To: All authorised deposit-taking institutions (ADIs)
This letter sets out APRA’s expectations for banks in managing exceptions to housing lending policy. Some banks have recently announced changes to their exception processes to support borrowers that may be experiencing challenges. It is important that these changes are implemented prudently.
Exceptions to policy
Under APRA’s prudential framework, banks must apply certain minimum criteria when assessing a borrower’s repayment capacity. This includes a 3 per cent minimum serviceability buffer, to be applied above the housing loan interest rate.
The serviceability buffer provides a contingency for rises in interest rates over the life of the loan, as well as for any unforeseen changes in a borrower’s income or expenses. With the potential for interest rates to rise further, inflation still high and the possibility of weaker labour market outcomes, the buffer is an important risk mitigant.
In the current environment, some borrowers who are seeking to refinance with another lender may no longer meet standard loan criteria. The reasons behind this are varied: some borrowers may not pass the serviceability buffer requirement, given higher interest rates and cost of living pressures; other borrowers may have less equity in their property following declines in housing prices; and some borrowers may have experienced changes to their personal circumstances. It is important that these loans are assessed on a case-by-case basis.
APRA is aware that some banks have recently made changes to their exceptions processes to support borrowers who may be facing challenges in refinancing with another lender. An “exception to policy” occurs when a bank approves a loan that does not meet standard loan criteria, such as the serviceability buffer.
Under APRA’s prudential framework, banks can use exceptions to policy if these are managed prudently and limited. This approach allows banks to take into account additional indicators of repayment capacity beyond those captured in the standard serviceability test. For a borrower seeking to refinance, this could include past repayment behaviour.
APRA’s expectations for managing risks
APRA requires banks to have prudent policies and processes for dealing with exceptions to policy. Large volumes of exceptions can create risks by weakening banks’ risk profiles and increasing the vulnerability of their loan books to future shocks. Historically, serviceability policy exceptions have accounted for a small share of banks’ total housing lending, at between 2 and 3 per cent.
It is important that exceptions are used in a prudent and limited manner, so as not to undermine the intent of the core policy. In using exceptions, APRA expects banks to make a prudent assessment of repayment capacity so that there is a good outcome for borrowers and the financial system. Prudent banks would have acceptable reasons and clear justifications for loans written outside policy. It is also important that banks have considered their Responsible Lending Obligations, which are administered by the Australian Securities and Investments Commission.
Loans written as exceptions must be regularly reported to the relevant internal governance bodies of the bank and monitored against risk appetite limits. Prudent boards would assess the impact of any proposed changes to exceptions processes on the bank’s risk profile and risk appetite. This includes understanding the types of loans that are being written outside policy, such as like-for-like refinancing.1
Further details on APRA’s existing guidance for exceptions is provided at Appendix A.
APRA requests that banks notify their supervisor ahead of material changes to their exceptions process. APRA will be monitoring exceptions trends closely and may request additional information to assess how banks are managing risks. Banks reporting large volumes of policy exceptions will be subject to heightened supervisory attention.
Appendix A: APRA’s requirements and guidance
Set out below is key references to APRA’s requirements and guidance for managing exceptions to loan policy, including for capital purposes.
Prudential Standard APS 220 Credit Risk Management
An ADI must have prudent credit risk policies and processes with respect to overrides, waivers or exceptions, including clear identification of approval authorities and limits that reflect the maximum level of allowable overrides, waivers or exceptions. An override occurs when an exposure is approved outside the ADI’s credit assessment criteria. This may also include where decisions suggested by models, such as a scorecard, are overridden. Overrides may occasionally be needed to deal with exceptional or complex credit applications.
Exposures originated as overrides, waivers or exceptions to, or otherwise not in compliance with, credit risk policies must be regularly reported to an ADI’s relevant internal governance bodies and review functions.
An ADI must ensure that the credit origination, credit assessment and approval function is properly managed and that credit exposures are within levels consistent with an ADI’s limits. An ADI must establish and enforce internal controls and other practices to ensure that overrides, waivers or exceptions to policies, processes and limits are reported in a timely manner to the appropriate level of management for action.
Prudential Practice Guide APG 220 Credit Risk Management
Good practice is to consider portfolio limits for:
(d) overrides to lending policy, which APRA expects would be strictly contained so as not to undermine the intent of the core policy.
The management, monitoring and reporting of overrides, exceptions or waivers is fundamental to ensuring credit policies are followed in practice. A disconnect between lending policies and lending practices can lead to a significant increase in credit risk. A prudent ADI would monitor the frequency, reasoning and materiality of overrides, exceptions or waivers, including where ADIs use automated decision models. It is prudent for risk appetite limits to appropriately reflect the maximum level of allowable overrides, exceptions or waivers.
Prudential Practice Guide APG 223 Residential Mortgage Lending
Typically, senior management is responsible for monitoring compliance with material policies, procedures and risk limits and reporting material breaches or overrides to the Board. Further, where risk limits are routinely breached or policies and procedures overridden, senior management and the Board could consider whether this is indicative of a less prudent lending culture than that reflected in its risk appetite and what steps could be necessary to remedy any identified deficiency.
An override occurs when a residential mortgage loan is approved outside an ADI’s loan serviceability criteria or other lending policy parameters or guidelines. Overrides are occasionally needed to deal with exceptional or complex loan applications. However, a prudent ADI’s risk limits would appropriately reflect the maximum level of allowable overrides and be supported by a robust monitoring framework that tracks overrides against risk tolerances. It is also good practice to implement limits or triggers to manage specific types of overrides, such as loan serviceability overrides. APRA expects that where overrides breach the risk limits, appropriate action would be taken by senior management to investigate and address such excesses.
There are varying industry practices with respect to defining, approving, reporting and monitoring overrides. APRA expects an ADI to have a framework that clearly defines overrides. In doing so, it is important that any loan approved outside an ADI’s serviceability criteria parameters should be captured and reported as an override. This includes loans where the borrower is assessed to have a net income surplus of less than $0 (even if temporary) or where exceptions to minimum serviceability requirements have been granted, such as waivers on income verification. ADIs may have their own definitions that include other types of loans (such as those outside LVR limits) as overrides for internal risk monitoring purposes.
In addition, a sound framework would also detail the approval process, documentary requirements for an override approval (including acceptable reasons for an override) and an oversight mechanism to monitor and report such overrides. It is good practice to monitor and report the reasons for overrides, to provide an aggregate view for senior management and enable an assessment of trends.
Deliberate misreporting or non-reporting of overrides is indicative of poor practice. A sound risk management framework would capture such instances, prompting appropriate investigation and swift and appropriate action where necessary.
Good practice is for regular override reporting to be provided to senior management and to the Board. Such reporting would include:
(a) delinquency rates for residential mortgage loans approved as overrides and exceptions;
(b) tracking against risk tolerance limits for overrides;
(c) reasons for overrides; and
(d) distribution of overrides across business units, products, locations, third-party originators and, where relevant, ADI officers associated with a disproportionate number of overrides.
Prudential Practice Guide APG 112 Capital Adequacy: Standardised Approach to Credit Risk
To classify a property exposure as a standard loan, an ADI must also complete an assessment with a positive determination that the borrower can meet their repayment obligations. While APS 112 includes minimum criteria for this assessment, it is not intended to be a complete list of factors that a prudent ADI would consider. APRA expects an ADI to have appropriate controls and justification for implementing serviceability overrides, which may be used to make a positive determination of a borrower’s ability to meet their repayment obligations.
1 Like-for-like refinancing is often used to describe a situation where a borrower moves between lenders without increasing their total debt exposure.
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