The Australian Prudential Regulation Authority
(APRA) has shed light upon its stance on interest rate buffers suggesting that authorised deposit-taking institutions (ADIs) use a buffer of at least two percentage points.
This suggestion was released yesterday (24 October) in an updated version of Prudential Practice Guide APG 223 Residential Mortgage Lending
“Good practice would apply a buffer over the loan’s interest rate to assess the serviceability of the borrower (interest rate buffer). This approach would seek to ensure that potential increases in interest rates do not adversely impact on a borrower’s capacity to repay a loan,” the APRA report states.
“The buffer would reflect the potential for interest rates to change over several years. APRA expects that ADI serviceability policies should incorporate an interest rate buffer of at least two percentage points. A prudent ADI would use a buffer comfortably above this.”
While this is not a new direction for APRA, the revisions effectively crystallise the authority’s stance on these buffers, Martin North
, principal and founder of Digital Finance Analytics (DFA), told Australian Broker
“There’s not much that’s necessarily new because everybody knew that this was how they were thinking,” he said. “What it really does is crystallises what they view as an acceptable level of interest rate buffer.”
Another crucial aspect of the APRA revisions relates to serviceability, North continued.
“They’ve made some strong points about not relying on the Henderson Poverty Index (HPI) or other quasi tests. You’ve actually got to do the work. You’ve actually got to understand household income and expenditure and variability to suit the mortgage.”
Although these types of indices are used often, they may not appropriately indicate a borrower’s actual living expenses, APRA wrote in their report.
“Reliance solely on these indices generally would therefore not meet APRA’s requirements for sound risk management,” the association said.
Instead, the authority has recommended using the greater of a borrower’s declared living expenses or an appropriately scaled version of the Household Expenditure Measure (HEM) or HPI.
“That is, if the HEM or HPI is used, a prudent ADI would apply a margin linked to the borrower’s income to the relevant index. In addition, an ADI would update these indices in loan calculators on a frequent basis, or at least in line with published updates of these indices (typically quarterly).
“Prudent practice is to include a reasonable estimate of housing costs even if a borrower who intends to rely on rental property income to service the loan does not currently report any personal housing expenses (for example, due to living arrangements with friends or relatives).”
One interesting aspect, North said, was that APRA had chosen not to take these prudential requirements even further.
“If I were in their shoes, I would be more worried about the risk in the books than they are,” he told Australian Broker
. “So essentially while they’ve crystallised a lot of things and they’ve made a few changes, to my mind they haven’t fundamentally removed the risk.”
APRA has invited submissions to all proposed amendments by 19 December and interested parties can offer suggestions through the regulator's website. The revised guidance will be finalised in the first quarter of 2017.
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