Assessing Serviceability Buffer and its challenges today

While it is true that only 10% of borrowers borrow the maximum amount, according to the Commonwealth Bank of Australia, the majority have additional resilience beyond the minimum buffer. Over the years, the serviceability buffer and related measures have undergone significant changes. In December 2014, APRA standardized serviceability assessments, requiring a minimum 2 ppt buffer and 7% floor, which was removed in July 2019. However, the buffer was increased to 2.5ppt in the same year and further to 3 ppt in November 2021. 

Due to interest rates persistently below the 7% floor rate, the gap between the floor and actual rates paid has become significant, which led APRA to acknowledge that the amount of resilience built into mortgages was too large. This restriction on borrowing capacity and its impact on people’s ability to enter the housing market was deemed unnecessary. 

While the serviceability buffer protects borrowers from interest rate risk, covering around 95% of historical interest rate increases over the first 7 years of a loan’s life, which is the period when borrowers are most vulnerable to interest rate increases, APRA acknowledges that no buffer can eliminate all interest rate risk since interest rates can increase indefinitely. Therefore, lowering the buffer to its previous level of 2.5ppt would cover only 80% of historical interest rate increases over the first 7 years and 90% over the first 5 years. APRA needs to determine whether this level of resilience is sufficient before making any changes to the buffer. 

Although adjusting the serviceability buffer based on expected interest rates may seem intuitive, it is impractical to operationalize. Interest rate forecasts can change quickly, and if these forecasts are wrong, borrowers may be left with reduced resilience. Additionally, the reintroduction of a floor rate would require APRA to have a view on the “normal” level of mortgage rates, which is difficult to determine. Therefore, there is a need for a well-defined buffer that remains constant throughout the economic cycle. 

While the buffer is important for protecting against interest rate risk, it cannot account for income loss or inflation. Incorporating inflation would lead to smaller buffers. Additionally, reducing the buffer to 2.5ppt would decrease borrower resilience to 80-90% of historical interest rate risk. However, adjusting the buffer based on expected interest rate movements would be difficult and require ongoing discussions, as well as getting interest rate forecasts right. APRA will need to determine if reducing the buffer is worth it.