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By Gareth Vaughan
In a move that won't thrill the country's big four Australian owned banks, the Reserve Bank wants to fully align the way they categorise loan-to-value ratios (LVRs) on residential mortgage lending with the way the rest of the country's banks do it.
This means personal loans and credit card debts, when secured by a property, would have to be included in LVR calculations by the big four as they are by the other banks. The move could potentially see the percentage of the big four banks' residential mortgages classed as high LVR loans increase.
Other areas also coming under Reserve Bank scrutiny include how banks calculate LVRs when more than one property is used as security for a loan, or when a residential property has more than one buyer, and how banks treat loans to owners of lifestyle blocks. The Reserve Bank is also casting an eye on how banks treat lending exposure to properties used for both residential and commercial purposes, and residential properties that include multiple dwellings.
And the Reserve Bank says it also wants to ensure valuation policy isn't affected by "current market conditions" by making sure banks' valuations on residential properties they loan against stick to the valuation at the time a residential mortgage loan is originated.
In a consultation paper entitled Review of bank capital adequacy requirements for housing loans and internal models processes the Reserve Bank says it wants all claims secured by way of a first ranking mortgage to be included in how banks calculate their LVRs.
The big four banks - ANZ, ASB, BNZ and Westpac - use what's known as the internal model, where they build their own models to calculate their regulatory capital requirements and must then get them approved by the Reserve Bank. All other banks, including Kiwibank, run what's known as the standardised approach where the Reserve Bank prescribes their regulatory capital requirements. Allowing the big four to run the internal model approach is in line with international guidance from the Basel Committee on Banking Supervision.
The standardised approach and the internal model approach don't currently contain the same definition of the loan amount, or the numerator in the LVR equation, the Reserve Bank says.
The standardised approach states the “loan value is the total amount, as at balance date, of: (i) all claims secured by way of first ranking mortgage over the residential property; and (ii) all undrawn commitments to the borrower that when drawn down will be secured by way of first ranking mortgage over the residential property.”
The internal model approach says the “LVR is defined as the current loan balance …. . The current loan balance includes the exposure at default amount of any off-balance sheet exposures…”
The Reserve Bank says as much as possible all banks should be subject to the same definition of the loan amount when calculating LVRs.
"The current situation where one group of banks includes all claims secured by the residential property, whereas the other group does not, leads to the calculation of LVRs that are inconsistent and therefore lack comparability across both groups of banks," the Reserve Bank says.
"The first definition (standardised approach) clearly includes all claims secured by way of first ranking mortgage, while the second definition (internal model) does not state so explicitly. Although the intention has always been for both groups of banks to calculate their LVRs on an equal basis as far as that is possible, (the internal model approach) may be interpreted as not including other claims secured by the residential property."
"It is the Reserve Bank’s understanding that this is how internal model banks have interpreted the definition. Standardised banks, on the other hand, currently add all claims to the loan amount," the consultation paper adds.
'All obligation mortgages' bringing in personal loans & credit cards
The paper adds that most mortgages are "all obligations" mortgages, which generally means if a customer defaults on any other loan he or she has with the bank, for example a personal loan or a credit card debt, the bank can exercise the security it holds over the residential property and sell the house to recoup what it's owed through the outstanding credit card or personal loan balance.
"In practice, a bank’s incentive to take this measure will depend on the size of the defaulted loan, and a more common scenario might be that the outstanding balance is simply added to the mortgage loan," the Reserve Bank says. "This link from other loans, such as credit cards or personal loans, to the residential property suggests that all other claims should be included and that the definition currently in the standardised approach should also apply to the internal model banks."
Ensuring an LVR restriction is effective; Change could lead to higher LVRs
The treatment of "all other claims in the LVR calculation" is important for its incoming LVR restrictions, the Reserve Bank points out.
"Excluding them from the LVR calculation leads to lower average LVRs and could impact the effectiveness of an LVR restriction, particularly if borrowers became tempted to use their credit card facilities or personal loans to raise or increase the deposit needed to obtain a mortgage. This would be an extremely expensive approach to take, since these other loans are typically more expensive to service than a mortgage loan, but it could diminish the effectiveness of an LVR restriction."
Thus, at this stage, the Reserve Bank says it believes all claims legally secured by a residential property should be included in the loan amount when an LVR is calculated.
"Although we are cognisant of the argument that the treatment of the lending as an unsecured loan means that it already incurs a higher capital charge, ensuring that an LVR restriction is effective requires the current standardised approach definition to be extended to internal model banks."
To the extent internal model banks don't include all claims and undrawn commitments secured by way of first-ranking mortgage over the residential property, this change could lead to higher LVRs and therefore increase risk weights on residential mortgage loans, the Reserve Bank points out.
"The Reserve Bank is interested in gaining a better understanding of the capital impact this might have and the implications of changing IT systems to implement the proposed new definition."
Meanwhile, the Reserve Bank says it also wants to ensure valuation policy isn't affected by "current market conditions." Therefore it proposes the following requirement; "Property value is the value of the residential property determined under a bank's residential property valuation policy when a residential mortgage loan is originated."
What to do when there's more than one buyer or more than one property used as security?
The Reserve Bank also wants to "deepen its understanding" of how banks calculate LVRs when more than one property is used as security for a loan, or when a residential property has more than one buyer, as it looks to set minimum rules, - if necessary.
And there could be changes afoot for how life style blocks are treated for capital adequacy purposes. Where the borrower is predominantly reliant on income generated by the property, the farm, to make loan payments, it shouldn't be treated as residential property for capital adequacy purposes, the Reserve Bank argues.
And residential properties with multiple dwellings are also coming under scrutiny with two options cited.
"The first option is a solution similar to what we propose for lifestyle blocks. That is, if the borrower is dependent on the income generated by the residential property dwellings to make principal and interest repayments, then the loan is treated as a business rather than a residential mortgage loan," says the Reserve Bank.
"The second option is to set a limit on the number of dwellings that can be included in a residential mortgage loan. Under this option, if there are more than four dwellings used as security by the borrower, then the exposure(s) is business rather than residential mortgage. This second option is intended as a more pragmatic solution that recognises some borrowers invest in a second, third or fourth house while continuing in their usual occupation, but as some point (which we propose to be dwelling number five) the investment becomes a business rather than a supplementary source of income. We anticipate this definition would be easier for banks to administer than option one."
Submissions on the proposals are sought by October 25. The Reserve Bank says it'll then analyse feedback and publish a summary of submissions and updated capital requirement details with new conditions of bank registration.
"It is currently envisaged that the new requirements will take effect in Q1 (the first quarter) of 2014, subject to feedback on the time required for (bank) IT system changes."
From October 1 all banks must restrict new residential mortgage lending at LVRs of over 80% to no more than 10% of the dollar value of their new housing lending flows. Allowing for exemptions the Reserve Bank estimates this 10% "speed limit" will effectively limit the banks’ high-LVR lending flows to about 15% of their new residential lending, versus the estimated 30% they've been doing in recent months.
Banks do, however, have six months to phase in the new restrictions meaning the first test of the LVR restrictions will effectively come at the end of March next year.