How APRA's reduced real estate revaluation requirement is providing capital and operational relief.

Earlier in March this year, APRA revised the implementation schedule of Basel III reforms in Australia to support of banks grappling with the heightened volume of enquiries from customers seeking loan repayment deferrals. The prudential regulator’s decision came against the backdrop of the postponement announced a few days earlier by the Basel Committee on Banking Supervision (BCBS) with the participating member nations following suit in their respective jurisdictions.

To learn more about all of the major announcements by APRA in response to COVID-19, please read our previous article here.

As a follow-up release on prior announcements, APRA also published a list of FAQs on its website, broadly addressing the industry’s inquiries pertaining to the series of changes announced on capital treatments in response to the COVID-19 global pandemic.

Notably, the regulator has already extended the preferential capital treatment during loan deferral period from 6 to a total of 10 months or 31st March 2021, whichever occurs first. APRA, in its letter to the industry, on 9th of July 2020, has clarified that the extension, after the initial non-repayment period of three months, can only be granted after conducting a thorough assessment of borrower’s serviceability.

The regulator has also asked banks to apply discretionary judgement while assessing the relaxation requirements based on individual circumstances of the borrower i.e. rather than adopting repayment deferments as an all-encompassing solution, banks may, as alternative, also consider loan restructuring or changing repayment type to interest only from principal & interest repayment schedule. Furthermore, where borrowers are assessed to be in a position to restart loan repayments, APRA requires banks to encourage them to do so, as soon as the initial loan deferral period of three months comes to an end. The regulator has also urged the industry to not stray away from their responsible lending obligations in their endeavours to assist borrowers facing hardships.

One of the other highlights of the FAQ publication is the granted relaxation with regards to the revaluation requirement of real estate properties for the purpose of capital calculations. In this article, we will dive deeper into the announcements from APRA around mortgage revaluation requirements and their implications on the operational efficiencies of the banking industry.

Residential property revaluation requirements

While the capital relief during the loan deferral period applies to the entire loan book of the banks, APRA has also extended further support to banks on their residential mortgage secured portfolios by discontinuing the revaluation requirement of the underlying property. With the residential real estate prices experiencing downward pressure in the face of the pandemic, the removal of the mandatory revaluation requirement under APS 112 Capital Adequacy: Standardised Approach to Credit Risk has brought in much needed certainty going into the capital allocations against deferred loans for the banks.

Before the removal of the condition, ADIs were under obligation to revalue the residential mortgage as soon as the lenders became aware of the material changes in property prices in the regions where mortgage loans have been written.

Previously, as per Attachment C of the prudential standard (snapshot below); all else being equal, the capital required against falling prices of real estate security also went up due to increase in LVR which in turn enhanced the quantum of assigned risk weights and hence the overall size of the risk weighted assets of mortgage portfolio. Consequently, the change in minimum capital requirements resulting from revalued properties had a tendency to act in a pro-cyclical manner. That is, the required capital could increase exponentially during downward movement of real-estate prices and vice-versa. While lower capital required during the period of economic expansions could be countered by building up of mandatory counter-cyclical capital buffer; the increase in minimum required capital during economic contraction could severely hamper banks’ ability to lend and thereby pushing the economy further down the trough.

Note that banks, at their own discretion, can still revalue the prices of underlying property to make adjustments to their portfolio and required capital, however, the mandatory requirement under APS 112 from capital calculation perspective has been removed by APRA to allow relief to ADIs struggling to allocate adequate resources in facilitating their business operations.

Commercial property revaluation requirements

In its announcement dated, July 24th 2020, APRA has temporarily removed the requirement for Basel IRB compliant banks to revalue the collateralised commercial properties on an annual basis. According to APS 113 Capital Adequacy: Internal Ratings based Approach to Credit Risk, the residential and commercial real estate can qualify as eligible collateral, as long as the repayment of the loans are not solely dependent upon the performance or cash flow of the underlying property. Earlier, as per the APRA mandate under APS 113 and APS 220 Credit Risk Management, banks were required to revalue the underlying security, at least, on an annual basis.

The revaluation requirement, as clarified by APRA, has only been deferred to temporarily relieve banks of their obligation due to increased operational difficulties in obtaining property valuations and also the strain such exercises can exert on the banks’ resources. And hence, the regulator has set the deferral deadline of 31st March 2021. After which the lenders are expected to cover the backlog of revaluations over a period of six months, ending September 2021. This would ensure that there only lapses a limited period of time before banks’ commercial real-estate exposures would again start reflecting the risks accurately, thus allowing banks to allocate adequate capital against their portfolios.

Note that the deferral decision only covers the claims secured by commercial properties that do not fall under Specialised Lending arrangements i.e. the arrangement under which, repayments of loans must entirely be covered by the cash flow generated by the underlying (property). Hence, specialised lending asset class: IPRE (Income Producing Real Estate), where the claims against real-estate security can only be repaid by the cash generated from the underlying, remains out of the purview of APRA’s announcement.

Impact on banks and their operational efficiency

Considering the critical nature of the mandatory revaluation requirement, APRA has removed the condition with immediate effect ensuring banks can utilise their operational resources and capital reserves to continue lending and thereby supporting the nation’s economy in the face of the crisis. The move will therefore help the industry in channelling its operational resources towards providing support to their customers who are experiencing hardships. Banks have already been experiencing bottlenecks on the operational front to comply with APRA’s mandate on reviewing the borrowers’ repayment capacity at the 3 month check-in point since their loan deferral arrangement was initiated. The ADIs, as a result, have welcomed the regulators’ decision to remove the condition to revalue residential properties under such demanding circumstances that have been putting constant strain on their available resources.

Although, the removal of revaluation requirement as a measure of support, would mean that banks, for now, will be less impacted by volatility in the prices of residential and commercial properties; APRA has also been very clear that adequate steps must be taken by the lenders in order to ensure that their mortgage lending portfolio is appropriately assessed for any systemic or specific risks arising due to COVID-19 situation or otherwise. As a result, revaluations must still be undertaken where necessary to address risks that may harm the bank’s solvency and sustainability. This includes but is not limited to addressing the additional capital needs for already defaulted loans or adhering to APS 220 in actively dealing with the accounts where banks have become aware of the substantially deteriorated credit quality.

The regulator has also made it clear that the relaxation in property revaluation is only applicable to existing loans and does not automatically extend to any new loans. Therefore, banks must ensure that appropriate valuations are undertaken and brought into consideration while making new lending decisions.

With the ongoing uncertainty and the lack of visibility on what lies beyond the COVID-19 pandemic, APRA’s constant release of clarifications, through FAQ publications as well as letters to the ADIs, clarifying how the various relief initiatives need to be implemented, has helped banks maintain a fine balance between assisting customers while also adhering to their regulatory obligations. The decision to remove mandatory mortgage revaluation requirement will considerably reduce bank’s burden on both operational as well as capital management front and therefore, has been viewed as an encouraging step in the right direction and will definitely facilitate banks in their ongoing efforts of supporting the customers through this period of pandemic-stricken uncertainty.

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