Comments on: APRA increases the cost of home loans – again

By: ozrisk

ozrisk — Thu, 15 Mar 2007 11:08:33 +0000

To be honest, aus – no. Any problems I have seen relate to the corporate portfolios where there can be less data. I must assume he is talking about the long run LGDs being under the estimate APRA has from the ICA (as from riskopedia above) and therefore (in APRA’s understanding) wrong.
I wonder what criteria APRA will use for ascertaining these as “correct” later? That they give a number near 20%?
Thanks also for pointing me at the speech – I must confess I had missed it. I think it will provide grist for a few posts over the next few days.

By: aus

aus — Thu, 15 Mar 2007 08:35:09 +0000

For an APRA justification see the speech by Bernie Egan (p7) to the RMA which suggests that the floor is temporary and will be in place until banks address certain ‘deficiencies’…. Any thoughts ozrisk on what he’s talking about?

http://www.apra.gov.au/Speeches/upload/MEETING-THE-CHALLENGES-OF-THE-IMPLEMENTATION-OF-BASEL-II-Bernie-Egan-130307.pdf

By: ozrisk

ozrisk — Wed, 07 Mar 2007 14:02:04 +0000

Riskopedia,
Thanks for that. I would suggest you add in the 1.06 factor to get the numbers post QIS5, but the change is minor. The capital change between 10 and 20% LGD is over $10m on your scenario. Chuck in the value of the CBA’s home loan book (2006 annual report, p142) with the rest of the numbers you have and you are talking $1.5bn in additional, un-needed, capital. Ouch. Realistically it will be more than this, though as the PD of 1% is conservative.
I like the point about adding in the pillar 2 issues – to which you can also add the K for operational risk.
As I note in the post on the CBA the effect of this is not going to be evenly spread – it will penalize the banks overweight in home loans to retail clients.
I would love to see some rationale from APRA on this.

By: Riskopedia

Riskopedia — Wed, 07 Mar 2007 12:34:16 +0000

Using the QIS 5 workbook from http://www.bis.org/bcbs/qis/qis5.htm.

Lets take the following scenario:
- Let say majority of Non-defaulted home loan has approx 1% TTC PD (using APRA stressing testing results, P.1)
- Downturn LGD is the 10% floor. (for argument sake)
- EAD is $1,000,000,000

–> In Standardised, it would have $500,000,000 as RWA. (50% of EAD)
–> In IRB approach, The RWA would be $125,330,946, and RWA is 12.53% of EAD.

If we now change to 20% floor
–> RWA would now be $250,661,891. I.e. double of what we have before. RWA is now 25.06% of EAD.

Now, what I have heard before is that even after the Basel II implementation next year, the “savings” on capital would be capped at 10% discount for couple of years (again, can correct me on the statement). Using the above as an example, I am supposed to save 75% of my current capital requirement under 10% LGD floor. But I would of only “save” 7.5% using the 10% cap rule, which, it would still be above the 20% LGD floor.

Given all the above, we all know what APRA is trying to do, but I agree with Ozrisk that there needs to be a hearing on APRA points of view (so that at least we know APRA didn’t pick a number out from the air). As a side note, all the above calculation is only on Pillar 1, if you then add on the Pillar 2 stuff, the RWA could easily gone back to 50% of EAD if also applied the 20% floor.

However, I do think that APRA will take it case by case from different banks for discussion sake. (But the likelihood of changing the mindset, may be very unlikely).

By: ozrisk

ozrisk — Wed, 07 Mar 2007 11:32:31 +0000

Bruce,
I think we should organize some Parliamentary hearings on this. I would love to hear that explanation on the formal record.
Just as a side point – I am not sure many consumer loans would get below 0.03% PD (I will have to remember to ask coldies on this) as this would constitute a S&P AAA rating. Technical defaults are likely to be a little more plentiful than this. I do agree it would be very low, though.
So far I have not heard one nice thing said about this idea – and I have spoken and listened widely on it. C’mon – there has to be one of you out there that agrees with this.

By: bruce

bruce — Wed, 07 Mar 2007 09:42:14 +0000

From a simple view point, A high quality low risk mortgage book could have a PD (for a big chunk of the book) below the floor of 0.03%. As PD is correlated with LDG to an extent. These same loans are likely to have an LGD below the floor.

So the Risk Weight percentage for these loans would be 0.98% of EAD under the 10% LGD floor rule.

An RW% of 1% for mortgages may be a step too far for the regulator (Under the Basel 1 rules all mortgages had a RW% of 50%). Doubling the LGD floor would increase this to just short of 2%.

So it maybe as simple as they dropped their bottle.

By: ozrisk

ozrisk — Tue, 06 Mar 2007 13:04:29 +0000

I agree – a 20% floor makes the capital less risk sensitive.
If there is anyone form APRA out there who wishes to put their view I would be interested to hear it – ‘coz I can’t work it out.

By: Riskopedia

Riskopedia — Tue, 06 Mar 2007 11:57:34 +0000

- LMI industry normally deals with High risk loan, e.g. LVR > 80% (at least) or high risk customer (from bank’s perspective). As for retail banks, large proportion of the loan is normally less than or equal to 80%. Hence, would not be surprised if retail bank has a low LGD figures (again, forget about the whole beign economic environment). So, I do question the use of LMI results on 20% LGD.

- Basel Accord indicated that a bank needs to segment LGD if can do. So, if one bank decided to have multiple LGDs values (whether based on LVRs, Age of Account etc.), I do not believe to set a 20% floor is appropriate when it kinda contradict what Basel is trying to achieve. Else, why we would have segmented LGD in the first place?

By: Riskopedia

Riskopedia — Tue, 06 Mar 2007 11:51:48 +0000

cont..

- LMI industry normally deals with High risk loan, e.g. LVR > 80% (at least) or high risk customer (from bank’s perspective). As for retail banks, large proportion of the loan is normally

By: Riskopedia

Riskopedia — Tue, 06 Mar 2007 11:50:49 +0000

There is another article I have found
“http://www.apra.gov.au/RePEc/RePEcDocs/Archive/discussion_papers/dp0014.pdf“

Again, similar para. on P.8 “Loss-given-default Loss-given-default (LGD) in the proposed MER model is based on the long-run average LGD of 20 per cent reported by LMIs, across all LVR buckets, from 1980 to 2000. Consistent with economic intuition, the proposed model allows LGD to vary with LVR. This increases the model’s sensitivity to risk compared with the current model, which has a flat LGD across all LVR buckets.”

Regardless of what results we have in MER model, I have couple of comments:

- From a general logical pt. (also proven in APRA stress testing results), a bank would expect to get a Higher LGD% for those High LVR Young accounts during downturn. But if a loan got below 70% – 80% LVR (just assume no LMI), even if the property price dropped by 20% (during a downturn). The “LGD” is very unlikely to be 20%, when it pretty much means the price of the property would of dropped by another 10-20%. (i.e. the asset value cannot cover the remaining loan)

- LMI industry normally deals with High risk loan, e.g. LVR > 80% (at least) or high risk customer (from bank’s perspective). As for retail banks, large proportion of the loan is normally