The blunter instrument
APRA’s pre-emptive limit on mortgage lending at a high Debt-to-Income ratio highlights that good lending practice should not be distorted by system-level controls. At the margin, the policy is slightly dovish for the interest rate outlook.
This week APRA announced a limit on the share of new mortgage lending where the borrower’s total debt is at or more than six times income (DTI limit). For some people, this will limit mortgage loan sizes to an even lower ratio. Some of these larger-sized loans will be allowed, and currently APRA’s limit is not binding for mortgage lending overall, though it might constrain some individual lenders. Even so, there will likely be some distributional impacts, particularly on investors and younger home-buyers.
APRA’s move is pre-emptive given current housing market conditions. Indeed, some indicators might already be signalling a coming loss of steam. The policy itself also needs to be understood in the context of the known limitations of macroprudential tools.
At the margin, we see this policy announcement as slightly dovish for the interest rate outlook. With macroprudential tools already in place, it will be harder to argue that a buoyant housing market requires tight monetary policy.
If you thought monetary policy was a blunt instrument, let me introduce you to so-called ‘macroprudential tools’. These became popular in the wake of the Global Financial Crisis. Regulators were looking for something to control financial stability risks when low interest rates seemed to work in the opposite direction. International organisations such as the IMF and BIS were particularly enamoured of them.
There were sceptics about some of the proposals – including, uh, me. Too many of the tools looked like an effort to shoehorn prudential supervision into a monetary-policy-shaped mould. Some of them do not comport with good practice for lending. And they push attention onto the housing market, where lending is more homogeneous and quantitative metrics on the system can be more readily defined. In doing, so they could deflect attention from some other areas that could pose risks to financial stability, like, say, private credit.
These tools have nonetheless found a place in the Australian regulatory framework. Some, like the limits on interest-only lending and investor lending, have been imposed for limited periods to good effect. Others, such as the countercyclical capital buffer, have become more-or-less permanent add-ons to the base Basel capital rules, rather than the “in case of looming risks, pull lever” they were originally designed to be.
To understand how DTI limits work, it helps to know how they interact with mortgage lending practice in a country like Australia. Good mortgage underwriting practice uses a ‘Net Income Surplus’ model of determining how much a lender is willing to lend to a particular mortgage borrower. The idea is that the borrower’s non-mortgage expenses are deducted from their usual income. The difference is then considered available to service the mortgage, with a little surplus left over to cover unexpected expenses. The calculated repayment is then used to work out the loan size, based on the desired term in years, and an appropriate interest rate. In Australia, this loan size calculation is done using an interest rate that is higher than the actual rate the borrower will initially pay. The size of this interest rate buffer is another standard set by APRA, currently 3 percentage points.
Depending on the borrower’s income, family structure and other circumstances, the allowable mortgage repayment will vary as a share of income, and thus so will the loan size. For example, a couple with no children and their associated expenses will be able to borrow more than a couple with three children. Someone with other debts will be able to borrow less. (This Box from the RBA’s Financial Stability Review is a good tutorial.) This means that there is no one-size-fits-all cap on the appropriate ratio of loan-to-income (LTI) for everyone – or repayment-to-income, for that matter.
The Financial Stability Board’s (FSB) 2012 Principles for Sound Residential Mortgage Underwriting Practices supports this approach. It states that ‘[j]urisdictions should ensure that lenders make reasonable allowance for committed and other non-discretionary expenditures in the assessment of repayment capacity.’ Temporarily high incomes should be ‘suitably discounted’. This means good lending practice is more than just a blanket LTI or repayment-to-income cap for every borrower. The risk of ‘macroprudential’ tools, if not well designed, is that they subvert good practice in individual loan decisions, such as the Net Income Surplus method.
The APRA measure is a DTI limit, not an LTI limit. This means that the limit is on the borrower’s total debt, not just the new loan. This includes things like HECS debt and Buy-Now-Pay-Later balances, which might be particularly constraining for younger, potential first-home buyers. It is nonetheless in line with the FSB principles and best practice, but differs from the UK regulation, which limits high-LTI lending. Investors and other borrowers with other mortgages are also more likely to hit DTI limits. So might some unincorporated small businesses. Some of these loans are probably not that risky, which is why the APRA rules allow for some high-DTI lending to occur but limit how much. Still, there is a balance to be struck between setting a tight limit and preventing good borrowers from getting credit, something other countries’ regulators have previously highlighted.
Currently, the limit is not binding on the industry. The current share of high-DTI lending is well below the limit APRA has set, though it could constrain some individual lenders. There is a flavour here of the earlier rounds of portfolio limits, where the limit had the effect of bringing a more aggressive minority of lenders back closer to the more-prudent pack. In this sense, the boundary between ‘macro’-prudential and ‘micro’-prudential becomes blurred. The UK evidence on LTI limits nonetheless suggests the distributional impacts on households can be substantial, even in these circumstances.
This week’s announcement stands in contrast to the earlier episodes of macroprudential limits, though, in how pre-emptive it has been. APRA assesses that housing lending standards are currently sound overall. Interest rates have declined only ¾%pt from a peak that almost everyone at the time thought was restrictive. Housing prices have picked up, especially in the smaller state capitals, but the latest data for Sydney and Melbourne suggest some moderation in growth and a step down in auction clearance rates. And while the RBA has argued that the response of the established housing market to the cash rate was a bit more than it expected, housing credit growth has not been exceeding household income growth.
This early introduction of macroprudential tools helps head off arguments that a buoyant housing market demands tighter monetary policy than otherwise. Prudential action is already handling this, the argument will go, no need for you central bankers to hold off on further cash rate cuts. And if this deflects attention from the concentration of the recent inflation pulse in administered prices, so much the better from some people’s perspectives. (This is not just about Canberra. One of the surprises in the October CPI was water charges. It turns out that IPART determined in September that typical Sydney Water charges should rise by 11.8% plus inflation from 1 October, and 5.1% plus inflation each July from 2026 to 2030. This added 4.2% in the October month to the national index for water and sewerage, which normally only increases in July.)
All the more reason not to jump at noisy shadows. While we are seeing a genuine upswing in activity in both our Card Tracker of consumer spending and the latest data on business investment, the evidence that this has been the main driver of the recent upside inflation surprise is flimsy. And given the uncertainties around how macroprudential tools affect outcomes, the risks are not one-sided.
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