In the final report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Commissioner Hayne makes many recommendations for changes, but on the subject of responsible lending he sums up his conclusion as: “apply the law as it stands.” In Hayne’s assessment, the problems with responsible lending are not the existing law, but lenders not understanding their obligations and not applying the law properly:
The responsible lending issues identified during the Commission’s hearings will be resolved by banks applying the law as it stands.
It’s you, not me
What did lenders get wrong?
They thought responsible lending is when the borrower is unlikely to default.
… there is the body of evidence about how the four largest banks have dealt with responsible lending obligations. They have seen these obligations as satisfied whenever the bank, as lender, is satisfied that the borrower is unlikely to default. That is, they have each understood, and applied, the law that requires lenders to ascertain and form a view about the borrower’s requirements and objectives and the borrower’s financial situation as met by asking only whether the lender is taking an acceptable credit risk.
Instead of looking at the borrower’s requirements and objectives and financial situation, as required by the responsible lending obligations, the major banks were only looking at whether the borrower was an acceptable credit risk. A lender focus rather than a borrower focus.
Responsible lending is not a credit risk assessment. Responsible lending is what the Government requires a lender to do before it makes a loan.
The key steps are:
1. Inquiries step: making reasonable inquiries about the consumer’s requirements and objectives and financial situation.
2. Verification step: taking reasonable steps to verify the consumer’s financial situation.
3. Assessment step: making an assessment whether the credit contract will be unsuitable for the consumer (and not proceeding with the loan if it will be unsuitable).
Responsible lending requirements are to protect the consumer from a bad loan, not to protect the lender from a bad loan.
Hemming in the HEM
The use of benchmarks was singled out by the Royal Commission as a practice which may have failed to comply with the existing law.
Many lenders have used the Household Expenditure Measure (HEM), a benchmark of household expenses. Using a benchmark makes perfect sense from a credit risk standpoint. The benchmark data may often be more reliable than what the loan applicant declares in their application.
But from a responsible lending standpoint, relying on benchmarks is a problem. By itself, a benchmark does not reflect the individual circumstances of the customer.
Commissioner Hayne found in his report:
while the HEM can have some utility when assessing serviceability – that is to say, in assessing whether a particular consumer is likely to experience substantial hardship as a result of meeting their obligation to repay a line of credit – the measure should not, and cannot, be used as a substitute for inquiries or verification.
He also wrote:
Both income and expenditure must be considered in first inquiring about, and then verifying, the customer’s financial situation. I said in the Interim Report that I consider that verification means doing more than taking the customer at his or her word.
What the guidance said
ASIC first published its regulatory guide on responsible lending (RG 209) in 2010 when the responsible lending obligations were introduced. Initially RG 209 only mentioned benchmarks as
useful tools in the process of determining whether a particular consumer will experience substantial hardship as a result of meeting the obligations of a credit contract. Applying benchmarks … may provide a credit licensee with an indication of whether a consumer would be assumed to be exposed to substantial hardship.
RG 209 was updated in 2014 to warn about the limitations of using benchmarks:
Use of benchmarks is not a replacement for making inquiries about a particular consumer’s current income and expenses, nor a replacement for an assessment based on that consumer’s verified income and expenses.
This comment says that benchmarks cannot replace the inquiries step or assessment step in responsible lending, but it does not rule out using benchmarks in theverification step – when the lender must take reasonable steps to verify the consumer’s financial situation. In fact, the 2014 version of RG 209 expressly states that benchmarks can be used as part of the verification step:
After inquiries have been made and information about the consumer’s financial situation has been gathered, a credit licensee may use benchmarks or automated systems and tools for testing the reliability of the information obtained as part of the process for taking reasonable steps to verify the consumer’s financial situation. For example, these kinds of systems and tools can be useful for confirming whether it is reasonable to rely on the information provided by a consumer for the purposes of the unsuitability assessment, or whether further inquiries may be warranted. However, automated systems and tools are not a substitute for making inquiries about the consumer’s current financial situation. (RG 209.49 – emphasis added).
While ASIC has said that benchmarks can be used in responsible lending, it launched a legal action against Westpac in March 2017 in relation to more than 260,000 home loans going back to 2011, alleging a breach of the responsible lending obligations involving the use of HEM.
Westpac had an automated decision system which used HEM instead of the customer’s declared expenses when calculating serviceability.
You can read more about this case in our article here, which has reached an interesting place because the judge has refused to accept the proposed settlement between the parties, on the basis that their Statement of Agreed Facts did not explain why Westpac used the HEM rather than declared living expenses when it was seeking to carry out its responsible lending obligations.
Off the back of the ASIC action against Westpac, plaintiff law firm Maurice Blackburn has now commenced a class action against Westpac on behalf of persons who entered into unsuitable loans secured by residential property with Westpac.
The issues raised by ASIC in the Westpac case appear to be more about the use of HEM in the assessment step of responsible lending rather than the verification step. This may be why, when mentioning the Westpac case in his final report, Commissioner Hayne noted that:
… the Statement of Agreed Facts filed by the parties … said nothing at all about ‘verification in accordance with section 130’ (as mentioned in section 128(d)) and nothing about the operation of section 130(1)(c) requiring a licensee, for the purposes of section 128(d), to take ‘reasonable steps to verify the consumer’s financial situation’.
The guidance is changing
Soon after the final report of the Royal Commission was handed down, ASIC issued a consultation paper to update its guidance on responsible lending (CP 309). Comments are due by 28 May 2019. On the use of benchmarks, CP 309 says that ASIC proposes to clarify its guidance in RG 209 as follows:
- A benchmark figure does not provide any positive confirmation of what a particular consumer’s income and expenses actually are. However, ASIC considers that benchmarks can be a useful tool to help determine whether information provided by the consumer is plausible (i.e. whether it is more or less likely to be true and able to be relied upon).
- If a benchmark figure is used to test expense information, licensees should generally take the following kinds of steps:
- ensure that the benchmark figure that is being used is a realistic figure, that is adjusted for variables such as different income ranges, dependants and geographic location, and that is not merely reflective of ‘low budget’ spending;
- if the benchmark figure being referred to is more reflective of ‘low budget’ spending (such as the Household Expenditure Measure), apply a reasonable buffer amount that reflects the likelihood that many consumers would have a higher level of expenses; and
- periodically review the expense figures being relied upon across the licensee’s portfolio—if there is a high proportion of consumers recorded as having expenses that are at or near the benchmark figure, rather than demonstrating the kind of spread in expenses that is predicted by the methodology underlying the benchmark calculation, this may be an indication that the licensee’s inquiries are not being effective to elicit accurate information about the consumer’s expenses.
ASIC’s commentary in CP 309 appears again to confirm that benchmarks can be used in the verification step instead of positive confirmation of expenses, but says that if this approach is used, there is a higher risk that the resulting loan will be unsuitable:
If a licensee is relying on comparison to a benchmark figure to test estimates provided by a consumer, rather than using a positive form of verification such as transaction statements or third-party information sources, there is a higher risk of using information that is in fact not true. As a result, there may be a higher risk of the consumer entering a contract they cannot afford and that is unsuitable. (Paragraph 55)
Licensees should consider the circumstances of the particular consumer and credit product being applied for to determine whether it is sufficient to compare the consumer’s estimated general living expenses to a benchmark figure to confirm that it is reasonably reliable, or if they should take additional steps to seek positive confirmation of the information provided. (Paragraph 57)
The composition of the benchmark expenses must also be taken into account:
Even if a licensee has reference to a benchmark figure to test whether information provided about general living expenses (e.g. food, clothing, communication and entertainment) is plausible, the licensee will still need to make inquiries about whether the consumer has expenses of the kind that are not included in the benchmark calculations and seek verifying information about those expenses. (Paragraph 53)
These comments suggest that in some cases it may be sufficient to verify the consumer’s expenses simply by comparing against a benchmark figure in order to satisfy the verification step with respect to expenses, at least when it is a like-for-like comparison. If that is not the intent of the proposed ASIC guidance, then the guidance should be revised for greater clarity.
ASIC takes a different approach in CP 309 with respect to verification of a consumer’s income:
Given the importance of income as an element of a consumer’s financial situation, we propose to make it clear in our updated guidance that licensees should always positively verify the relevant income sources of a consumer. We do not consider there are any circumstances in which it will be sufficient not to do so. (Paragraph 43)
In summary, the current position seems to be:
- If the lender does not even ask the consumer about expenses, this is likely to be non-compliant with the inquiries step.
- If the lender collects expenses information from the consumer but doesn’t take account of it and just uses a benchmark expenses for calculating serviceability, this may be non-compliant with the assessment step. (The outcome of the Westpac case may shed more light on this).
- It is unclear whether a lender can collect expense information from the consumer and simply use the higher of declared expenses and the benchmark expenses amount for calculating serviceability, in order to meet the verification step. It may be sufficient if the benchmark is robust, in line with ASIC’s proposed new guidance, but expenses that are not included in the benchmark would still have to be verified another way.
There is widespread reporting of a noticeable tightening in consumer credit availability over the last 12 months, depriving some consumers of access to finance, with flow on effects to the economy. It is claimed that one of the causes has been the banks “applying the law as it stands” on responsible lending, in the words of the Royal Commission.
While questioning in his final report whether the Royal Commission had this effect, Commissioner Hayne said that
… steps taken by banks to strengthen their home lending practices and to reduce their reliance on the HEM – are being taken with a view to improving compliance with the responsible lending provisions of the NCCP Act. If this results in a ‘tightening’ of credit, it is the consequence of complying with the law as it has stood since the NCCP Act came into operation.
However the tightening of credit was a relevant consideration in the Commissioner’s decision to recommend against extending the responsible lending obligations to small business:
… extending the responsible lending obligations in the NCCP Act would likely increase the cost of credit for small business and reduce the availability of credit. I am not persuaded that the benefits to be gained in individual cases from applying the NCCP Act to small business outweigh the overall costs of taking that step.
So the increased cost of credit and reduced availability of credit were given as reasons why responsible lending obligations should not be applied to small business, but the Royal Commission accepts that a tightening of credit may be a necessary result of the law being applied to consumers.
Time will tell whether the public benefit of “applying the law as it stands” to consumers has outweighed the cost.
Patrick Dwyer and Kathleen Harris
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