan, must be assigned into Non-Standard Category.
Standard & Non-Standard Loans
The differentiators to segregate between Standard & Non-Standard loans have been expanded in the proposed revision to APS 112. The basic criteria for a standard loan still exists as the foundation i.e., before tagging a loan as Standard: At the time of loan origination, the bank should have conducted thorough assessment on repayment ability of the borrower as well as the marketability and fair value of the property being accepted as security.
However, APRA has also introduced additional conditions at a more granular level for the banks to classify their property exposures into the Standard & Non-Standard Category.
In this edition, we are primarily going to cover two major differentiation factors:
A. Loans Secured Against a Second Mortgage
B. Assessment of Borrowers’ Repayment Ability
A. Loans Secured Against a Second Mortgage
If a bank is exposed to a property as a second mortgagee then before classifying the loan into eligible standard loan category which attracts lesser quantum of risk weighting, the bank must ensure that:
- The ADI has written consent from the first mortgagee bank (before approving the loan) and has also received current outstanding balance for the first mortgage as the same needs to be added into total exposure amount for deriving LVR.
- The second mortgagee must also ensure that its rights are protected at all times; especially in the event of liquidation where sale of the property should not induce undue losses to the second mortgagee.
- Also, the second mortgagee bank should be able to sell off the property in the event of default without any interventions.
- Lastly, any additional loans disbursement against the property should be junior to second mortgagee bank’s claim.
B. Assessment of Borrowers’ Repayment Ability
APRA is also keen on ensuring the borrowers’ repayment ability has been subjected to various factors, stressed to adequate levels, to ensure that the borrower is able to repay the loan during high interest rate environments and through the periods when interest-only repayment arrangement comes to an end, and the loan enters into amortisation phase.
It is noteworthy that some of these criteria have already been incorporated in most of the banks’ credit decisioning policies yet, the rules have now been explicitly added into the standard, thus becoming part of the legislation.
Considering the stricter entry rule for standard loans category based on borrowers’ repayment ability; APRA has also proposed to exempt the loans originated prior to Jan 2023 from the assessment criteria provided the loans haven’t undergone material changes with regards to its terms & conditions ("grandfathering arrangement").
Risk Weighting Criteria & Additional Data Requirements
APS 112 lays out prudential requirement for deriving LVR (Loan to Value Ratio) and eligibility of LMI (Lender’s Mortgage Insurance) for the purpose of risk weighting as well as credit risk mitigation.
There are substantial changes brought into the derivation rules for LVR. For instance, now LVR must be computed by considering all outstanding loans against the property including the committed but undrawn amount as well as the arrangements involving multiple banks as first & second mortgagee. Such scenarios can also add on to the complexities involved from operational point of view especially for the cases where the loans are under amortisation phase.
APRA has also recognised the Federal Government’s guarantees for residential loans under First Home Loan Deposit scheme (FHLDS) and therefore, allowed the eligible loans to risk weighted at 35%.
One of the major changes coming along for the banks is the additional data requirement for deriving risk weighted assets. As is evident from the decision tree below, banks would require loan purpose & repayment types to identify the risk weight to be assigned for an exposure category – all else being equal.
And Lastly, on the non-standard loans, only reverse mortgages under certain circumstances could enjoy slightly lesser risk weights. Apart from that, all non-standard loans which also happen to include property loans to SMSF, loans with Interest only term of over 5 years and the residential property loans where banks also happen to own part equity.
Summary
Additional criteria have been added for segregating the Standard and Non-Standard Loans. The banks are expected to not only stress test the borrowers’ repayment ability by calibrating the interest rates but also required to ensure protection of their interests in complex loan structures such as loans where banks act as second mortgagee. Before classifying such loans into standard category, the bank must have ensured that its financial interests in the property are always protected. Furthermore, some of the property loan products such as mortgage loans to SMSF, reverse mortgages and loans with interest-only repayment period of more than 5 years will now be classified into Non-Standard category, thereby, attracting higher risk-weightage.
The benign risk weighting provisions for standard loans would also act as a great motivation for the ADIs to classify maximum of their property exposures into the category as opposed to non-standard loans category where majority of exposures attract a flat risk weight of 100%.
One of the key driving factors for risk-weight assignment are the derived LVR% (Loan-to-Valuation Ratio) of the loan. The derivation criteria have now been reformed as per the new standard and now banks are required to aggregate all the outstanding loan amount (in case of multiple loans) for computing the ratio.
Considering the granularity and the substantial increase in the number of conditions for classifying the loans under standard and non-standard category, the implementation of revised legislation would not only require industry-wide upliftment of data collection & operational efficiency but also the transformation in loan disbursement and credit policies to better align with the proposed standard.
Considering the high proportion of ADI's balance sheet being mortgage exposures, entities are well-advised to review the opportunities and implications of these new capital rules. LVR-driven pricing is quickly becoming common practice and first-movers will have first-movers advantage in this space.
RegCentric provides training and consulting services to assist ADI's in assessing the impact of the new Basel standards on their business across policies, operations and technology.
Contact us to discuss how we can support your organisation to leverage the new regulation to drive sustainable transformation.
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