Australian banks' profitability to suffer from tighter mortgage lending standards

The share of new loans with high loan-to-value ratio fell to 22.3% in December.

According to BMI Research, the Australian housing market is already significantly overvalued, and the rapid increase in property prices continues to pose a significant risk to financial stability, with mortgages accounting for more than 60% of the loan portfolio of banks. According to Corelogic LP, average home prices in the country rose by 12.9% y-o-y in March, which was the fastest pace of growth since March 2010, and the boom was led by Sydney, which surged by 18.9% y-o-y.

Here's more from BMI Research:

Australia regulators also recognise that risks are rising in the housing market, and in an effort to cool it, the Australian Prudential Regulatory Authority (APRA) announced a number of new macro-prudential measures on March 31, which we expect to have a negative impact on credit growth and slow house price gains.

Given that housing credit is a significant driver of overall credit in Australia, we therefore maintain our forecast for the country's overall credit growth to slow to 3.0% in 2017, from 6.1% in 2016, which will be a headwind for the profitability of banks.

The new measures mainly focus on new interest-only residential mortgage lending, and in our view, growth of investor housing credit is likely to take a big hit. Indeed, there is a high correlation between the share of new interest-only mortgage loans as a share of overall new residential term loans to households with the growth of investor housing credit.

According to data from the APRA, new interest-only mortgage loans accounted for 37.7% of overall new residential term loans to households in December 2016, and we estimate that a decline to the regulator's stipulated level of 30.0% would potentially result in investor housing credit growth decelerating to 4% y-o-y over the coming months, from 6.7% y-o-y in February.

When the APRA first tightened macro-prudential measures by limiting investor housing credit growth to 10% y-o-y in December 2014, growth in that category trended lower from above 10.3% y-o-y to a low of 4.8% y-o-y in July 2016, and we therefore highlight that risks are heavily weighted to the downside.

The tighter lending standards by the APRA are negative for the profitability of banks as the amount of new risky lending for property purchases declines. According to data from the APRA, the share of new loans approved with loan-to-value (LVR) of above 80.0% fell to 22.3% in December 2016, from 36.8% in March 2008.

We expect the proportion of significantly high LVR loans to remain on a downtrend over the coming months amid attempts by policymakers to place strict limits and scrutiny on the volume of interest-only lending for LVR above 80%, and this will likely dampen earnings growth.

Australian banks continue to pay out generous dividends, despite profitability headwinds. In light of the challenging operating environment, banks could preserve cash by cutting dividends over the coming quarters.