Be Prepared for More Tightening from APRA in the Mortgage Market
Borrowers and in particular, investors, have already been adversely affected by government intervention in the banking sector, but it is not finished yet. The Australian Prudential Regulation Authority (APRA) has signaled that it will soon publish a paper on what it considers banks must do to be “unquestionably strong”, a recommendation of a 2014 international financial system inquiry.
In layman’s terms, this means APRA will announce how much extra capital they will require the banks to hold to act as a buffer to absorb possible loan losses. Since the global financial crisis, Australia’s banks have been required to increase the amount of capital they hold several times. Every time they do this, mortgage prices invariably rise. This is because most banks and lenders are highly leveraged, so any increase in capital decreases their return on equity, which can have a drastic effect on their share prices, and likely on the bonuses of their executives.
How Will This Affect Borrowers and Investors?
The aspects of the inevitable announcement that will effect borrowers the most depends on how much money the banks need, as well as how much time they will be given to raise the money. These are important factors because they will affect how fast the extra capital accumulates, which will affect the bank’s interest rate policies.
The best-case scenario for borrowers and investors is if the amount of extra capital the banks require ends up being relatively small. However, even if it is large, borrowers and investors may not bear too much of the brunt of the changes if APRA phases the requirements in over an extended period. A long lead time before the additional funds must be in place would make the changes more tolerable. Additional time would give the banks the opportunity to raise equity through existing dividend reinvestment plans. It can also enable the banks to decide to keep dividends flat and retain a higher share of profits.
How Will This Affect Banks?
If the banks are required to raise significant funds inside a relatively short time period, they will need to pass the cost of those higher costs to borrowers in the form of higher rates. Not doing so would have too great an effect on their profitability. Competitive forces may eventually pressure lenders to pass some of the costs on to shareholders. But, this would be a slow and drawn out process and of no comfort to those already in the mortgage market or about to enter it.
Recent reports suggest that APRA is considering placing stricter requirements on “domestic systemically important banks” like Commonwealth Bank, Westpac, National Australia Bank and ANZ Bank – the Big Four. This could potentially place these lenders at a competitive disadvantage compared to smaller lenders, as it would impose a cost on them that would not affect their competitors.
Will the Fallout Be Worse for Investors?
Yes, it is most likely that investors will feel the most pain. APRA has flagged changes in the way it calculates risk, which impacts the amount of capital banks are required to hold against different types of loans. They view investment and interest-only loans as being riskier and will invariably attract higher capital requirements. That means the banks will have to pass this extra expense on to borrowers in the form of higher interest rates.
APRA last imposed increased capital requirements on investment loans in 2015. At the time, they gave the banks only 12 months to comply. What resulted was a rather rapid increase in rates charged for investment loans, even above rates for other mortgages, during that period. According to industry sources, the banks will not implement similar future changes as rapidly
What Should You Do?
The primary way you can insulate yourself from the effects of the inevitable changes is to fix your interest rates. But, before you do that, you must also consider the possibility of further rate cuts by the Reserve Bank (RBA). It is highly possible they are making these changes to allow the RBA to further decrease rates without further inflating property prices. A lower RBA cash rate would offset higher bank margins, giving them more wriggle room to keep profitability up. Weak wages growth, low inflation and slow economic growth all make further cuts by the RBA possible.
The other thing to consider is that these changes will not directly affect all lenders. APRA does not regulate many of the non-bank lenders, so while the activities of banks affects all parts of the finance sector, and the government can exert pressure on other lenders through the Australian Securities and Investment Commission (ASIC), the changes will not influence the pricing policies of these businesses to nearly the same extent.
A Silver Lining
Most borrowers do not have the most suitable loan structures or best rates currently in place. You may have more power than you think to save money, even if rates do rise across the board. These times of uncertainty that we are currently experiencing present a unique opportunity for investors and borrowers who are willing to put in a little effort to give themselves a considerable advantage over their peers. A small cost advantage today can translate into significant long-term gains.
If you would like an expert to look over your existing loan portfolio, get some advice on how best to start, or if you have any other finance-related queries, please fill out the form at PropertyInvestingFinance.com, or email me directly.