Basel II, an international accord designed to better match loan credit risk with how much capital APRA-regulated lenders, or approved deposit-taking institutions (ADIs), need to hold, is a "sleeper" issue which may have a greater impact on the broader mortgage industry than many expect, a leading mortgage insurance company said.

"I don't think it's got a lot of attention in terms of what it means for competition in the lending industry generally," Craig MacKenzie, general counsel at Genworth Financial, told MPA Lender.

The US sub-prime crisis demonstrated how quickly events can unfold and markets can change internationally, he said.

The rules, which are due to take effect on 1 January next year, were (at the time of writing) still being worked through by APRA. The regulator released a discussion paper on the proposed changes in September. Essentially, Basel II has three pillars: minimum capital requirements, supervisory review of capital adequacy, and market discipline through disclosure.

PMI Australia CEO Ian Graham said he was concerned the removal of incentives to use lenders mortgage insurance (LMI) for some loans would reduce the risk mitigation benefits of using mortgage insurance.

"Under the proposed changes, home lenders will have far less incentive to use LMI to level the playing field for all borrowers because APRA has substantially reduced the capital concessions for loans which are protected by LMI cover," the company added.

PMI wants new rules to remove the imbalance, and wants a review on the impact on first homebuyers and lower income borrowers, especially in those regional/rural areas primarily served by smaller financial institutions, building societies and credit unions.

MacKenzie said Basel II creates two classes of ADIs, namely advanced or internal ratings based (IRB) organisations, or the top four or five banks, and standardised banks or the remainder.

"For the IRBs, Basel II enables lenders to develop their own economic capital and determine - based on your loss experience - your own capital outcomes," he said. "APRA has to ultimately approve the model and its output, but essentially, IRB lenders will develop how much capital is required to hold for the mortgages written. For the standardised [lenders], it's much more prescriptive. APRA has provided a table of risk weights that outline how much capital a standardised lender is required to hold depending on LVR, the type of loan and whether there's acceptable LMI attached to the loan."

A May 2007 Deloitte report, entitled Global Risk Management Survey: Fifth Edition -
Accelerating Risk Management Practices, said US regulators were concerned Basel II relied too heavily on a bank's internal risk models.

Mark Degotardi, senior adviser, public and policy affairs at ABACUS, the industry body for Australian credit unions and mutual building societies (which are all ADIs), agreed. "Exactly how robust are the banks' risk models anyway?. APRA can't be 100% on this, therefore it should err on the side of caution and not just rely on the banks' estimates."

MacKenzie said self-assessment may give the major banks an advantage over standardised lenders. "The Australian mortgage market is predominantly concentrated by a few major lenders who have gained share due to distribution advantages, economies of scale and risk management capabilities. The question is: will these regulatory changes have any further impact on the current competitive landscape by offering different capital rulings?"

Degotardi said Australia's mutual building societies and credit unions are used to battling against the bigger banks. Whether it would give the IRB banks an advantage in product pricing, though, was unclear. "The largest banks have economies of scale ... Having said that, the banks have a set of people they need to satisfy that we don't, and that's their shareholders... they've got to turn those profits into dividends."

He added that it wouldn't necessarily influence what products ABACUS members sell either, as they have generally been more prudent and conservative lenders than their bank counterparts.

Banking and securities specialist Kay Thawley, partner at Deloitte, said banks had improved their risk management and segmenting techniques over the past few years, although this had been masked by the erosion in loan risk premiums.

"This has been a global trend in all segments," she said. "The difference in pricing between the higher and lower risk debt has been removed so significantly, and that's underlined the problem that we're now in, that there is insufficient pricing for risk.

"I think that would have made it difficult to observe the capability of [the major banks'] highly segmented risk [capability]. This will be much more evident now, not because of Basel II, but because of the external environment issue."

The Fujitsu JP Morgan Australian Mortgage Report said the difference between low-doc and full-doc interest rates was now around 0.2%, down from 1.3% in 2000. It added that this erosion was "beginning to unwind" in lieu of recent liquidity concerns.

In terms of Basel II's potential impact on non-ADIs, MacKenzie said reduced capital requirements for banks could help to improve their ability to reduce interest rates on certain mortgage products.

When asked whether non-banks would need to improve their own risk rating mechanisms to ensure continued and growing support from capital market investors, MacKenzie said this was likely to happen regardless, in light of the US sub-prime fallout. "Risk is being repriced," he said. "Moving forward, we can expect to see more of a reward for having a good quality performing loan book."

James Austin, chief financial officer at wholesale lender Firstmac, pointed to one key positive emanating from Basel II: cheaper mortgages. "Over the past 24 months we've seen the price of RMBS come in, largely off the back of Basel II, he said. "[Basel II] had quite a positive influence because the amount of capital a bank or investment house purchases in RMBS with an AAA rating, then the amount of capital they have to put aside for that is significantly reduced under Basel II. As a result, the spreads on RMBS have tightened considerably."

On what impact Basel II would have on LMI, MacKenzie said this would be minimal, as regulatory capital relief was just one of the reasons why lenders use mortgage insurance. LMI plays other important roles to assist with either risk management, capital management, market growth or support for capital market funding. LMI remained highly valued for non-banks as a source of credit enhancement for bond issues, while continued demand for high-LVR loans, spurred on by the high cost of property, will also support the need for mortgage insurance.

"The growth we've seen in the 90LVR-100LVR space over the past one to two years has been significant," he said. "We can expect high-LVR lending to continue in the future."

Degotardi said it's possible that "Basel II will see ADIs focus on certain segments of the mortgage market, as other segments are less attractive due to capital requirements. I think the competition for the more lucrative side of the portfolio, the very good [prime] loans, will become increasingly difficult for the non-ADIs to play in," he added.