Is it time for a review of interest rate buffers?

Is it time for a review of interest rate buffers?

During the Covid-19 epidemic, interest rates were at record low levels.

For outsiders looking in, you could be confused into thinking that borrowing power of Australian consumers went to the moon. However, this is not so. In fact, although rates were low, every institution was required to add at least 2.75% higher than the actual rate. This is because, due to the record-low rates and booming house prices, the Australian Prudential Regulation Authority (APRA) expected household debt to exceed household income for the near future, therefore, introducing the buffer as a regulatory attempt to minimise the risk to the economy.

The thought behind this policy was to ensure that when rates returned to normalised levels, borrowers could still repay their loans. This “serviceability buffer” was used by banks to assess loans, in an attempt to reduce borrowing power and cool the property boom. The tightening of lending standards was initially made to tackle high debt home loans and house price inflation. However, any ‘fast interest rate rising cycle’ would then push new borrowers to their limits as the rate exceeds the buffer and is stress testing borrowers’ budgets.

Fast forward a couple of years and that is exactly what is happening, with variable rates hovering between 5.5% and 6.5% 

Whilst this buffer was put in place to ensure borrowers can afford to make their repayments if rates increase, thankfully, it appears at this stage that people are indeed coping with the current interest rate increases.

The buffer has allowed households to smooth their spending and maintain required debt payments when faced with lower income or cash flows, or higher expenses. Has this buffer helped protect against the risk that, as rates rise, households will find themselves unable to meet debt repayments?

One of the major consequences of the above policy is that it dramatically reduces borrowers’ capacity to borrow. In turn, this subsequently (and artificially) affects the free markets of lending. The policy change will result in future applicants borrowing less money than they would have otherwise, with the increase in the interest rate buffer fundamentally having a major shift in the outlook for home prices in 2022.

There can be no argument that the policy was warranted during unprecedented times, with rates at historically low levels. As we have gotten to the point of incredible housing inflation, it is necessary to recognise that the issue is not simply a result of Covid-19.

Given the policy was implemented to protect borrowers and factor in inevitable rate rises, is this policy even required?

Rates have now risen every month since May with inflation showing signs that it may have peaked. Is it likely that rates will rise another 2.75% from where they are today? No, it feels unlikely that they will rise another 2.75%.

Are we at the point now where interest rates have normalised? I do believe so, as do a chunk of bank economists.

Should the buffer be reduced, or even removed? Again, yes, I do believe so. 

It just so happens that these policies are introduced at the speed of light. However, these policies are also removed at a snail’s pace.

Only time will tell.