Narrow mortgage risk weight differences

Recommendation 2

Raise the average internal ratings-based (IRB) mortgage risk weight to narrow the difference between average mortgage risk weights for authorised deposit-taking institutions using IRB risk-weight models and those using standardised risk weights.

Description

APRA should adjust the requirements for calculating risk weights for housing loans to narrow the difference between average IRB and standardised risk weights. This should be achieved in a manner that retains an incentive for banks to improve risk management capacity. It should also appropriately recognise the differences in the risks captured by IRB and standardised risk weights.

In making these changes, the adjusted framework should remain compliant with the Basel framework and remain risk sensitive.

Objectives

  • Improve the competitive neutrality of capital regulation by limiting distortions caused by the differential regulatory treatment of different classes of ADI.
  • Retain an incentive for ADIs to improve risk management capacity.

Discussion

Problem the recommendation seeks to address

Australia’s current capital framework for ADIs includes two approaches to determining risk weights for the purpose of calculating capital ratios.

  • Standardised approach: This is the default approach, where ‘standardised ADIs’ use a common set of risk weights that seek to reflect general risks of different broad asset classes. These risk weights are not tailored to a specific ADI and are set at a conservative level to ensure standardised ADIs are adequately capitalised.
  • IRB approach: Accredited ADIs (IRB banks) use their own internal models to determine risk weights for credit exposures. These risk weights are tailored to the internally assessed risks of the asset and institution, and are more granular than standardised risk weights. Achieving IRB accreditation requires a strong and sophisticated risk management framework and capacity. To date, APRA has only accredited the four major banks and Macquarie Bank to use IRB models.

Prior to Basel II being introduced in 2008, all ADIs were required to operate with the same risk-weight model, which resulted in the same capital for a given asset, including loans. Since the IRB approach was introduced, the divergence in mortgage risk weights between the two approaches has widened, as IRB banks have refined their models and adjusted their balance sheets in light of modelled risks. The average mortgage risk weight for an ADI using the standardised model is currently 39 per cent — more than twice the size of the average mortgage risk weight for banks using IRB models, which is 18 per cent.44

IRB risk weights are lower for many reasons, including because this method reflects a more refined calculation of the risks at IRB banks. However, the Inquiry notes that the principle of holding capital relative to risk should apply, not only within an institution, but also across institutions. In the Inquiry’s view, the relative riskiness of mortgages between IRB and standardised banks does not justify one type of institution being required to hold twice as much capital for mortgages than another. This conclusion is supported by the findings of APRA’s recent stress test, which found regulatory capital for housing was more sufficient for standardised banks than IRB banks.45

The gap between average IRB and standardised mortgage risk weights means IRB banks can use a much smaller portion of equity funding for mortgages than standardised banks. Because equity is a more expensive funding source than debt, this translates into a funding cost advantage for IRB banks’ mortgage businesses to the extent that the riskiness of mortgage portfolios is similar across banks.

Given that mortgages make up a significant portion of the assets of almost all Australian ADIs, competitive distortions in this area could have a large effect on their relative competitiveness. This may include inducing smaller ADIs to focus on higher-risk borrowers. Restricting the relative competitiveness of smaller ADIs will harm competition in the long run.

Rationale

The Inquiry considers that, absent other policy objectives, competitive neutrality is an important regulatory principle. In the case of risk weights, two policy objectives justify a difference in risk weights between IRB banks and standardised ADIs:

  1. To encourage improved risk management capacity at ADIs. Achieving IRB accreditation can result in lower risk weights and a related reduction in funding costs. This is an incentive for banks to develop further risk management capacity to achieve accreditation.
  2. To conform with the principle that capital should be commensurate with risk. This enhances efficiency and gives ADIs incentives to align risk and capital. Where an institution can model its risks to an acceptable standard, estimates from these models should reflect the actual risk of a portfolio and more accurately align risk and capital (the IRB approach). Where that capability does not exist, a benchmark risk weight provides a conservative measure to ensure the ADI is appropriately capitalised (the standardised approach).

The Inquiry accepts both policy objectives and believes they provide a reason for some difference in risk weights. It also notes a natural gap between risk weights under the two systems, reflecting that, unlike IRB risk weights, standardised risk weights take account of more than credit risk. However, in the Inquiry’s view, none of these provide a sufficient rationale for the magnitude of the differences that have developed between IRB and standardised mortgage risk weights.

The Inquiry believes the incentive to improve risk management capacity can be maintained with a narrower difference between mortgage risk weights. In implementing this recommendation, APRA should preserve appropriate risk incentives and take into account differences in the broader frameworks for IRB and standardised ADIs.

This recommendation addresses appropriate competitive neutrality of the risk-weighting framework. Larger ADIs may have a number of other advantages, such as economies of scale, more sophisticated business models, and a greater ability to diversify assets and manage risk. These are part of the market process; the Inquiry is not suggesting these are a problem.

Options considered

The Inquiry considered two options to narrow the difference between standardised and IRB mortgage risk weights:

  1. Recommended: Raise average IRB mortgage risk weights.
  2. Lower standardised mortgage risk weights. In submissions, some ADIs argue that a mortgage risk weight of around 20 per cent would be appropriate.46

Option costs and benefits

Raise average IRB mortgage risk weights

ADIs that use the standardised risk-weight model strongly support narrowing the difference between IRB and standardised mortgage risk weights. These ADIs argue they are at a considerable competitive disadvantage. In some cases, these ADIs contend that, without change, they will be forced out of the market — materially lessening competition. Although ADIs using the standardised model generally advocate for lowering standardised mortgage risk weights, many indicate that raising IRB risk weights would also address the problem.47 This includes some smaller banks that have spent significant resources on IRB capacity but have not yet achieved IRB accreditation.

In general, the major banks advocate for smaller ADIs to be supported in achieving IRB accreditation, rather than making changes to risk weights. They are particularly opposed to raising IRB risk weights, arguing that changes to the IRB model could move the resulting risk weights away from the underlying principle that risk weights should reflect the actual risk of the portfolio. They also note differences in risk between mortgage portfolios at the major banks and some other ADIs. In discussions, some major banks indicated they had no strong objections to reducing standardised risk weights for mortgages.

One major bank submits that the effective difference between the credit risk portion of mortgage risk weights under the IRB and standardised models is small (in the order of seven percentage points), since reported standardised risk weights captured more than credit risk.48 Although the Inquiry accepts the broader point that IRB and standardised risk weights capture different things, its judgement is that the gap is not likely to be as small as suggested by the bank’s analysis. For example, that estimate adjusts for the D-SIB buffer, which is unrelated to risk weight models and not applied to all IRB banks. However, in implementing this recommendation, APRA should consider factors which generate a gap between standardised and IRB risk weights.

In discussions, one major bank argued that raising IRB risk weights would have effects beyond the mortgage market. In particular, it may induce them to reduce other types of lending, such as business lending, to offset overall increases in funding costs. While each institution will make its own lending decisions, many factors other than mortgage risk weights will affect the type of lending banks undertake, including the level of demand for overall credit, the strength of returns for the banks, the rate of capital generation and competition in the sector.

If this recommendation is adopted, APRA has indicated its strong preference is to narrow mortgage risk weights by raising IRB risk weights.49 This reflects the need to maintain appropriate prudential capital settings, particularly for Australian ADIs’ largest exposure class, and that lowering standardised risk weights below 35 per cent would not be permitted under the Basel framework.

Stakeholder’s raised a number of concerns with the risk-weight approach to calculating capital ratios. The Basel Committee is already reviewing parts of the standardised and IRB framework. These measures include reducing the modelling choices in the IRB framework when determining estimates of credit, market and operational risk-weighted assets.50 This work is not due to be completed until the end of 2015 but may result in increases in some areas.

This recommendation does not seek to eliminate entirely the difference in risk weights between the IRB and standardised models. It recognises that the current system provides incentives for ADIs to improve their risk management capabilities and that the IRB approach seeks to better align capital with risk.

Other countries have also placed restrictions on IRB mortgage risk weights through a number of means. For example, Sweden, Hong Kong and the United Kingdom have all used or proposed a mortgage risk-weight floor of 15–25 per cent. New Zealand has made a number of changes to the Basel-specified parameters for IRB models. Norway will introduce a 20 per cent floor on the loss given default parameter, which is the same as the current practice in Australia.

In addition to assisting with regulatory competitive neutrality, increasing IRB risk weights has two further benefits:

  1. It would reduce the likelihood of the IRB approach underestimating risk, or being subject to model risk or outright manipulation.51 A minimum average risk weight prevents very low risk weights being assigned in a manner that may not reflect the true risk of an asset. The Inquiry notes that models based on individual borrower characteristics rarely capture the systemic risk that can become the primary risk driver at the portfolio level.
  2. It would increase the capital IRB banks require, increasing their resilience.

The principal cost of raising the average IRB mortgage risk weights is that greater use of equity, which is typically more expensive than debt, would raise the average cost of funding for IRB banks. The cost of meeting higher average mortgage risk weights is expected to be small. The required quantum of capital to achieve an average risk weight of 25–30 per cent would be roughly equivalent to a one percentage point increase in major banks’ CET1 capital ratios from current levels. This corresponds with a small funding cost increase for the major banks. Competition will limit the extent to which this cost is passed on to consumers, and shareholders will likely bear some of the cost in the form of a lower ROE. This in turn should be at least partially offset by lower required returns due to the banks being less likely to fail.

Lowering standardised mortgage risk weights

The alternative option of lowering standardised mortgage risk weights to be closer to their IRB equivalents would have a similar primary benefit to the recommended option. It would promote competition and improve the future viability of smaller ADIs. In addition, as ADIs using standardised risk weights would need less equity funding, the costs identified above would run in the opposite direction, possibly giving those ADIs a funding cost reduction.

However, this option suffers from several drawbacks relative to raising IRB risk weights:

  • It is non-compliant with the Basel framework.
  • It would mean standardised ADIs use less equity and other regulatory capital funding, which could weaken their prudential position, making these ADIs less resilient and increasing their probability of failure.
  • It would reduce the incentive to improve risk management practices and create an incentive for standardised ADIs to increase mortgage lending as a share of their balance sheet.

Conclusion

The costs to the economy of making the regulatory approach for mortgage risk weights more competitively neutral are modest. The Inquiry judges that these are outweighed by the long-term competition benefits of assisting to maintain a diversity of ADIs into the future.

The Inquiry judges the option of lowering standardised mortgage risk weights to be substantially inferior to the recommended option of raising IRB mortgage risk weights.

Implementation considerations

The recommended option is predicated on the existing Basel framework, which the Inquiry understands is currently under review. The intention is to narrow the difference between IRB banks and standardised average mortgage risk weights. If the existing Basel framework alters, this should be taken into account.

The Inquiry considers a range between 25 and 30 per cent to be appropriate, to be decided on by APRA in targeting an average IRB mortgage risk weight. This is based on international experience and the current average IRB and standardised mortgage risk weights of 18 per cent and 39 per cent respectively.

The risk weight gap could be narrowed in a variety of ways. In determining the approach, APRA should seek to maintain as much risk sensitivity in the capital framework as possible and recognise lenders mortgage insurance where appropriate.

This recommendation is focused on mortgage portfolios, given the importance of this market for Australian ADIs. APRA could also investigate whether similar issues exist in other portfolios.

The recommendation should be considered in conjunction with others in this report; in particular, Recommendation 1: Capital levels and Recommendation 4: Transparent reporting in relation to Australian ADIs’ capital position and transparency of the capital framework.

To promote incentives for ADIs to develop IRB capacity, APRA could also consider how to make the accreditation process less resource intensive without compromising the (necessarily) very high standards that must be met. APRA has already indicated it is willing to explore a proposal to decouple the need to achieve internal model accreditation for both financial and non-financial risks simultaneously. That is, an ADI may be accredited for regulatory capital models for credit and market risks without having been accredited to model operational risk. The Inquiry supports exploring such initiatives.

Some ADIs will not use the IRB approach, because it may not be cost effective for smaller institutions. As such, the gap between IRB and standardised mortgage risk weights should be closed to improve competitive neutrality, regardless of any assistance provided to help with IRB accreditation.


44 Australian Prudential Regulation Authority 2014, Second round submission to the Financial System Inquiry, page 9.

45 “Regulatory capital for housing held by standardised banks was (just) sufficient to cover the losses incurred during the stress period; that was not the case for IRB banks”, Byres, W 2014, Seeking strength in adversity: lessons from APRA’s 2014 stress test on Australia’s largest banks, AB+F Randstad Leaders Lecture Series, 7 November, Sydney.

46 For example, Suncorp Bank 2014, First round submission to the Financial System Inquiry, page 6.

47 Customer Owned Banking Association 2014, Second round submission to the Financial System Inquiry, page 27.

48 National Australia Bank 2014, Second round submission to the Financial System Inquiry, page 11.

49 Australian Prudential Regulation Authority 2014, Second round submission to the Financial System Inquiry, page 11.

50 Basel Committee on Banking Supervision 2014, Reducing excessive variability in banks’ regulatory capital ratios: a report to the G20, Bank for International Settlements, Basel.

51 Byres, W 2012, Regulatory reforms — incentives matter (can we make bankers more like pilots?), remarks to the Bank of Portugal conference on Global Risk Management: Governance and Control, 24 October, Lisbon.