Bank of England drops 3 percentage points lending buffers; it’s time for APRA to follow suit

As the cash rate moves higher, it’s no longer appropriate to stress-test for unrealistically high lending rates

Lending buffers revised

The Bank of England recently relaxed the requirement for borrowers to be assessed for a potential 3 percentage points increase in mortgage rates, but it is unclear whether APRA in Australia will make similar changes.

They first introduced the stress test in 2014, and amended it in 2017, to assess borrowers for whether they could comfortably service a mortgage in the event of interest rates being increased by 300 basis points. In the event, the base rate only lifted by a maximum of 0.50 percentage points between 2017 and 2021, and it was concluded that the stress test was far too stringent.

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From this month, the stress test rules have now been eased, so that lenders only need to assess for a minimum stress buffer of 1 percentage point, although rising power bills will also still need to be factored in.

Counter-intuitively, the change comes at a time when the Bank of England base rate is expected to rise further, having until recently been stuck at 1 per cent or lower since 2009. This may appear to be counter-intuitive, but the bank is already around 165 basis points into its hiking cycle.

So as the hikes flow through, a rigid buffer would be stress-testing for an unrealistically high terminal rate, starving the market of funds, making refinancing unfeasible for many mortgagors, and unnecessarily pricing out many first homebuyers.

APRA may also review buffers

With Australia’s cash rate target already having been lifted from 10 basis points to 1.85 per cent and set to rise to 2.35 per cent next month according to most market analysts, the equivalent stress test in place in Australia should also come under scrutiny next month.

In early October 2021, APRA introduced a requirement for a lending assessment buffer of at least 300 basis points, which was deemed prudent at the time to address rising systemic risks, and reflective of evolving market pricing for the trajectory of interest rates. But with the cash rate set to rise to 2.35 per cent next month, such a large stress test would no longer make sense, especially with the banking system so well capitalised, and with the regulator confirming that sound lending standards continue to be applied overall.

Australia’s 3-year bond yield is now trading at well under 3 per cent, and the terminal cash rate for this cycle is also expected to be somewhere around that level.

A buffer of, say, 2 percentage points would be far more appropriate now, not least because the current rules make it far too difficult for many borrowers to switch lenders, often leaving them trapped on unattractive mortgage rates and poor terms.

Challenging optics

Making changes to lending standards is frequently challenging because of how amendments are perceived in media reporting. It’s sometimes difficult for regulators to communicate the reasoning behind changes, which are often either misunderstood or misreported by non-financial media outlets or ‘shock jock’ websites. 

For example, even a reduction in the lending buffers to 2.5 percentage points would inevitably be perceived by many media outlets as increasing the risks to financial stability, whereas in reality, the opposite would be true.  

The ability to refinance is an important safety valve for the housing market and for financial stability.  Many of our clients and other borrowers are finding it impossibly difficult to refinance when lending standards are so tight, leaving them stuck with unattractive mortgage rates or on challenging repayment terms.  

This is actually a net negative for financial stability risks, of course, though sadly media reporting rarely reflects this accurately. Realistically the cash rate target is extremely unlikely to increase to anywhere near the implied 5.35 per cent in the current monetary tightening cycle.  

Assessing borrowers for such extreme outcomes would thus be unnecessary, at a time when Australia is close to experiencing full employment and rental vacancy rates are tracking at near 20-year lows. 

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