A new working paper released by the Bank for International Settlements (BIS) takes a look at the relationship between bank capital and mortgage supply based on an experiment using the Italy's mortgage market.

According to the study, banks with higher capital ratios are more likely to accept mortgage applications. A one per cent increase in capital ratio raises the likelihood of a mortgage application being accepted by 20 per cent. Similarly, these banks are also more likely to approve the application and extend credit compared to banks with lower levels of capital. In fact, the BIS paper points out that bank capital is the leading variable affecting a bank's decision to accept an application, followed by liquidity and cost of funding.

After all, banks with higher capital also have more regulatory capacity to lend than less well-capitalized banks, which have already exhausted their capacity. The former are also more willing to take risks in the mortgage market while the latter are more exposed to negative shocks to their income, hence making them more risk-averse.

However, the effects are a bit different when applied to the Australian property sector. The increase in the minimum level of required capital for mortgage lenders as warranted by the Australian Prudential Regulation Authority inversely affected the systemic mortgage supply.

Using the Interest Ratings-Based (IRB) approach, the average risk weight of residential mortgage exposures increased to at least 25 per cent from an average of 17 per cent. Hence, this increase in regulatory capital floor also reduced the amount of funds that Australia's biggest banks are lending towards housing.