There is a simple and free way to observe a fascinating yet little-known aspect of Australia’s banking system.

By browsing the internet to a bank-based ‘Home Loan Repayment Calculator’, you can, by entering certain information, get a fast estimate of the required monthly repayments for various loan amounts.

I input into the calculator that the property I wanted to buy was valued at $1 million, and the loan amount I needed was $400,000. I chose the ‘variable rate’ option and declared myself to be an ‘owner occupier’. All the other settings I left as the default.

The default home loan product is called ‘Express,’ and the repayment type is ‘principal & interest’. The default loan term is 30 years.

Once completed, the calculator estimated a monthly repayment obligation of $2,401 over 30 years; the applicable interest rate was 6.01 per cent.

In the scenario I used, the absolute key information is the loan amount versus the property value. These two numbers give a core metric used in banking, known as the loan-to-value ratio (LVR). The LVR is simply calculated: it is $400,000 divided by $1 million, which in percentage terms is 40 per cent.

The LVR is so critical because it indicates the level of risk in a loan. If the borrower stops repayments, is there enough security value in the property when sold to ensure the bank gets its $400,000 back?

Assuming the initial property valuation is conservative (as normal practice), an LVR of 40 per cent means the loan is essentially risk-free. For the bank to lose even one dollar on the loan, the property value would need to decline by around 60 per cent.

This is not something that we have observed before in Australia, especially on a nationwide basis, and the scenarios where such price declines might occur are in the realm of meteor strikes and democracy collapse.

Now, here’s the interesting thing. If, in the bank’s calculator, you change one variable – the borrower identity – from ‘owner occupier’ to ‘investor’, then the calculator gives a different estimate. Instead of an interest rate of 6.01 per cent, the new applicable interest rate is 6.29 per cent. As such, the repayment obligation increases by an extra $73 per month over the 30-year term.

Why, when there is no greater risk on the loan due to a very low LVR, has the loan calculator increased the associated interest rate? Possibly it is because the bank has made a strategic business decision to slow its investment housing loan growth.

The more likely answer, however, is that the bank’s differential pricing reflects an important government regulatory obligation known as the capital adequacy rules. To ensure banks have enough capital to withstand economic downturns, the government mandates rules to determine the minimum capital requirement.

Is this regulation really needed?

One argument is that without government intervention, the bank management and owners have an incentive to reduce the equity (capital) in the business to increase leverage and drive higher profitability. They will do so to a level that makes the overall banking system too vulnerable to an economic shock, creating a serious externality, with the costs borne by taxpayers and those who lose their job due to an economic shock and thinly capitalised banking system.

Technically, the government forces the banks to maintain a level of capital against nearly every loan the bank makes. This capital obligation is required on a per-loan basis to give those banks that make safer loans a capital advantage over those that make riskier ones.

In the current set of capital adequacy regulations, a bank that issues an investment housing loan is required to maintain more capital than if the same loan amount is issued to an owner-occupier. To account for the higher capital requirement, the bank has an incentive to increase the interest rate of the loan.

I’ve gone into some detail because I recently saw a financial analyst make an interesting proposal to help young people buy houses.

The idea is that by adjusting the risk-weighting of housing loans, allowing the banks to maintain less capital against loans to first-home buyers (FHB), they can offer lower interest rates.

If this happens, the home loan calculators will have to ask a new question: Is the borrower a first-home buyer or not? If yes, then the idea is that they will get a lower interest rate than those with a similar profile but are not a FHB.

The idea is simple to criticise, especially given the experience of the global financial crisis in 2008-09. That crisis was triggered by large defaults on US housing loans, and part of the underlying reason was US government policies aimed at improving housing access for low-income people.

Would tinkering with bank loan risk weights in Australia to help first-home buyers get a foot into our expensive property market be short-sighted, risky?

Would it perhaps help some but at the risk of system-wide instability? Possibly, but the author of the risk-weight proposal addresses this issue of risk.

Firstly, he argues that young people wanting to enter the housing market are probably lower risk than older buyers and that currently the risk weight system does not properly capture this lower risk profile in capital requirements.

One reason for lower risk is that young people’s incomes tend to rise over time at a faster rate than older workers.

Second, while the proposal would lower capital requirements for FHB, it would marginally increase capital requirements for other borrowers – leaving unchanged the system-wide level.

While this sounds like a political obstacle, disadvantaging some to help others, the practical implementation would be politically benign, just as the current system is rarely criticised for advantaging low-risk borrowers over higher-risk ones.

The chief attractiveness for a political party looking for election policies to deal with housing affordability is that altering housing risk weights can be implemented without any cost to the Federal Budget.

Therefore, it could be something the Coalition considers as the next election draws closer, in addition to its mantra about increasing housing supply. It may also deflect criticism that negative gearing is hurting young people to the advantage of land-owning older generations.

Nick Hossack is a public policy consultant. He is former policy director at the Australian Bankers’ Association and former adviser to Prime Minister John Howard.

This is an opinion piece only. It does not offer financial advice of any kind.