This morning the Unconventional Economist posted an excellent article which points out that both credit rating agencies and our ADI regulator, APRA, are concerned about Australian banks’ lending practices for residential mortgages. In short, in the banks’ drive for both mortgage market share and to keep the credit machine churning there is concern that banks are or may be taking on too much risk.
For this commentator, the actions of APRA and even the credit rating agencies are extraordinary. Never, in the history of the Australian financial system since deregulation has the public and private regulators warned the industry as a whole about lending standards on a single asset class ie residential mortgages. But what I find equally extraordinary about these public stick raising exercises, is that nothing is put forward as to solutions or penalties for non compliance on what is a very general directive.
APRA and the credit rating agencies differ in their market functions but both are regulators of sorts. Let’s look at APRA first.
APRA must have very strong concerns to write to the Chairpersons of every ADI on underwriting standards for residential mortgages. But what are these concerns based on? Are they forming opinions on bank product advertising or information captured through the bank reporting process? Or is it that product advertising does not seem to match with the reporting? Or even more cynically, is the APRA letter a simple exercise in bureaucratic arse covering?
If APRA did have accurate information on the risks that each ADI was taking in the residential property market then matters on excessive underwriting risks would be dealt with at the individual organisation level. In these circumstances, APRA could apply higher capital requirements for the mortgages adjudged to be high risk. Why has this not been done?
As I have posted on a number of occasions, capital allocation against mortgages and rehypothication is at the heart of the credit expansion for residential mortgages. Capital allocated by Australia’s major banks against residential mortgages is not sufficient to reflect the risk. At less than 2% capital across the whole mortgage book I think keeps the issue in everyone’s face.
Australia’s major banks with about 90% of the market use an IRB approach under Basel II to calculate the capital required for residential mortgages. Under Pillar 3 to Basel II the banks must provide enough information to be able to in effect reverse engineer their IRB methodologies. They don’t and we can’t, obviously neither can APRA. The lack of transparency on data and methodology is a very serious breach by our banks of international reporting standards.
When capital is cheap via reducing the capital requirement, credit can expand exponentially. In order to reduce risky lending (including systemic risk), the risk needs to be recognized in the amount of capital allocated by the ADI. The Basel II framework for calculating risk weighted assets plus the new Basel III for recognizing systemic risks are meant to deliver the appropriate amount of capital to be allocated for the risk taken on by Australia’s ADIs.
In summary, Australia (along with the rest of the world) theoretically has the system to ensure that undue risk taking by banks through residential mortgage lending does not occur, or at least does not impose a systemic risk. The power is in the hands of APRA, so what was the extraordinary letter about residential mortgages to ADI Chairpersons all about? As a believer of the politico-housing complex, I’d say nothing more than window dressing and will not change a thing. Action must be taken to more accurately calculate capital requirements to reflect the risk, to ensure that risky mortgages are not viable for the banks.
The credit rating agencies suffer from the same type of malice. CRAs are a pseudo private regulator with the power to punish a borrower for risk taking by lowering a bank’s credit rating and thereby increasing the cost and difficulty of borrowing. Moody’s did take action to reduce the major banks’ ratings some months ago which undoubtedly had the effect outlined if only marginally. Nevertheless, in order to provide their opinions, CRAs do require information on their subject, which is mostly residential mortgages, if the subject is Australia’s banks.
For CRAs the information drought is aligned with that of APRA and the public. There is little transparency on the risk in residential mortgages on banks’ balance sheets. CRAs only give opinions on credit and they can give opinions on credit ratings with whatever information they have at hand. However anyone relying on those ratings should be made very aware of the lack of information and therefore the strength of the rating opinion. CRAs could refuse to give opinions or severely penalize for the lack of information and having to rely on banks’ representations, but that is not a very good business decision for them.
Both APRA and the CRAs publicly highlighting what are probably excessive risk taking by our banks in residential mortgages is a step of acknowledgement. It is not going to have any real effect without action and that action must cost or punish those organizations with excessive risks.