APRA increases banks’ loan serviceability expectations to counter rising risks in home lending

The Australian Prudential Regulation Authority (APRA) has today increased the minimum interest rate buffer it expects banks to use when assessing the serviceability of home loan applications.

In a letter to authorised deposit-taking institutions (ADIs), APRA has told lenders it expects they will assess new borrowers’ ability to meet their loan repayments at an interest rate that is at least 3.0 percentage points above the loan product rate. This compares to a buffer of 2.5 percentage points that is commonly used by ADIs today.¹

APRA’s decision, which reflects growing financial stability risks from ADIs’ residential mortgage lending, is supported by other members of the Council of Financial Regulators (CFR), comprising the Reserve Bank of Australia, the Treasury and the Australian Securities and Investments Commission. In determining its course of action, APRA also consulted with the Australian Competition and Consumer Commission.

APRA Chair Wayne Byres said this is a targeted and judicious action designed to reinforce the stability of the financial system. 

“In taking action, APRA is focused on ensuring the financial system remains safe, and that banks are lending to borrowers who can afford the level of debt they are taking on – both today and into the future. 

“While the banking system is well capitalised and lending standards overall have held up, increases in the share of heavily indebted borrowers, and leverage in the household sector more broadly, mean that medium-term risks to financial stability are building.

“More than one in five new loans approved in the June quarter were at more than six times the borrowers’ income, and at an aggregate level the expectation is that housing credit growth will run ahead of household income growth in the period ahead. With the economy expected to bounce back as lockdowns begin to be lifted around the country, the balance of risks is such that stronger serviceability standards are warranted,” Mr Byres said.

Together with other members of the CFR, APRA will continue to closely monitor risks in residential mortgage lending, and can take further steps if necessary. 

A copy of today’s letter to ADIs is available on the APRA website at: Strengthening residential mortgage lending assessments.

Additional background information 

What risks are APRA responding to?

The current environment of very low interest rates and rapidly rising house prices means that pressures on household indebtedness are likely to remain heightened. Household credit growth is expected to exceed household income growth in the period ahead, further adding to concerns around overall household indebtedness.  

A more highly indebted household sector presents risks to future financial stability. Highly indebted borrowers are likely to be less resilient to future shocks, such as from rising interest rates or a reduction in income. Macroeconomic impacts can be material if such risks materialise, with international studies suggesting highly indebted households are more likely to reduce their consumption in the event of a shock, amplifying the impacts of any economic downturn.

Why is APRA acting now?

Housing credit growth is increasingly being driven by lending to more marginal and highly indebted borrowers. In the June quarter 2021, for example, more than 20 per cent of ADIs’ new lending was to borrowers that had borrowed more than 6 times their pre-tax income. This is high by both historical and international standards – and without action, the share is likely to increase further. 

While these trends have been emerging in the past couple of quarters, APRA and other members of the CFR have been wary of intervening while large sections of Australia were in lockdown, and many sections of the community were under economic stress. However, with lockdowns soon to be lifted, and expectations that the economy will bounce back, APRA considers the balance of risks has shifted such that a timely adjustment to serviceability standards is now warranted. This step is supported by the other agencies of the CFR.

Why did APRA raise the interest rate buffer rather than, for example, increasing the interest rate floor lenders also use, or imposing limits on high debt-to-income lending?

In the current circumstances, APRA’s view is the interest rate serviceability buffer is the most appropriate tool to use. It acts as a cap on leverage, is relatively easy to implement, and will not have any impact on mortgage interest rates. 

APRA chose not to use an interest rate floor as a means of achieving a similar effect. It would also be relatively easy to implement and would not impact mortgage pricing, but would be more restrictive on owner-occupiers and have a lesser impact on investors. A limit on the extent of high debt-to-income borrowing would precisely target more highly indebted borrowers. Compared to raising the interest rate buffer, however, limits would be more operationally complex to deploy consistently, and may lead to higher interest rates for some borrowers as lenders effectively seek to ration credit to this cohort.

On balance, it was considered raising the interest rate buffer was the preferred response on this occasion. It does not rule out that the other measures might be used in the future.

Which borrowers are likely to be impacted?

The increase in the interest rate buffer applies to all new borrowers. 

Across borrower cohorts, the impact of a higher serviceability buffer is likely to be larger for investors than owner-occupiers. This is because, on average, investors tend to borrow at higher levels of leverage and may have other existing debts (to which the buffer would also be applied). On the other hand, first home buyers tend to be under-represented as a share of borrowers borrowing a high multiple of their income as they tend to be more constrained by the size of their deposit. 

What impact does APRA expect to have?

Putting aside the impact from other aspects of serviceability assessment, a 50 basis points increase in the serviceability buffer will reduce maximum borrowing capacity for the typical borrower by around 5 per cent. 

Given some borrowers are already constrained by the floor rates that lenders use, and that many borrowers do not borrow at their maximum capacity, the overall impact on aggregate housing credit growth flowing from this is expected to be fairly modest.

In taking action in relation to mortgage lending standards, APRA is not seeking to target the level of housing prices. Rather, APRA’s objective is to ensure that mortgage lending is conducted on a prudent basis, and that borrowers are well-equipped to service their debts under a range of scenarios.  

The increased buffer is being expected of ADIs. Why isn’t APRA announcing measures for non-ADIs? 

Under Part IIB of the Banking Act 1959, APRA can only make rules in relation to non-ADI lenders if those lenders are considered to materially contribute to risks of instability in the Australian financial system. 

APRA is closely monitoring trends in non-ADI lending, but does not consider there to be a basis for a policy response in relation to non-ADI lenders at this point in time. Non-ADI lenders currently account for a quite small share (<5 per cent) of total housing lending. 

Footnotes

¹ APRA’s existing guidance in APG 223 Residential Mortgage Lending states: “a prudent ADI’s serviceability policies would incorporate an interest rate buffer of at least two and half percentage points.” APG 223 also states: “A prudent ADI would regularly review its interest rate buffers and floors … to ascertain whether the current buffer and floor is appropriate …” (emphasis added). Most ADIs have set their buffers at the minimum expectation, and few have reviewed the level despite the changing risk environment.