Optimising Return on Capital under BASEL III/IV

In December 2020, APRA released for consultation full drafts of Prudential Standard APS 110 Capital Adequacy, Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk and Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk. Introduction of these revised standards marks a major milestone in APRA’s implementation of BASEL III/IV revisions in Australia. The proposed standards will come into effect from 1st January 2023.

The proposed revisions to the prudential standards will have a significant impact on the banking industry at large.

Entities must prepare early for this change and take a strategic approach to these regulatory reforms looking at both impacts to their business model as well as internal operations.

APRA's intent is to enhance competition, and create a more level playing field in the banking industry through the revisions to the capital framework. Entities will need to review their product and pricing strategy to ensure its portfolio mix - of both the back book and the front book - is optimally balanced to maximise the return on its capital.

In this article, we will focus on the residential mortgage lending portfolio.

The Australian lending market is heavily concentrated towards residential mortgage lending. While this portfolio has managed to weather the storm of the pandemic pretty well, in part due to government relief schemes such as repayment deferral, APRA continues to focus on this asset class with increased data collections from the industry in the recent months. (For more information on APRA Residential Mortgage information requirements, you can watch our on-demand webinar here).

Through the revision to APS-112 and APS-113, APRA is introducing a more granular breakdown of risk-weights in the residential mortgage exposure class, making the capital requirements more risk-sensitive:

The revised rules have a direct impact on the return on risk adjusted regulatory capital. Return on risk adjusted regulatory capital is the profit measured against the capital required to be held by the organisation; a key indicator to measure product and portfolio performance. Banks will need to take into account the impacts of the new capital requirements across their portfolio when defining their business and pricing strategy.

Below is an illustrative example of the impact on return on regulatory capital of different residential mortgage scenarios under the BASEL IV standardised approach.

The example above illustrates the significant decrease in return on capital for non-standard loans compared to a standard loan (assuming the same interest margin). Similarly we can observe the impact of loan purpose (Owner Occupied vs Investment) on the profitability of the contract. Each factor in the Risk Weight Assignment decision tree has a direct impact on the ROE of the contract. As all banks will be looking to optimise their ROE under the same rules, competitive pressures will build in the LVR bands that are most attractive from a risk-adjusted return on capital perspective. We can already observe LVR-based pricing in the market using the more granular LVR banding under Basel IV.

In line with APRA’s intention of increasing risk sensitivity, the criteria for defining non-standard loan has widened with the revised standard. Some examples of non-standard loans are

• Reverse mortgages

• Loans to Self-managed super funds

• Loans with an Interest only period > 5 years

• Equity line of credit

• Bridging finance

• Loans that do not fulfil the criteria for serviceability, enforceability, and valuation as outlined in the prudential standard

Considering the above, there will be more products attracting the non-standard risk weights which will need to be reflected in pricing. This may result in these products becoming less or non-competitive for banks compared to non-ADI lenders.

Given the increased granularity of data requirements to allocate the more beneficial risk weights and the complexity of legacy loan origination and core banking systems, organisations should not under-estimate the effort required to implement the system and technology changes required to meet the regulatory compliance deadline.

Conclusion

Entities must prepare early for both the operational impact due to BASEL IV (i.e. impact to process and systems required to meet the regulatory requirements) as well as for the business impact. Banks need to consider the impact of return on regulatory capital in the product pricing strategy to optimise the overall profitability of a product.

With the implementation due date just over 18 months away - ADI's must be well-progressed in their project planning and design phase.

If you would like to know more about BASEL IV and its impacts, please Contact Us. We also run regular training sessions on BASEL IV, you can register here.

RegCentric offers holistic services and solutions for BASEL IV that considers both the business and operational impacts. To know more about our offerings, click here.