Homebuyers could see their capacity to borrow cut by up to 40 per cent as a result of reforms likely to be driven by the banking royal commission.

Key points: Homebuyers' borrowing limits likely to be cut by up to 40 per cent due to higher expense benchmarks

Homebuyers' borrowing limits likely to be cut by up to 40 per cent due to higher expense benchmarks Current benchmarks used in 75pc of loans expect Sydney family of four to have expenses lower than income of aged pensioners

Current benchmarks used in 75pc of loans expect Sydney family of four to have expenses lower than income of aged pensioners Tighter credit rules likely to lead to falling house prices, according to UBS

Research from investment bank UBS found the expected tightening of lending standards and raising of living expense benchmarks would cut credit availability by 21 to 41 per cent, depending on the borrowers' incomes.

Currently, about three-quarters of all home loans are assessed against the "basic" Home Expenditure Measure (HEM) benchmark.

For a family of four, that is $32,400 a year, a level below the current old age pension for a couple.

UBS economist George Tharenou said while banks were already undertaking greater due diligence at the Australian Prudential Regulation Authority's (APRA) behest, the royal commission had established misconduct was more severe than many observers anticipated, and irresponsible lending was already a key finding of its investigations.

"In particular, APRA raised an alarm regarding the over reliance on the HEM benchmark," Mr Tharenou said.

"This benchmark assumes only a very modest or frugal level of household expenditure — it assumes that a family of four in Sydney has living expense slightly less than the income provided to a retired couple on the old age pension."

UBS said the "lavish" HEM benchmark of annual expenses at $58,200 was much closer to what the royal commission was likely to recommend regarding banks making "reasonable inquiries" about a customer's financial position.

"When we re-ran the major banks' home loan calculators using the higher-living expenses, we found the borrowing limit fell sharply, by 30 to 40 per cent in many cases," Mr Tharenou said.

Raising the HEM

Gross income Assumed living expenses Borrowing limit Loan-to-income ratio Reduction in credit availability $80,000 $50,000 $195,912 2.4x -42pc $100,000 $58,320 $327,000 3.3x -32pc $125,000 $68,320 $465,615 3.7x -28pc $150,000 $78,320 $538,622 3.6x -34pc $200,000 $88,320 $792,804 4.0x -31pc $500,000 $108,320 $2,472,763 4.9x -21pc

Source: Major banks' borrowing calculators, HEM "lavish" lifestyle, UBS

Even using the "lavish" HEM for a family of four with a gross income of $100,000 a year, didn't mean a comfortable existence according to Mr Tharenou, but it was closer to reality than banks' current benchmarks.

"We do not believe that raising two children in Sydney or Melbourne on $58,320 a year would provide a truly 'lavish' lifestyle, especially when lumpy, unexpected items and potentially school fees are taken into consideration," he said.

The banks' relaxed view of household spending often allows homebuyers to borrow more than five or even six times their annual income.

The NAB recently cut its "hard cap" on loan-to-income ratio from eight times income to seven times income.

The higher benchmark would see loan-to-income ratios drop to a multiple of about three to four times, according to UBS numbers.

"This is consistent with lending limits that were considered conservative prior to the housing boom, and is consistent with lending limits generally available overseas," Mr Tharenou said.

Borrowing limits would be crunched if higher household expenditures were enforced. ( Source: Major banks' borrowing calculators, HEM "lavish" lifestyle, UBS )

Credit Crunch

UBS found the likely impact of tighter lending rules meant the banks' lending "super cycle" was over.

Even under UBS's more benign base-case scenario, mortgage funding for the big banks would fall from close to $300 billion over the past two years to $222 billion in 2019 and housing credit growth would flatline.

"In a more negative scenario, the banks may be required to undertake due diligence on customers' financial situation to comply with the 'reasonable inquiries' within the Responsible Lending Laws," the UBS research said.

That sharp reduction in borrowing capacity and credit would likely have a nasty impact on the broader economy.

"Further, the household wealth effect could reverse and many potential investment property buyers could avoid the market," UBS said.

The resulting credit crunch, where new funding falls by 25 per cent in 2019 and a further 10 per cent in 2020, "is not inconsistent with experience seen overseas during the GFC," the report found.

"Further, consumption and GDP would be likely to slow sharply and the RBA may consider cutting rates."

And as Mr Tharenou pointed out: "There is a strong correlation between home-lending volumes and house prices."

"If this correlation holds and housing finance falls as seen in our scenario analysis, this could lead to a substantial reduction in Australian house prices."