James Eyers & Misa Han | The Australian Financial Review | 10 May 2019
It’s a case that will define one of the most fundamental jobs of a bank – working out whether to lend to a customer.
On one side is the Australian Securities and Investments Commission. The regulator has taken Westpac Banking Corp to task over allegedly breaking responsible lending laws 261,987 times.
It is a headline-grabbing figure for a regulator hell bent on pursuing a “why not litigate” strategy, after its own reputation took a beating during the Hayne royal commission.
In ASIC’s view, Westpac acted egregiously by using a “frugal” benchmark to estimate potential borrowers’ living expenses – a figure which, in some cases, mimics the expenses of a family living close to the poverty line.
On the other side, Westpac remains defiant. It insists it acted in good faith when assessing the loans and satisfied its legal obligation to lend responsibly by not providing customers with loans that were “unsuitable”.
During intense hearings in Sydney this week, Westpac barrister Jeremy Kirk, SC, attacked ASIC’s “19th-century” approach of dictating to banks a particular formula for determining suitability. The regulator is arguing lenders should take customer income and deduct their expenses and only lend when the result is a suitably positive number.
Kirk boasted Westpac has a “21st-century system” that is “complex, multifactorial and much more sophisticated” than ASIC’s approach. He said it should be for the bank to determine what information it uses during the assessment process.
On the bench is Justice Nye Perram. He shoulders the responsibility of deciding the most consequential piece of litigation the banking sector has faced for decades. By stipulating what needs to be done to meet the “responsible lending” requirements, this test case will have wide-reaching ramifications for all lenders.
The responsible lending law, introduced by Labor in 2009, was one of the central issues explored by the Hayne royal commission. But the inquiry left it to Justice Perram to determine how it works in practice.
The case is being closely watched by investors in the banking sector, already bruised after the Hayne inquiry dragged down bank stocks on the prospect of more intrusive regulation of their lending decisions.
The case is also being heard as property markets suffer steep declines – in part due to banks tightening up lending processes in the face of uncertainty about what the law requires. It’s possible this case will trigger more onerous and risk-averse decisions, so it has implications for the economy at a time the Reserve Bank is desperately trying to find ways to reinvigorate economic growth.
Lenders’ discretion challenged
Boiled down to its essence, this case is about lenders’ discretion. It will decide whether it’s for a bank to work out the rules to be used to assess a customer for a loan, or whether the regulator can prescribe a particular formula despite the statute being written in broad, principles-based language.
ASIC says Westpac breached its duty because rather than using borrowers’ actual declared expenses, the bank used the household expenditure measure (HEM), a statistical benchmark of spending. ASIC argued Westpac approved some loans using HEM when the customers’ actual declared expenses were higher than the benchmark.
The case is in court because the National Consumer Credit Protection (NCCP) Act of 2009 is silent on the specific information lenders should use in determining suitability.
Rather, it simply creates an obligation for a lender to make an assessment that a particular loan is not unsuitable for the customer. The law says lenders should make “inquiries and verification”, perform an “assessment”, and not make a loan that is “unsuitable”, which means a customer going into substantial financial hardship in order to repay it.
While ASIC has guidance about what lenders need to do to meet these requirements in practice – its so-called Regulatory Guide 209 is in the process of being updated – the core provisions in the NCCP Act have never been the subject of a detailed judicial determination.
Westpac has rejected ASIC’s approach as simplistic. During the hearing, it has argued that although it did use the HEM, it made various adjustments to the index depending on the borrower’s marital status, dependents, the location of the property and quarterly inflation. These were part of 200 rules driving the automated assessment engine. Even if expenses were understated, the bank says it overestimated interest repayments because the system includes a big servicability “buffer”, and various other checks and balances.
Furthermore, the bank has told the court that in 80 per cent of the loans alleged by ASIC to be improperly assessed, borrowers declared their total living costs were below – not above – what the HEM indicated they should be. This suggests many customers may be underestimating expenses to get a bigger loan, and perhaps it’s more conservative for a bank to rely on the HEM in aggregate rather than potentially misleading information borrowers submit.
Tech solutions to bring down costs
All lenders are watching this case with interest because the court will consider the role of computer programs to assess loans. As the recent reporting season has shown, banks are under enormous pressure to automate lending processes in order to keep costs down in the face of revenue headwinds.
Westpac’s system included the use of a “70 per cent rule”, meaning customers would be referred for manual assessment if their declared living expenses exceeded 70 per cent of their verified monthly income. Banks want comfort from the court they are able to set computer rules that only send some loans for human assessment; the alternative would be much higher costs and, potentially, interest rates for all borrowers.
The court’s decision comes amid warnings that the economy could be harmed if legal standards are moved too far away from borrower responsibility. As Financial System Inquiry chairman David Murray put it in The Australian Financial Review in December: “Proposals which drift from caveat emptor towards caveat vendor can have profound systemic consequences”.
Westpac’s approach has already won support from the former solicitor-general of Australia, Justin Gleeson, SC. He was appointed by the court last year to advise it on whether a proposed settlement of the case was appropriate, after the court rejected it.
Gleeson decision supported Westpac
Gleeson said Westpac should have discretion to set the rules for its loan assessments, so long as this was conducted in good faith. He said the regulator’s interpretation of the lending law was “absurd”.
“ASIC and Westpac’s constructions, which do seek to ‘read into’ [the law] some ‘use’ requirement, do have the potential to create absurdities and frustrate the statutory purpose,” Gleeson said.
The case also points to the increased use of the courts to clarify principle-based legislation, after the royal commission called the regulator out for its timidity towards litigation.
It will go down in law school textbooks as a case study of how not to settle a matter. When ASIC and Westpac last year settled the case with the bank agreeing to a $35 million fine, Justice Perram refused to rubber stamp the deal, because the settlement failed ot articulate how Westpac breached lending laws. Gleeson suggested a fine of about $100 million would have been more appropriate.
And so this week, it was back to square one.
Perram sees ‘fat’ to cut from expenses
During the hearing this week, it appeared Justice Perram was leaning towards the bank’s case. He suggested some customers, ordinarily accustomed to travelling business class and holidaying in exotic resorts, might cut their expenses in order to pay mortgages – which suggested ASIC’s formula could be too simplistic.
“There may be a lot of fat on the lamb,” Justice Perram said.
He also wondered whether financial hardship was subjective as well as objective, and asked whether the HEM benchmark could be used to pinpoint a level at which hardship is encountered.
“I mean, some people might ‘suffer’ if they had to go without the San Pellegrino mineral water,” he said.
But ASIC barrister Jeremy Clarke, SC, disagreed. He said there were many expenses which could not easily be cut that are not included in the HEM. They included medical expenses, school fees, payments for elderly relatives, and pets and car costs.
“It’s just an extraordinary assumption that all people can just come back to some generic extremely conservative level,” he said.
The case is also being closely watched by the legislature. As Commissioner Kenneth Hayne said in his final report, it could prompt redrafting to the extent the court highlights problems. “If the court processes were to reveal some deficiency in the law’s requirements to make reasonable inquiries about, and verify, the consumer’s financial situation, amending legislation to fill in that gap should be enacted as soon as reasonably practicable,” Commissioner Hayne said.
Class action lawyers are ready to jump. Westpac is facing a class action from law firm Maurice Blackburn for its over-reliance on benchmarks when assessing home loan applications, which will piggyback on the findings of Justice Perram if he decides in ASIC’s favour.
So the battle lines are drawn and the stakes are high. The hearing will conclude next week.