Transcript of Question & Answer Session Understanding Rising Housing Loan Arrears

Thank you, Jonathan. So we now have some roving microphones, so if you want to ask a question, feel free to. Or you can also send your questions through our website, which is up on the screen with the details there. So, I might just kick off and talk about a little bit about what you talked about, APRA's tightening of lending standards and what happened back in December 2014. APRA decided to ease those back now. We're starting to see that come through, but if you were to cast your mind back, given how quickly that's really impacted house prices and the knock-on consequence that's had to arrears as well.

Do you think we moved too quickly and tightened those lending standards too quickly? What are your reflections now with the benefit of hindsight?

I think the first thing to note is we do think that the tightening in housing lending standards had some impact on the property market. But by and large most of the decline in the housing market has come through from weaker demand. There are a few factors driving the weaker demand. One of which was just that with there being such a big increase in property prices that the level of prices became unaffordable for a large number of borrowers. But there had also been a very big increase in supply. The property sector had taken some time to respond to the increase in population growth and the increase in demand that had occurred. We'd also seen a reduction in demand coming from foreign investors. There'd been a significant reduction coming from China.

So, it's interesting if we look at house prices for detached houses versus the prices for apartments. If it was going to be the lending standards that had driven this, those lending standards have probably affected investors more so than owner-occupiers because of the impact on interest-only loans and so forth, and the benchmark on investor credit growth. Investors tend to buy more apartments. So, if it was these lending standards driving things, we would have expected to have seen declines in apartment prices more so than detached house prices.

But ultimately, in order to have a good financial system, we do need to have appropriately tight lending standards. Conditions had got to the point where it was necessary to have a tightening in lending standards and that needed to happen at some stage. The sooner you do it, you end up having a better-quality lending book and so the financial system is more stable.

So, from our perspective, it was appropriate for APRA and ASIC to make those tightening decisions when they did.

And if you're looking forward to where we are right now with APRA having easing some of that back, but obviously the banks now have had to introduce some new borrowing capacity rules as well. If you're looking forward and looking at some of the risks around those arrears and negative equity in homes, how much are you concerned about housing prices falling further and what that will then have to do in terms of impacts on negative equity, arrears and stability. What's the magic number that house prices have to fall before you get more concerned?

I think one thing to just start off in making comment about falling housing prices is that for many decades, we had exceptionally strong house price growth and I think a lot people became conditioned by that. Now, there are reasons that house prices increased so strongly for a few decades and that was the decline in interest rates and financial sector reform. And so these were one-off effects, but stretched over a long period of time. So, looking forward, we wouldn't expect to see the average house price growth of ten percent or more, which we had seen for many years.

So, if we're going to have lower average house price growth, we're going to experience periods of declining house prices more frequently, just because if you have a cycle around a lower mean. So, that would indicate that the borrowers and lenders have to be making appropriate decisions, conditioning for the fact that you are more frequently going to have declines in prices. So far, we've seen a decline nationally of a bit less than ten percent and in Sydney/Melbourne it's been a bit more. And that has certainly contributed to some borrowers falling into negative equity – where the value of their loan exceeds that of the property.

And that is a bit of an issue for those borrowers and for the lenders exposed to them. But, at the moment, we've estimated in our most recent Financial Stability Review, that that only accounts for probably about three percent of banks' housing lending. But if you had another ten percent (fall in prices), just because of the nature of where loan-to-valuation ratios sit, you would get a bigger increase (in negative equity) than what we've seen to date. So it does accelerate the share of households that are in (negative equity). But, three percent is still a pretty low number that won't cause significant problems for the financial sector and so their ability to lend.

That's great. So, we spent a bit of time this morning talking about the housing sector and, you touched on as well, it's obviously such an important part of the economy and also just a confidence in the market. But I might switch now to the commercial real estate sector because a lot of our delegates in the room are also so very, very focused on the commercial sector. From the RBA's perspective, and I know you touched on this in your Financial Stability Report, can you just talk through some of the things that you look at when you look at the commercial real estate sector and how the debt and financing in that sector impacts how you view the financial stability and some of the things you look at as metrics in a commercial real estate space.

So, we obviously look at the style of lending, the quality of lending, what lenders are involved in lending to the property sector. There are significant differences between when we look at the commercial property that is the construction of residential property and that has quite different dynamics to the other parts of the commercial property sector. One of the things that we have seen is that there has been a large decline in rental yields on commercial property and that seems to be essentially being driven by global factors in the decline in interest rates globally on all sorts of assets.

And so, whilst we think of the yields on commercial property in Australia as being quite low, in a global context, they're still relatively attractive, particularly given the very good economic conditions and the strong outlook with relatively strong population growth. And so, we will tend to look at the amount of construction because there can tend to be boom/bust cycles in commercial property. Historically, commercial property has tended to be one of the more significant problems for banks if we look back to the early 1990s in Australia.

But currently, commercial property accounts for actually a relatively small share of banks' lending. And so it doesn't seem to be a risk to them. It's been interesting seeing a number of non-banks coming into the commercial property sector and they're harder for us to track because there is less information available about them, there's less reporting, but to the extent that there's equity investments in it to an extent, they probably pose less of a risk for the financial sector because the money's not actually interacting with the banking system. So, from our perspective, they're probably less risky.

The risk that we can see when we have lenders outside our financial system, whether it's non-banks or international banks' lending is the potential that they drive the cycle further. And so, you get more money flowing in and that then influences prices, and so then that can influence the quality of the loans for our domestic banks. So, we still do need to pay attention to what is coming from the rest of the world, as well.

And just touching then on the non-bank sector, you were just saying that there's a lot of new entrants to the market. In some ways, you could say that's a great thing because we're getting more competition into the market and that's diversifying our funding sources. But what are some of the risks you see and how is RBA and APRA working together to actually understand that market more and actually then be able to quantify what those risks are and then develop appropriate responses to that.

That's been a fairly important development in the housing lending space, coming back to that side where APRA has gained new powers now for being able to collect more information from non-bank lenders. Because the first thing to do to know whether there is a risk to the financial system is to be able to measure it and if we can't, we don't know how much lending is going on and by whom, we can't really assess that. Now, to the extent that this lending ends up coming say from mortgage-backed securities and if those mortgage-backed securities are being held by real money investors, then that is diversifying the risk and so I think that's actually a good thing. So … in the current environment where we've had a tightening in lending standards by the banks and potentially in some areas, excessive caution, the existence of non-bank lenders actually acts as a spare wheel for the financial system to ensure that lending is still going out. So, it can be quite beneficial, as well.

Well, fantastic. I think that brings us up to time. So, if everyone could just join me in thanking Jonathan for being so generous with his time today.