Banking regulator APRA late on Monday afternoon released its new bank capital framework, which it has described as "more risk-sensitive".

As a result, the current higher interest rates facing property investors, borrowers with small deposits or little equity, and those on interest-only loans are likely to remain, if not increase.

However, because a very similar draft was flagged a year ago, it is understood APRA is not expecting big shifts in market pricing for mortgages and other loans as a result of the final changes.

While the size of a loan relative to the bank's valuation of the property (loan to valuation ratio, or LVR) was previously the main measure of risk considered by the regulator, APRA will now also differentiate between owner-occupier and investor loans, as well as principal and interest versus interest-only loans, with the latter in both cases considered riskier.

In the context of capital requirements, riskier loans resulting in bigger capital requirements will mean higher costs for the bank and, therefore, the borrower.

How do capital requirements work?

Here is how it will work, in very simplified terms.

Capital is the buffer banks are required to hold to absorb losses from bad loans, particularly during times of financial or economic stress.

It is relatively expensive because banks have to deliver a sufficient return to the investors (shareholders and bondholders) who are putting their cash on the line in the event things go sour.

Because of this, the level of capital required for a particular type of loan is a significant determinant of its cost, or the interest rate the bank will charge.

APRA is slightly shifting the dial through changes to the "risk weighting" it applies to different forms of lending.

The risk weighting is basically an estimate of how risky a loan is, and therefore how much it should count towards the "risk-weighted assets" that banks have to hold capital against.

If a loan has a risk weighting of 100 per cent, its entire value is considered at risk. If it has a risk weighting of 40 per cent, the bank only has to hold capital against that at-risk portion.

So, for example, if a bank was required to hold 10 per cent capital, it would have to hold $100,000 in capital against a million-dollar loan with a 100% risk weight, but only $40,000 against the same-sized loan with a 40 per cent risk weight.

To give a simple example from APRA's new policy, under its "Standardised" model (used by the smaller and mid-sized banks) the risk weighting on an owner-occupier home loan that is for less than half the value of the property is 20 per cent, but it is double that (40 per cent) for mortgages with a loan-to-value (LVR) ratio between 80 and 90 per cent.

So a bank would have to hold twice as much capital against the 80-90% LVR loan as it does against the one below 50 per cent.

As you can see from the graph, for any given LVR, investor loans and longer-term interest-only loans will have a higher risk weight than owner-occupier principal and interest mortgages.

Therefore they are likely to continue having higher interest rates. The benefit may go to owner-occupiers with large deposits or lots of equity in their home, who are likely to continue seeing relatively cheaper mortgages.

While the standardised risk weightings do not apply to the major banks, and some other larger institutions that use APRA-approved internal risk models, the same principles will apply.

Business loans may become cheaper relative to mortgages:

APRA figures show that the major banks, on average, are likely to see a small reduction in their risk-weighted assets under the new rules, which may mean they can slightly reduce the capital they hold.

However, the regulator indicated that this is due to a fall in risk weights for commercial property and large corporate loans, while mortgages will see a slight increase in overall capital requirements.

"One of the objectives of the new framework has been to strengthen the amount of capital held by banks for residential mortgage lending, given the industry concentration in this asset class," noted an information paper released by the regulator.

"In APRA stress testing, mortgages are a significant driver of overall losses, and typically account for around a third of aggregate bad debts.

"Under the new framework, APRA has increased capital for residential mortgages relative to other asset classes, and better distinguished higher and lower risk lending."

APRA also noted that risk weights for small and medium enterprises will be lowered for banks using its standardised approach, potentially facilitating slightly cheaper lending to this sector.

Story By | Michael Janda