Royal Commission (Part Three): Consumer Protection vs Credit Risk

This article is Part Three in a series. Subscribe to Financial Services Updates to receive each part of our Royal Commission Series. Parts One, Two and Four can be found at the bottom of this article.

The Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Royal Commission) has provided a damning assessment of the financial services industry. In its first round of public hearings, the focus was on consumer lending because consumer lending affects both consumers and financial service entities equally. This interrelationship led the Royal Commission to conclude that the conduct indicated fell far below community standards and expectations.

In Part One of our Royal Commission Series, we discussed the overall landscape and reactions to the Interim Report, focusing in general terms on the key issues raised by Commissioner Hayne. In Part Two of our Royal Commission Series, we discussed the issues of conflicted remuneration, grandfathering provisions and the vertical integration model. Here, in Part Three, we discuss responsible consumer lending, intermediaries and the issue of assessing credit risk rather than unsuitable lending.

Consumer Protection

The Interim Report suggested that the “fair treatment of consumers requires that financial products and services perform in the way that consumers expect or are led to believe.” Both AFSL and ACL holders have very similar obligations in relation to their dealings with consumers.

Under the Corporations Act 2001 (Cth), AFSL holders must “do all things necessary to ensure the services they are licensed to provide are provided efficiently, honestly and fairly.” Similarly, under the National Consumer Credit Protection Act 2009 (Cth) (NCCP Act), ACL holders must “do all things necessary to ensure that the credit activities authorised by the licence are engaged in efficiently, honestly and fairly.”

Commissioner Hayne found that these consumer protection considerations should be at the forefront of a financial entity’s mind when engaging with consumers.

Within the area of consumer lending and especially in relation to responsible lending obligations, there will always be a question of balance between the interests of the consumer and the lender, with what the NCCP Act requires for a financial services entity to determine reasonable inquiries and reasonable steps, to be scalable, depending on:

  • the potential impact on the consumer of entering into an unsuitable credit contract
  • the complexity of the credit contract
  • the capacity of the consumer to understand the credit contract, and
  • whether the consumer is an existing customer or a new customer.

However, as the Interim Report pointed out, some financial service entities have taken this scalable obligation to mean that if it is “too hard” or too costly to the entity to verify a consumer’s information, then it was not worth doing.

Nowhere is this attitude more prevalent than in relation to the verification of an applicant consumer’s financial situation.

Responsible Lending not Credit Risk

The responsible lending obligation encapsulated in the NCCP Act is designed to enable consumers and lenders to trade fairly and in good faith while fostering effective competition in the consumer lending market.

In terms of credit contracts, before an ACL holder assesses whether a credit contract is not unsuitable, the licensee is mandated by the NCCP Act to take a number of steps including:

  • making reasonable inquiries about the consumer’s requirements and objectives
  • making reasonable inquiries about the consumer’s financial situation
  • taking reasonable steps to verify the consumer’s financial situation.

Commissioner Hayne, in the Interim Report, concluded from the case studies and evidence submitted that “credit licensees too often have focused, and too often continue to focus, only on ‘serviceability’ (i.e. credit risk) instead of undertaking these reasonable inquires as required by the law.”

Hayne went on to conclude that credit licensees are failing to meet their legal responsible lending obligations by determining only whether the consumer is unlikely to default in its performance under the credit contract.

In reaching this conclusion Hayne drew particular attention to the use by credit licensees of general statistical benchmarks, such as the Household Expenditure Measure (HEM) (which represents the median spend on absolute basics, doesn’t include ‘non‑basics’ spend and only includes minimal discretionary basics), when considering a consumer’s financial situation. Evidence led at the Royal Commission established that during the credit application process credit licensees, including the big banks, used the higher of the HEM and the relevant borrower’s declared expenses.

However, use of a statistical guide for measuring borrower’s expenditure rather than individually examining the circumstances of each borrower means, in many cases, that the discretionary spending of the individual was discounted or minimised. Taking this further, use of the HEM takes no account of that particular individual’s personal financial expenditure circumstances. Accordingly, Hayne concluded that using the HEM as a default measure did not constitute any verification of the borrower’s expenditure, and much more often than not, will indicate that insufficient inquiry by a financial services entity has been undertaken as to the borrower’s financial position.

The reasons why financial institutions use the HEM (or other statistical benchmarks) in place of undertaking a process of verifying a consumer’s stated expenditure will vary across entities. Some of the banks involved in the case studies submitted that there was a trade-off between obtaining financial statements documentation and verifying expenses and processing applications for credit efficiently. Mr Rankin leader of ANZ’s ‘Homeowners team’ went as far as saying that reviewing bank statements to identify any obvious inconsistencies between a borrower’s declared expenses and their actual transaction history, or to identify any general indicators of financial stress would not have any ‘material uplift’ for the cost and time spent.

But, as the Interim Report continued, “what was meant by verifying outgoings being ‘too hard’ was that the benefit to the bank of doing this work was not worth the bank’s cost of doing it.”

This prevailing attitude of financial institutions of the ‘cost of compliance’ is a constant theme within the Interim Report, and points to a culture which assesses the cost of compliance against the benefit to the financial institution. Tellingly, the Interim Report highlighted that, too often, financial institutions are determining that the benefit in complying with their regulatory obligations is outweighed by the benefits of profit.

Commissioner Hayne appears to suggest that the comparison of evidence of consumers’ statements to verify expenditure and identify any inconsistencies with stated borrower’s expenditure or identification of expenditure above HEM, is a requirement to fulfil responsible lending conditions. He indicates that the defence by many financial service entities, when providing evidence, that they relied simply on comparison of expenditure with HEM, is inadequate at best and potentially non-compliant with their responsible lending obligations.

Similarly, the reliance of financial services entities on determining a borrower’s credit default risk was also suggested by Commissioner Hayne to not fulfil responsible lending obligations. When ANZ stated in the public hearings that reviewing bank statements to identify any obvious inconsistencies “would not have any ‘material uplift’ for the cost and time spent”, the implication can be drawn that the inherent cost of implementing such a procedure would not provide any benefit to the bank in reducing the credit default risk.

Commissioner Hayne roundly criticised this methodology in the Interim Report stating that “verification, as distinct from the inquiry, of the customer’s expenses remains largely with the customer.” Financial services entities should expect there to be changes in customer verification measures to include more specific and individualised consumer obligations for the lender. But, the problem that will need to be addressed is the measure of the customer verification. Commissioner Hayne suggests that HEM is not appropriate, and neither is using the measure of a borrower’s credit default risk, as neither are specific enough to meet responsible lending obligations. However, Commissioner Hayne does not suggest any other method, leaving financial services entities to guess at what should be the right measure. Obvious inconsistencies? Evidence of financial distress? More should be revealed when the Final Report is released.

There is also a risk that many lenders skip the essential step of verification to remain competitive in the financial services industry. Further oversight and monitoring by the regulator will be a must in any new developments in this space.

The cost of increased compliance could also have profoundly negative effects on the industry including unmanageable time and cost and a competitive disadvantage for small firms, resulting in either an investment in new technology to confirm customer verification in line with responsible lending obligations, or passing this additional compliance cost directly to consumers.

Therefore, the financial services industry should be expecting a final recommendation somewhere in between the current situation and extremely onerous compliance obligations, taking into account both the behaviour and responsibility of consumers (especially the changes in spending over time and associated with being granted a large loan) and the compliance obligations of financial services licensees. Current responsible lending obligations require assumptions to be made about future behaviours of consumers which also do not seem to fit with the expansive definition of customer verification as indicated by Commissioner Hayne.

The financial services industry should instead adjust their expectations about future recommendations to include changes to verification for minimum expenditure claims by the consumer, and a focus on compliance procedures and processes to identify those customers that require deeper investigation based on them falling within a pre-determined risk profile.

Intermediaries and Consumer Lending

The conflict in duties between intermediaries, lenders and the borrowers that they “serve” was highlighted by the Interim Report. In particular, Commissioner Hayne raised the issue of the agency of the intermediary. Where an intermediary is acting ostensibly on behalf of the borrower, does the borrower believe this? And does the fact that the intermediary is being paid by the lender confuse these roles?

The Interim Report suggested that even if an intending borrower believes that an intermediary is acting on their behalf, the intermediary owes no duties to the borrower to seek out either the best or the most appropriate deal, with many intermediaries selling only the products for the lender who pays them. As mentioned in Part Two of our Royal Commission Series, this is another example of conflicted remuneration. However, financial services entities should acknowledge that this also leads to deficiencies in the processes, systems and procedures for verifying borrower information, as nobody technically “owns” the duty to perform this step in responsible lending.

The consequences of value-based remuneration for intermediaries has also been associated with:

  • higher leverage
  • higher incidents of interest-only loans
  • higher total debt-to-income ratios
  • higher incurred interest costs
  • an increasing likelihood of borrowers falling into arrears or paying more interest than other borrowers.

The financial services industry should expect an extension of the duties owed by financial advisors to intermediaries acting on their behalf. This is the only way that responsible lending can be guaranteed and conduct falling below community expectations can be managed appropriately.

What Can Financial Services Organisations do Now?

Intermediaries are a core part of the financial services industry, standing at a point where, if compliance tasks are done properly, they will help to fulfil a financial services entity’s responsible lending obligations. However, as the evidence and public hearings of the Royal Commission have revealed, if compliance is only a cost of business, then misconduct and conduct falling below community expectations is an inevitable result.

Other articles in this series:

Part One of our Royal Commission Series.

Part Two of our Royal Commission Series.

Part Four of our Royal Commission Series.

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