APRA increases capital adequacy requirements for residential mortgage exposures under the internal ratings-based approach

15.19

The Australian Prudential Regulation Authority (APRA) has today announced an increase in the amount of capital required for Australian residential mortgage exposures by authorised deposit-taking institutions (ADIs) accredited to use the internal ratings-based (IRB) approach to credit risk.

This change will mean that, for ADIs accredited to use the IRB approach, the average risk weight on Australian residential mortgage exposures will increase from approximately 16 per cent to at least 25 per cent.

The increase in IRB mortgage risk weights addresses a recommendation of the Financial System Inquiry (FSI) that APRA ‘raise the average IRB mortgage risk weight to narrow the difference between average mortgage risk weights for ADIs using IRB risk weight models and those using standardised risk weights’. The increase is also consistent with the direction of work being undertaken by the Basel Committee on Banking Supervision (Basel Committee) on changes to the global capital adequacy framework for banks.

The increased IRB risk weights will apply to all Australian residential mortgages, other than lending to small businesses secured by residential mortgage. The increase is being implemented through an adjustment to the correlation factor used in the IRB mortgage risk weight function for each affected ADI. In order to provide these ADIs sufficient time to prepare for the change, the higher risk weights will come into effect from 1 July 2016.

The residential mortgage portfolio is the largest credit portfolio for ADIs and, in aggregate, IRB accredited ADIs hold the material share of these exposures. Therefore, strengthening the capital adequacy requirement for residential mortgage exposures under the IRB approach will enhance the resilience of IRB-accredited ADIs and the broader financial system.

The increase in IRB mortgage risk weights announced today is an interim measure. It is not possible to settle on the final calibration between the IRB and standardised mortgage risk weights until changes arising from the Basel Committee’s broader review of this framework are complete. Further changes to IRB mortgage risk weights will be considered over the medium term in the context of these broader international developments.

Background

Q: Why is APRA making this change to mortgage risk weights?

A: The increase in IRB mortgage risk weights:

• addresses a recommendation of the FSI that APRA narrow the difference between average mortgage risk weights for ADIs using IRB risk weight models and those using standardised risk weights;
• aligns with the direction of work being undertaken by the Basel Committee; and
• will have the effect of enhancing the resilience of IRB-accredited ADIs and the broader financial system.

Q: Which ADIs are accredited to use the IRB approach to credit risk?

A: The IRB-accredited ADIs that will be affected by today’s announcement are: Australia and New Zealand Banking Group, Commonwealth Bank of Australia, Macquarie Bank, National Australia Bank and Westpac Banking Corporation.

Q: Why has APRA targeted an average IRB risk weight of 25 per cent, when the FSI recommended a range of 25-30 per cent?

A: The decision to target the lower end of the range primarily reflects the interim nature of the measure and uncertainty over the ultimate outcome of the Basel Committee’s review of the global capital adequacy framework. The final calibration of IRB and standardised risk weights, and the appropriate relationship between the two, will be subject to further consideration by APRA in response to these international developments.

Q: Does this mean 25 per cent is now the minimum risk weight on all residential mortgages?

A: No. Consistent with the FSI’s recommendation, APRA is targeting an average IRB risk weight for residential mortgage exposures, measured across all IRB banks, of at least 25 per cent. IRB-accredited ADIs will continue to have a range of risk weights for individual mortgage exposures and portfolio segments. This means that capital requirements for IRB-accredited ADIs will remain sensitive to the specific risk characteristics of the ADI’s mortgage portfolio.

Q: When might any further change happen?

A: The timing of any further changes to mortgage risk weights will be largely determined by the work being undertaken by the Basel Committee. Greater clarity on the outcomes of this work is unlikely before end-2015.

Q: How does this change relate to the forecast need for the major banks to increase their capital ratios by 200 basis points, as announced by APRA last week?

A: The forecast 200 basis point increase in capital ratios is APRA’s current judgement of the adjustment required for the Australian major banks’ capital ratios to be comfortably positioned in the top quartile of international peers over the medium- to long-term. To the extent that the major banks respond to the increase in IRB mortgage risk weights being announced today by increasing their actual capital levels to maintain their existing reported capital ratios, it will improve their position relative to international peers and contribute to closing the gap to the fourth quartile.

Q: How much of the forecast 200 basis point increase does this change in mortgage risk weights account for?

A: Broadly speaking, an increase in the IRB risk weight for Australian residential mortgage exposures from the current average of around 16 per cent to 25 per cent is the equivalent of increasing minimum capital requirements for the major banks by approximately 80 basis points. The impact will vary somewhat from ADI to ADI, depending on the size and nature of their lending portfolio.

Q: Has APRA changed its prudential standard to give effect to this change?

A: The changes have been implemented by way of a technical adjustment to the individual model approvals of the IRB-accredited ADIs, to increase the correlation factor in the IRB risk weight function. No changes will be made to APRA’s prudential standard at this time.

Q: Is APRA also changing mortgage risk weights for the non-IRB ADIs?

A: The increase in mortgage risk weights announced today affects IRB-accredited ADIs only. No changes have been made to the capital requirements for ADIs using the standardised approach (non-IRB ADIs).