The Australian Prudential Regulation Authority (APRA) is laying down the law to Australia’s banks like never before – including setting out specific details of how it expects the bank to assess customer’s ability to repay loans.

APRA updated its industry guidance yesterday, to ensure the banks including Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC) are managing their lending risks appropriately.

That includes specifying the interest rate that needs to be used to assess the ability to repay home loans of at least 7%, despite many banks offering variable mortgage loans with rates under 4%.

APRA also says banks need to ensure that a customer can still repay their loan even if the interest rate on the loan rose 2%. The regulator has never specified how big the buffer needs to be.

While many of the banks are already following those guidelines, it’s clear the regulator doesn’t trust them unless the rules are clearly laid out. The regulator criticised the banks for some of their lending practices last year, saying some standards had fallen to “horribly low levels”.

As APRA’s chairman, Wayne Byers told a Senate estimates hearing last year, “We were a bit surprised by how much the competitive pressures in the industry and the competitive dynamic in the industry had led people to do things, albeit at the margins but nonetheless do things that were really in our view lacking in common sense.

What may be concerning APRA is the continuing rise in the Sydney and Melbourne housing markets, as auction clearance rates rocket along at boom-time levels. SMSF property buyers also appear to come under much greater scrutiny.

But will it be enough to protect the banks and the financial system if there’s a collapse? It may not, as the trigger could come from the flood of apartments about to be unleashed onto the market over the next year or so. That could see property developers at the forefront of foreclosures and falling into administration because they can’t repay their bank loans.

Foolish takeaway

The banks have taken steps to clean up their lending practices but it seems clear that the regulator is still concerned dodgy lending is still happening. That may not be good news for the big banks and their shareholders.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.