Recent lending rate increases by Australia’s major banks were prompted by expectations of imminent macroprudential tightening and of higher funding costs on the back of further US rate hikes. The increases should help cool growth in mortgage lending to more vulnerable borrowers, but high household debt and rapid property price appreciation are already key risks to the performance of the banking sector, Fitch Ratings says.

All four of the major banks – ANZ, CBA, NAB and Westpac – this month increased lending rates, primarily on investor and interest-only mortgages, which runs counter to the Reserve Bank of Australia’s (RBA) rate cutting cycle of recent years. Higher US interest rates are likely to push up the cost of wholesale funding, which the major banks rely on due to the general lack of deposits in Australia, but Fitch believes the latest lending rate increases were mainly driven by rising pressure to rein in some riskier forms of lending ahead of probable regulatory tightening.

The continuing pick-up in investor activity in the property market is likely to be the main target in the next round of macroprudential tightening. We expect the regulators to impose stricter mortgage-lending standards and perhaps lower the cap on annual growth of investor mortgages from the current 10%. This should reduce the incentive for the banks to compete on risk standards. The changes are also likely to encourage more price differentiation between mortgage types, with rates on investor and interest-only mortgages set to rise further. Broader increases in lending rates are likely in 2018, when we expect the RBA to start increasing its policy rate.

Households are sensitive to increases in lending rates due to high debt, low wage growth and the vast majority of Australian mortgages being based on variable interest rates. The household debt/disposable income ratio reached 187% at end-September 2016, which is very high by global standards. Moreover, a house price correction following unsustainable price gains over the last decade, particularly in Melbourne and Sydney, could erode the strong equity cushions currently held by many mortgage borrowers. Fitch revised the banking sector outlook from stable to negative in January in part to reflect these rising risks from the residential mortgage sector, which accounts for 39%-54% of the major banks’ exposure at default (EAD).

Some of the risk is mitigated by the regulators’ strict oversight, which includes publicly disclosing the minimum underwriting standards expected of a prudent bank. It would probably take a sharper increase in lending rates than we are currently expecting or a significant rise in unemployment to severely undermine households’ debt serviceability. The major banks also have solid capital buffers and strong pre-impairment profitability to help offset an increase in impaired assets. We affirmed the ratings of the four major banks are ‘AA-‘/Stable on 6 March, taking into account risks stemming from the household sector.

Source: FitchRatings