risk weights – From the outside

Risk weights, capital and competition in the residential mortgage market

I have posted a couple of time on a Discussion Paper published by The Australian Prudential Regulation Authority (APRA) in late 2020 (“A more flexible and resilient capital framework for ADIs”) setting out how it proposes to wrap up a number of prior consultations on a variety of aspects of ADI (authorised deposit-taking institution) capital reform in Australia (see here, here and here).

This post looks at the changes to mortgage risk weights (RW) outlined in the paper and attempts to explore (with limited information) what practical impact they might have. The short version is:

In very broad terms, APRA is seeking to assign higher RW to residential mortgages it deems to be relatively more risky but also lower RW for those it considers less risky
In pursuit of this objective, APRA has proposed two new categories of residential mortgage defined by the loan purpose (i.e. “Owner occupier loans paying principal and interest” and “Other Residential” including loans for investment and all interest only loans upon to 5 years tenor)
“Standard residential” mortgages see increased sensitivity of RW to Loan Valuation Ratios (LVR) while “Non-Standard residential mortgages face a 100% RW across the board irrespective of their LVR
Increased sensitivity to LVR is achieved via a simple recalibration of RW in the Standardised approach and via a reduction in the minimum Loss Given Default (LGD) applied in the IRB approach
The reduced LGD floor also indirectly allows Lenders’ Mortgage Insurance (LMI) to be recognised in the IRB models thereby creating greater alignment with the Standardised approach which directly recognises the value of LMI via a roughly 20% discount in the RW assigned to high LVR loans
With respect to the impact of RW on competition, APRA argues both that the existing difference between the Standardised and IRB approach is overstated and that the proposed changes will further assist the Standardised ADIs to compete.

APRA is not tinkering at the margins – there are quite substantial adjustments to RWs for both Standardised and IRB ADIs. That is the short version, read on if you want (or need) to dig into the detail.

Improved risk sensitivity cuts both ways

I have looked at “improved risk sensitivity” part of the overall package previously but, with the benefit of hindsight, possibly focussed too much on the expected reduction in aggregate risk weighted assets (RWA) coupled with the expansion of the capital buffers.

It is true that RWA overall are expected to decline – APRA estimated that the overall impact of the proposed revisions would be to reduce average RWAs for IRB ADIs by 10% and by 7% for Standardised ADIs. This obviously translates into higher reported capital ratios which is the impact I initially focussed on. Risk sensitivity however works both ways and a subsequent reading of the paper highlighted (for me at least) the equally important areas in which RW are proposed to increase – residential mortgages in particular.

APRA’s proposed revised approach to residential mortgage risk

APRA was very clear that one of their overall policy objectives is to “further strengthen capital requirements for residential mortgage exposures to reflect risks posed by ADIs’ structural concentration in this asset class“. In pursuit of this objective, APRA is targeting investment and interest only lending in particular but also high LVR lending in general.

In pursuit of these aims, the existing “standard residential mortgage” category is to be further broken down into 1) “Owner Occupied Principal and Interest” loans (OP&I) and 2) “Other Residential”. The “non-standard residential mortgages category (i.e. loans that do not conform to the credit risk origination standards prescribed by APRA) is to be expanded to include interest only loans with a tenor greater than 5 years.

So we get three broad vertical categories of residential mortgage riskiness

Low Risk	Higher risk	Highest risk
Owner Occupied Principal & Interest	– Interest Only (term <5yrs) – Investor mortgage loans – Loans to SME secured by residential property	– Interest Only (term >5yrs) – “Non-standard” mortgages

Note: RW are reduced where loans are covered by LMI but only for Standard Residential Mortgages and only where LVR is above 80%. To be classified as a “standard” mortgage a loan must satisfy minimum enforceability, serviceability and valuation criteria prescribed by APRA.

Impact on the Standardised ADIs

The table below compares the current RWs under the standardised approach (Source: Table 2 of APS 112 – Attachment C) with the indicative RWs APRA has proposed in the December 2020 Discussion Paper (Source: Table 2).

Residential Mortgage Risk Weights – Current and Proposed for Standardised ADIs

The RW within each of the three categories are being substantially recalibrated – APRA is not tinkering at the edges.

Increased sensitivity to LVR translates to higher RW applying in the upper LVR range but also reductions in the lower LVR range.
The increases in the high LVR ranges are particularly marked in the new “Other Residential” category (30-40% increases) but the reductions in the low LVR range are equally material (14-42%) for the OP&I category
Lender’s Mortgage Insurance (LMI) continues to be recognised at the high end of the LVR range (i.e. 80% plus) but the RW assigned to loans with LMI are higher than is currently applied.
In case anyone was wondering how APRA really felt about non-standard residential mortgages they receive a 100% RW irrespective of their LVR.

Risk weights under the Internal Ratings Based (IRB) Approach

It is a lot harder to figure out exactly what will happen to IRB RW but the starting point is the two new multipliers being added to the IRB RW formula. The OP&I multiplier adds 40% to RW while the Other Residential category gets a 60% loading. These replace the existing “correlation adjustment” factor that was applied to increase the average IRB RW for residential mortgages to a minimum of 25% as part of the effort to reduce the difference between IRB and Standardised capital requirements.

In aggregate, my guess is that the impacts are roughly neutral in the case of the “Other Residential” loans subject to the 60% loading and a net reduction for the OP&I category. The substitution of flat scalars for the existing correlation adjustment does however create some impacts at the upper and lower ends of the PD scale. Under the correlation approach, my understanding is that low PD exposures increase by proportionately more than the average impact and high PD exposures by less. Under scalar approach, the RW are increased by the same percentage across the PD scale. I am not sure how material the impacts are but mention them for completeness. The flat scalars certainly have the advantage of simplicity and transparency but mostly they establish a RW differential between the two types of standard residential mortgage.

The reduced LGD floor is a significant change because it offers the potential for RW to be halved for exposures that can take the maximum advantage. Consistent with the revised standardised RW, I assume that this will be at the lower end of the LVR range. IRB ADIs will have to work for this benefit however as APRA will first have to approve their LGD models. Some ADIs might be well advanced on this front but as a general rule risk modellers tend to have plenty to do and it is hard to see these models having been a priority while the 20% floor has been in place.

It is also worth noting that the risk differential between OP&I and Other Residential mortgages implied by the multipliers employed in the IRB approach is 14% (i.e. 1.6/1.4) is lower than the 20-30% difference in RW proposed to apply in the Standardised approach. This seems to reflect APRA’s response to comments received (section 4.3 of “Response to Submissions”) that the application of different multipliers could double count risks already captured in the PD and LGD assigned to the two different categories of lending by the IRB risk models.

Impacts, implications and inferences

I can see a couple of implications that follow from these proposed changes

LGD models start to matter
The unquestionably strong benchmark is reinforced
Potential to change the competition equilibrium between the big and small banks

LGD models start to matter

The IRB framework has been a part of the Australian banking system for close to two decades but the 20% LGD Floor has meant that residential mortgage LGD models mostly don’t matter, at least for the purposes of measuring capital adequacy requirements. I am not close enough to the action to know exactly what choices were made in practice but the logical response of credit risk modellers would be to concentrate on models that will make a difference.

APRA’s decision to reduce the LGD floor changes the calculus, IRB ADIs now have an incentive to invest the time and resources required to get new LGD models approved. Loan segments able to take full advantage of the 10% floor will be able to more than offset the impact of the multipliers. The LGD has a linear impact on risk weights so a halving from 20 to 10 percent will see risk weights also halve more than offsetting the 40 to 60% loadings introduced by the multipliers.

Exactly where the cut off lies remains to be seen but it seems reasonable to assume that the increases and decreases proposed in standardised risk weights are a reasonable guide to what we might expect in IRB risk weights; i.e. LGD may start to decline below 20% somewhere around the 70% LVR with the maximum benefit (10% LGD) capping out for LVR of say 50% and below. I have to emphasise that these are just semi educated guesses (hopefully anyway) and I am happy to be corrected by anyone with practical experience in LGD modelling. The main point is that LGD modelling will now have some practical impact so it will be interesting to watch how the IRB ADI respond.

Unquestionably strong is reinforced

On one level, it could be argued that the changes in risk weights don’t matter. ADIs get to report higher capital ratios but nothing really changes in substance. Call me a wide-eyed, risk-capital idealist but I see a different narrative.

First up, we know that residential mortgages are a huge risk concentration for the Australian banks so even small changes can have an impact on their overall risk profiles.

“While an individual residential mortgage loan does not, on its own, pose a systemic risk to the financial system, the accumulation of lending by almost all ADIs in this asset class means that in aggregate the system is exposed to heightened risks”
APRA Discussion Paper, “A more flexible and resilient capiutral framework for ADIs”, 8 December 2020 (page 12)

To my mind, the proposed changes can work in a combination of two ways and both have the potential to make a difference. The decline in residential mortgage risk weights is largely confined to loans originated at low LVRs – less than 70% in the case of “Owner-Occupied Principal and Interest” and less than 60% in the case of “Other Residential”. High LVR risk weights (i.e. 90% plus) are reduced for Owner Occupied Principal and Interest without LMI but my understanding is that these kinds 0f loans are exceptions to the rule, granted to higher quality borrowers and not a large share of the overall exposure. High LVR loans as a rule will face higher risk weights under the proposed changes and materially higher in the case of the “Other Residential” category.

In the low LVR lending, the decline in risk weights seems to be largely offset by higher capital ratio requirements via the increased buffers. In the case of the higher risk, high-LVR lending, the higher capital ratio requirements add to the overall dollar capital requirement.

Competition in residential mortgage lending

APRA has explicitly cited “enhancing competition” as one of their objectives. I don’t have enough hard data to offer any comprehensive assessment of the extent to which competition will be enhanced. The one thing I think worth calling out is the substantial reduction in RW assigned to low LVR loans under the Standardised approach. The table below maps the changes in RW with data APRA publishes quarterly on the amount of loans originated at different LVR bands.

Owner occupiers who have managed to substantially reduce the amount they owe the bank have always been an attractive credit risk; even better if appreciation in the value of their property has further reduced the effective LVR. The proposals reinforce the attraction of this category of borrower. The IRB ADIs will not give up these customers without a fight but the Standardised ADI will have an enhanced capacity t0 compete in this segment via the reduced RW.

At this stage we can only speculate on impacts as the final form of the proposals may evolve further as APRA gets to see the results of the Quantitative Impact Statements that the ADI’s are preparing as part of the consultation process.

Summing up

We are still some way way from seeing the practical impact of these changes and we need to see the extent to which the proposals are refined in response to what APRA learns from the QIS. There does however seem to be potential for the economics of residential mortgage lending to be shaken up so this is a development worth keeping an eye on.

Tony – From the Outside

Australian bank capital adequacy – “a more flexible and resilient capital framework”

This post looks at a Discussion Paper published by APRA in late 2020 titled “A more flexible and resilient capital framework for ADIs” setting out how it proposes to wrap up a number of prior consultations on a variety of aspects of ADI (authorised deposit-taking institution) capital reform in Australia. The next step in the roll out of the revised framework is to conduct a quantitive impact study (QIS) with selected ADIs to ensure that the proposed final standards are appropriately calibrated.

Key elements of the revised framework (effective 1 January 2023) include:

More risk-sensitive risk weights (mostly for residential mortgages but also SME lending) that are expected to reduce average risk weights by approximately 10% for Internal Ratings Based (IRB) banks and 7% for banks operating under the Standardised Approach (SA) to capital adequacy,
Support for enhanced competition between the big and small ADIs via a series of initiatives intended to limit the differences between the IRB and SA, approaches (though APRA also offers evidence that the existing differences are not as great as some claim),
Improved transparency and comparability both with international peer banks and between the big IRB banks and the smaller SA banks
Improved flexibility in capital requirements via an increase in the size of regulatory capital buffers.

Improved risk sensitivity (lower risk weights)

Improved risk sensitivity is obviously a two edged sword (capital requirements could increase) but APRA estimates that the overall impact of the proposed revisions will be to reduce average risk weights for IRB ADIs by 10% and by 7% for Standardised ADIs. I have published a couple of posts already on the proposed changes to residential mortgage risk weights (see here and here) so I don’t intend to cover that in any detail in this post.

The main points to note regarding residential mortgages are:

Standardised ADIs get
- more segmentation by loan purpose,
- a reduction in the lowest risk weight applied to the best quality loans from 35% to 20% and
- a 40% Credit Conversion Factor (CCF) for off-balance sheet exposures
IRB ADIs see
- the higher than Basel “correlation adjustment” currently used to narrow the difference between IRB and SA risk weights replaced by a simple “scalar” adjustment,
- the existing 20% LGD floor reduced to 10% for approved LGD models and
- recognition of the risk reduction value of Lenders’ Mortgage Insurance (LMI) in line with the SA.

I have not looked closely at the changes impacting the other RWA exposures but list them here for completeness:

SME lending
- Standardised ADIs – RW applied under the SA will recognise the value of commercial property security while RW for loans not secured by property will be reduced from 100% to 75% for loans less than $1.5m and 85% otherwise
- IRB ADIs – the thresholds for applying the Retail SME approach and the Corporate SME approach will be increased
Other credit portfolios
- Standardised ADIs see no real change (existing RW are already largely aligned with the Basel framework)
- IRB ADIs will see the overall credit scalar in the IRB RW formula increased from 1.06x to 1.1x, risk estimates will be more closely aligned to those of overseas peers (but still higher than those peers) and models will be permitted for the calculation of capital requirements for commercial property exposures
New Zealand based exposures
- RWA determined under RBNZ requirements will be used for group capital requirements

Enhanced competition, increased transparency and comparability

The main points to note here are:

The risk weight initiatives listed above should address a long standing complaint from the Standardised ADIs that the higher risk weights they are subject to place them at a competitive disadvantage relative to IRB ADIs
Note however that APRA has also provided evidence that the difference in capital requirements is not as large as is often claimed and can be justified by differences in the risk of the loan portfolios that different types of ADIs typically hold
The extent of any competitive disadvantage due to capital requirements will be further clarified by the requirement that IRB ADIs also publish capital ratios under the Standardised Approach
The extent of the differences between the capital requirements applied by APRA and those used to calculate the ratios reported by international peer banks will also be reduced thereby enhancing the transparency of the Australian ADI capital strength versus the international peer groups. This will make the “top quartile” test employed to determine the “unquestionably strong” benchmark simpler and more transparent.

Increased resilience via larger more flexible capital buffers

We noted above that RWA are expected to reduce by around 10 per cent on average for IRB banks and 7 per cent on average for standardised banks. All other things being equal this will translate into a very visible increase in reported capital ratios which requires a recalibration of the balance between minimum requirements and capital buffers:

The minimum Prudential Capital Requirement (PCR) remains unchanged in percentage terms (4.5%), as does the minimum threshold for Point of Non-Viability (PONV) conversion (5.125%), but these requirements fall in dollar terms due to the decline in average RWA
The Capital Conservation Buffer (CCB) – will be increased by 150 basis points (but only for IRB ADIs)
The default Countercyclical Capital Buffer (CCyB) – will be set at 100 basis points (versus zero under the current approach)

Minimum capital requirements

At face value, a reduction in minimum capital requirements sounds like a cause for concern. In theory you can argue that there is a slightly lower amount of CET1 capital available in a scenario in which a bank has breached the PONV threshold that triggers the conversion of Additional Tier 1 and any other layers of loss absorbing capital. In practice, however, this theoretical risk is more than offset by the increase in the CCB and the CCyB. APRA is at pains to emphasise that, all other things being equal, the dollar value of capital that ADI’s currently hold consistent with the Unquestionably Strong benchmarks introduced in 2017 does not change under the revised framework.

With amendments across a number of dimensions, reported capital ratios will inevitably change … However, APRA remains committed to its previous position that an ADI that currently meets the ‘unquestionably strong’ benchmarks under the current framework should have sufficient capital to meet any new requirements. Changing the presentation of capital ratios will not impact overall capital strength or the quantum of capital required to be considered ‘unquestionably strong’; but instead improves comparability, supervisory flexibility and international alignment.
“A more flexible and resilient capital framework for ADIs, APRA Discussion Paper, 8 December 2020 (page 5)

In addition to the increased base levels of CET1, the systemically important ADI are holding increasing amounts of “Additional Loss Absorbing Capital” that can be bailed-in to create CET1 capital in the event that a bank is at risk of breaching the PONV threshold. There are differences of opinion on whether APRA would be willing to pull the trigger to convert these instruments. We won’t know for sure until the time comes, but my colours are nailed to the assumption that APRA will much prefer to see shareholders get diluted rather than having to use government funds to bail-out a bank.

Capital Conservation Buffer

The 150bp expansion in the CCB only applies to IRB ADIs. APRA attributes this to the need to respond to “the greater level of risk sensitivity inherent in the IRB approach” (page 16 of the Discussion Paper). They don’t actually use the term but I think of this as a means of absorbing some of the pro-cyclicality that is inherent in any risk sensitive capital adequacy measure.

A simple way to think about this change is to link the 150bp increase to the roughly equivalent benefit of the 10% decline in RWA expected to flow from RWA changes set out in the paper. We note however that SA gets 7% decline due to improved risk sensitivity but no equivalent increase in CCB. So we get enhanced risk sensitivity in the IRB approach via the revised risk weights without exacerbating the concern about the difference in capital requirements.

However the increased risk sensitivity of the IRB approach also manifests in heightened sensitivity to an economic downturn. All other things being equal both Standardised and IRB ADIs should face similar increases in loan loss charges. The impact on IRB ADI capital ratios is however amplified by the increase in average RWs under stress. I don’t have any hard data to refer to but would not be surprised if the RWA inflation effect contributed another 150bp to the decline in capital ratios we see quoted in stress testing results under this new framework.

Viewed from this perspective the expanded CCB not only neutralises the benefit of lower IRB risk weights, it also helps absorb the increased sensitivity to declines in capital ratios that IRB ADIs can be expected to experience under a stress scenario.

Counter-cyclical Capital Buffer

The CCyB has, for me at least, always been a sound idea badly executed. It became part of the international macro prudential toolkit in 2016 and is intended to ensure that, under adverse conditions, the banking sector in aggregate has sufficient surplus capital on hand required to maintain the flow of credit in the economy without compromising its compliance with prudential requirements.

A key feature in the original Basel Committee design specification is that the buffer is intended to be deployed in response to high levels of aggregate credit growth (i.e high relative to the sustainable long term trend rates whatever that might be) which their research has identified as an indicator of heightened systemic risk. That does not preclude bank supervisors from deploying the buffer at other times as they see fit, but pro-actively responding to excess credit growth has been a core part of the rationale underpinning its development.

The idea of having a buffer that can be released in response to a downturn makes perfect sense but the analytical structure the Basel Committee developed to guide its deployment seems unnecessarily complex. The simple non-zero default level that APRA proposes to adopt is arguably a better (if not the best) approach and one that other countries are already pursuing (see here, here and here).

None of this pro-cyclicality benefit is spelled out in the material APRA released so I may be reading too much into the material. If I am analysing it correctly if is a subtle but still useful benefit of the package of changes that APRA is pursuing.

Conclusion

Broadly speaking, I think there is a lot to like in the revised framework that APRA is pursuing

Risk weights that are both more risk sensitive but also more closely aligned under the two approaches to capital adequacy measurement (IRB and Standardised)
An increased share of the capital requirement allocated to buffers that can be used rather than minimum requirements that can’t
A better approach to setting the CCyB

My primary concern is that the amplified pro-cyclicality in capital ratios that is seemingly inherent in any risk sensitive capital framework seems likely to increase but there is very little discussion of this factor . There are tools to manage the impact but one of the key lessons I have taken away from four decades in this game is that the markets hate surprises. Far better to quantify the extent of any amplified pro-cyclicality in capital ratios prior to the next crisis than to try to explain the impacts when capital ratios start to decline more quickly than expected during the next downturn/crisis.

Let me know what I am missing …

Tony – From the Outside

Some of the backstory

The idea that Australian banks needed to be “Unquestionably Strong” has dominated the local capital adequacy discussion for the past few years. The idea originated in a recommendation of the Australian Financial System Inquiry (2014) based on the rationale that Australian banks should both be and, equally importantly, be perceived to be more resilient than the international peers with which they compete for funding in the international capital markets.In July 2017, APRA translated the FSI recommendation into practical guidance in an announcement supported by a longer information paper.

For most people, this all condensed into a very simple message, the systemically important Australian banks needed to maintain a Common Equity Tier 1 ratio of at least 10.5%. The smaller banks have their own Unquestionably Strong benchmark but most of the public scrutiny seems to have focussed on the larger banks.

In the background, an equally important discussion has been playing out regarding the extent to which the Unquestionably Strong framework should take account of the “comparability” and “transparency” of that measure of strength and the ways in which “flexibility” and “resilience” could be added to the mix. This discussion kicked off in earnest with a March 2018 discussion paper (covered in more detail here) and has come to a conclusion with the December 2020 release of the APRA Discussion Paper explored in the post above.

Mortgage risk weight fact check

I have posted a couple of times on the merits of the argument that differences in mortgage risk weights are a substantial impediment to the ability of small banks employing the standardised approach to compete against larger banks who are authorised to use the Internal Ratings Based approach.

There was some substance to the argument under Basel II but the cumulative impact of a range of changes to the IRB requirements applying to residential mortgages has substantially narrowed the difference in formal capital requirements.

APRA has commented on this issue previously but that did not seem to have much impact on the extent to which the assertion gets repeated. For anyone still reluctant to let the facts stand in the way of a good story, Wayne Byres has restated APRA’s view on the issue in a speech to the Customer Owned Banking Association’s 2019 conference.

That brings me to the final point I want to make, about mortgage risk weights. Much is made of the headline difference in risk weights between the IRB and standardised approaches. At first glance, they do indeed look different. But as we pointed out in our most recent discussion paper, the comparison is much more complex than a superficial comparison implies: there are differences in capital targets, the treatment of loan commitments, the application of capital for interest rate risk in the balance sheet, and adjustments to expected losses – all of which have the effect of adding to IRB bank capital requirements and mean that the headline gap is greatly narrowed in practice.
When looked at holistically, we think any gap is small. Perhaps most tellingly, we now hear from candidates for IRB status that they are concerned the proposals being developed will not provide them with any capital benefit whatsoever. Whether that is the case or not, we are very conscious of this issue in designing the new proposals, and we have explicitly stated that we intend that any differences will remain negligible.
APRA Chair Wayne Byres – Speech to COBA 2019, the Customer Owned Banking Convention – 11 November 2019

Hopefully that settles the question. There is no question that all banks should be able to compete, as far as possible, on a level playing field but complaints about vast differences in the capital requirements applying to residential mortgages are a distraction not a solution.

Let me know what I am missing …

Tony