The case for low mortgage risk weights

I have touched on residential mortgage risk weights a couple of times in this blog, most recently in a post on the Dutch proposal to increase residential mortgage RW. This post explores the question of why residential mortgage RW under the Internal Rating Based (IRB) approach can be so low. More importantly, can we trust these very low risk weights (and the banks generating them) or is this yet more evidence that the IRB approach is an unreliable foundation for measuring bank capital requirements? It also touches on some of the issues we encounter in cross border comparisons of capital strength.

It has to be said at this point that IRB modelling is not an area where I claim deep expertise and I would welcome comments and input from people who do have this subject matter expertise. However, it is an important issue given the role that residential mortgage lending plays both in the economy as a whole. If nothing else, the post will at least help me get my thoughts on these questions into some kind of order and potentially invite comments that set me straight if I have got anything wrong. Notwithstanding the importance of the issue, this post is pretty technical so likely only of interest if you want to dig into the detailed mechanics of the IRB approach.

Recapping on the Dutch proposal to increase mortgage risk weights

First a recap on what the Dutch bank supervisor proposes to do. Residential mortgage RW in the Netherlands are amongst the lowest observed in Europe

DNB:Financial Stability Report Autumn 2019


The Dutch banks can of course cite reasons why this is justified but, in order to improve the resilience of the banking system, the Dutch banking supervisor proposes to introduce a floor set at 12% on how low the RW can be. The 12% floor applies to loans with a dynamic Loan to Value (LTV) of 55% or lower. The RW floor increases progressively as the LTV increases reaching a maximum of 45% for loans with a LTV of 100% or more. DNB expects the application of the measure to increase the average risk weights of Dutch IRB banks by 3-4 percentage points (from 11% to 14%-15%).

What drives the low end of the IRB Mortgage RW?

None of the discussion set out below is in any way intended to challenge bank supervisors seeking to apply limits to the low mortgage risk weights we observe being generated by the internal models developed by IRB banks. That is a whole separate discussion but the move to higher RW on these exposures broadly makes sense to me, not only for reasons of systemic resilience, but also with regard to the way that it reduces the disparity between IRB RW and those the standardised banks are required to operate against. It is however useful to understand what is driving the model outcomes before citing them as evidence of banks gaming the system.

This extract from Westpac’s September 2019 Pillar 3 Report shows a weighted average RW of 24% with individual segments ranging from 6% to 137%. The CBA Pillar 3 shows a similar pattern (RW range from 4.4% to 173.5%). I won’t get too much into the technical detail here but the effective IRB RW is higher when you factor in Regulatory Expected Loss. The impact on the RW in the table below is roughly 16% on average (I divide REL by .08 to translate it to an RWA equivalent and then divide by RWA) but this effect only becomes material for the 26% and higher RW bands).

Source: Westpac Pillar 3 Report – Sep 2019

I am very happy to stand corrected on the facts but my understanding is that the 6% and 14% RW bands in the table above capture “seasoned” portions of the loan portfolio where the Loan to Valuation (LVR) ratio has declined substantially from the circa 80% plus typically observed in newly originated loans. The declining LVR is of course a natural outcome for Principal and Interest loans which is the kind traditional prudent banking prefers.

What at face value looks like an incredibly thin capital requirement starts to make more sense when you consider the fact that the borrowers in these segments have demonstrated their capacity to service their loans and, perhaps more importantly, have built up a substantial pool of their own equity in the property that will absorb very substantial declines in property prices before the bank is likely to face a loss.

Australian owner occupied borrowers have an incentive to repay as fast as possible because their interest is not tax deductible (making the mortgage repayment one of the best applications of surplus cash) and they typically borrow on a floating rate basis. The natural amortisation of loan principal is also likely to have been accelerated by the progressive decline in interest rates in recent years which has seen a large share of borrowers apply the interest saving to higher principal repayments.

Comparing Dutch and Australian Mortgage Risk Weights

Looking at the Dutch RW provides some perspective on the mortgage RW of the Australian IRB banks and the initiatives APRA has implemented to increase them. I will only scratch the surface of this topic but it is interesting none the less to compare the 14-15% average RW the Dutch IRB banks will be required to hold with the 25% average RW that Australian IRB banks must hold.

The Dutch banks cite a favourable legal system that supports low LGD by allowing them to quickly realise their security on defaulted loans. That is a sound argument when you are comparing to a jurisdiction where it can take up to 3 years for a bank to gain access to the security underpinning a defaulted loan. That said, the Australian banks can make a similar argument so that does not look like a definitive factor in favour of lower Dutch RW.

The Australian LTV is based on the amortised value of the loan compared to the value of the property at the time the loan was originated. The Dutch LTV as I understand it seem to includes the updated value of the property as the loan ages. Again I don’t see anything in the Dutch system that renders their residential mortgage lending fundamentally less risky than the Australian residential mortgage.

The other positive factor cited by the Dutch banks is the tax deductibility of mortgage interest which applies even where the property is owner occupied. In Australia, interest on loans for owner occupied property is not tax deductible. The Dutch banks argue that the tax deduction on interest enhances the capacity of the borrower to service a loan but my guess is that this advantage is highly likely to be translated into higher borrowing capacity and hence higher property prices so it is not clear that there is a net improvement in the capacity to repay the loan.

I obviously only have a very rudimentary understanding of Dutch tax rules but my understanding is that tax deductibility of interest expense in some European jurisdictions is quid pro quo for including the implied value of rental on the property in the owner’s taxable income. If that is the case then it looks like tax deductibility of interest is a zero sum game from the lending bank perspective. Qualified by the caveats above, I will provisionally take the side of the Australian mortgage in this comparison. It seems equally likely to me that the the absence of a tax deduction creates an incentive for Australian borrowers to repay their loan as quickly as possible and hence for a greater proportion of loans outstanding to move into the low LVR bands that insulate the bank from the risk of loss. There does not seem to be the same incentive in the Dutch system, especially where the loans are fixed rate.

Summing up

The purpose of this post was mostly to help me think through the questions posed in the introduction. If you are still reading at this point then I fear you (like I) take bank capital questions way too seriously.

There are two main points I have attempted to explore and stake out a position on:

  • What at face value looks like an incredibly thin capital requirement for some parts of the residential mortgage portfolio start to make more sense when you consider the fact that the borrowers in these segments have demonstrated their capacity to service their loans and have built up a substantial pool of their own equity in the property that will absorb very substantial declines in property prices before the bank is likely to face a loss.
  • Cross border comparisons of capital are complicated but mortgages are a big part of the Australian bank risk profile and I still feel like they stack up relatively well in comparison to other jurisdictions that cite structural reasons why theirs are low risk.

If you have some evidence that contradicts what I have outlined above then by all means please let me know what I am missing.

Tony

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

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