Counting the cost of responsible lending

by Melanie Mingas02 Sep 2019

Following the shock ruling that saw ASIC’s responsible lending case dismissed by a judge, Australian Broker examines what the decision could mean for the future of expense verification and the ability of lenders to accurately predict serviceability

On 1 March 2017, ASIC commenced Federal Court proceedings against big four institution Westpac to test the responsible lending provisions of the National Consumer Credit Protection (NCCP) Act.

In nearly 10 years of NCCP application it was the first legal test of the Act, and, despite it taking 30 months for ASIC to get to the courthouse, things didn’t go how the regulator had hoped.

Specifically, proceedings focused on Westpac’s use of the housing expenditure measure (HEM) benchmark and assessment of interest-only home loans between December 2011 and March 2015. The bank’s reliance on HEM and failure to calculate individual serviceability on higher principal and interest repayments were central to the case.

Hearings started in May of this year and, on 13 August, Justice Nye Perram concluded that Westpac didn’t breach the law; ASIC misinterpreted it. The case was dismissed.

“It’s a fundamental shift from ... how ASIC thought a key component of responsible lending laws worked” Jesse Vermiglio, partner, Holley Nethercote

Not only did a regulator lose, but it did so on both its application of law and the facts of the case. 

“It’s a pretty big deal,” says Jesse Vermiglio, partner at the law firm Holley Nethercote.

“It’s a fundamental shift from the thinking as to how ASIC thought a key component of responsible lending laws worked – a shift from what they thought to what a judge has actually now decided.”

In a statement released the same day as the ruling, David Lindberg, the chief executive of Westpac’s consumer division, said, “This is an important test case for the industry, and we welcome the clarity that today’s decision provides for the interpretation of responsible lending obligations.”

Not only has the interpretation of the law been clarified, but the case also means that the slow creep to prescriptive legislation – and a resulting nanny-state approach to how the general population manage their finances – has been halted.

“From my point of view,” says credit and risk consultant Andrew Tierney, “it’s about looking at the loans that didn’t have the checks done and asking, is the default rate less or worse? Then there would be a case.” 

Illustrating his point, Tierney highlights that the case was based on 262,000 Westpac loans, 10,500 of which didn’t have full checks conducted. Further, 5,400 of these loans are still with the bank, representing 0.4% of Westpac’s total portfolio – and they are performing similarly to or better than the other 99.6%. 

“None of these loans went into hardship. So, when we look at it, what are we doing? Are we making it even more of a nanny state where we have to protect an individual from themselves and they are absolved of all blame?”

Tierney goes on to highlight that typically around 97% of all loans with all lenders are paid on time, and that most people are fully aware of how much they can afford to borrow. What people don’t know is what lies ahead – whether that’s pregnancy, divorce, bereavement or any other life event that can impact on their financial circumstances.“Responsible lending has always been a case of, you need to make sure you do the right thing by the customer. If you are doing something we can see isn’t the right thing, such as lending $30,000 to somebody with no job, that’s where it should be coming in,” Tierney says.

“But to absolve consumers of all responsibility opens the door to a lot of interpretation and a lot of legal action that may not be necessary.”

“Are we making it even more of a nanny state where we have to protect an individual from themselves and they are absolved of all blame?” Andrew Tierney, credit and risk consultant 

Questions remain
The case raises a number of important questions, one of which is whether or not a lender can ever truly know the full extent of a borrower’s living expenses.

“A lot of people have to get loans, whether it be a mortgage, a car loan, a credit card,” says Vermiglio.

“Whether it’s through a mortgage broker, direct through a bank, peer-to-peer, whatever, it doesn’t matter. This decision has an implication on all of those channels of responsible lending… and it’s not just on mortgages.

“My view is that it’s quite a significant decision.”

As Justice Perram said in his ruling, “I may eat wagyu beef every day washed down with the finest Shiraz but, if I really want my new home, I can make do on much more modest fare.”

In its submission to ASIC, the FBAA made a similar point. It said, “Administration of responsible lending laws [needs] to recognise that consumers change their spending behaviour in response to taking on a new loan, therefore a backwards-looking assessment of a consumer’s financial position was only partly helpful.”

Opposed to the prescriptive approach seen of late, FBAA managing director Peter White says, “Proper regulation of responsible lending must recognise that licensees and consumers each have equal responsibility when it comes to seeking credit and honouring repayment commitments.

“We are hopeful this judgment may be the start of things moving back towards balance where 100% of the compliance burden and 100% of the consequences aren’t shouldered by licensees.”

So how can the banks get – and remain – ahead on living expenses, and what does this mean for serviceability moving forward?

Although this case dates back to 2017, the assessment of living expenses was a key focus of the royal commission. Hayne didn’t call for an outright ban on the use of the HEM, but banks are reducing their reliance on it.

“ASIC is saying your past expenditure is what you need to rely on to assess if you’re able to make your repayments or not, whereas [Justice Perram] said that’s not necessarily the right way to assess if someone is going to be able to make their repayments. It doesn’t really tell us what changes in behaviour they’re going to make in terms of their expenses,” Vermiglio says.

“That’s the crucial part of the judgment that I think lenders will want to think about.”

The question is what happens next. One of the available options is to change the regulatory framework outlined in the NCCP to align more closely with ASIC’s interpretation of it. This would require a change in the law, something that ASIC is unable to initiate alone. However, there are other options. 

Building a crystal ball
A new generation of agile and tech-savvy lenders are developing their own systems to analyse expenses and, ultimately, predict risk and serviceability. 

One of these is Mortgage House, which utilises Yodlee to download bank statements and other documents to its own origination platform so AI can analyse the transactions.

So advanced is the system that after almost 30 years in the industry Mortgage House now considers itself more a technology company than a lender.

“That [system] predicts the likelihood of meeting the next month’s repayments as well as the borrower’s discretionary and mandatory expenses,” says CEO Ken Sayer.

“We are light years ahead of everybody else, and it’s only because we have built that from inception, based on actual data, and there is no human reconciliation, for want of a better word.”

While the approach works for individual lenders, cascading such a level of sophistication across the IT systems of a major bank – or the entire banking system itself – would be a whole different ball game. 

“There is only one way: ASIC builds the system and everybody plugs in. The master regulator APRA will then actually have a clean, digestible document,” Sayer suggests.

Referencing the Reserve Bank's work to create a centralised platform for real-time payments, he adds, “If ASIC wants to take control, it has to create a system from scratch and tell everybody to work within it. That would remove 100% of the variables.” 

The final option is to do nothing and instead wait for the full rollout of open banking and comprehensive credit reporting (CCR), which by their nature will collate vast volumes of data on borrower behaviour. 

“We just had some proper regulation on open banking, so if you are able to access bank accounts and you get a bureau report with CCR, you know what debts are outstanding and you can actually start to form a picture of the person straight away,” says Tierney.

“If ASIC wants to take control, it has to create a system from scratch and tell everybody to work within it” Ken Sayer, CEO, Mortgage House

While the initial applications of such a system won’t paint the full picture immediately, Tierney says CCR 2.0 is likely to be the solution, allowing consumer behaviour to be modelled in order to create new risk calculations and, essentially, a window into a person’s financial future.

“If I get the transaction history on a person in an automated fashion, I’m looking at that person in isolation. If we model 1,000 or 100,000 people to look at their incoming and outgoing transactions, how they affect the risk of that person, and so on, we get a very clear picture,” he explains. 

To achieve what currently seems impossible, CCR and open banking must reach an unprecedented level of sophistication incredibly quickly. In the meantime, individual players will no doubt continue to pioneer piecemeal solutions based on their own business objectives.

Consumers also deserve a look-in at this point. Without their buy-in to share their private financial information in the first place, all options are off the table. 

What can be considered a certainty is that, by default, fintech is about to take on a huge regtech component, and the lenders who don’t stay ahead of the developments could find themselves with outdated systems no broker wants to subject their clients to.