Squeezed, not crunched: Hayne, credit and the economy

In the event, the Commission proposed no radical alterations to lending practices. As a result, the near-term implications of any additional pressures on lending coming from the Commission itself look rather modest, with RBA Governor Lowe describing the outcome as ‘balanced and sensible, [which] should remove some uncertainty.’ It’s likely that the lion’s share of regulatory-led tightening in credit standards will have occurred before the report’s release. Granted, those prior changes, along with current economic conditions, will continue to influence the banks’ approach to lending, so credit conditions are unlikely to ease from what is already a relatively tight position. But the feared downside scenario has been avoided.

In the longer term, economic outcomes will reflect the precise details of the actual implementation of the Commission’s recommendations (and by the scale of any associated resourcing). Still, measures designed to restore trust in the system by reducing conflicts of interest, simplifying legislation and beefing up enforcement and regulation have at least the potential to deliver a modest improvement to both the resilience of the Australian financial sector and the quality of credit allocation, all of which should ultimately be positive for the economy’s medium-term growth performance.

Detail:

A well-functioning financial system plays a critical role in the successful operation of any modern economy: in his Interim Report, Commissioner Hayne likened the banking system’s function to that of ‘a central artery in the body of the economy’ noting that ‘[d]efects and obstructions can have very large effects.’ The financial system is responsible not only for providing the overarching framework for the transactions that underpin everyday economic activity and allow for the normal operation of monetary policy, but also for ensuring the effective allocation of savings to productive investments that helps determine an economy’s long-term growth prospects. Moreover, and as the 2008-09 global financial crisis (GFC) demonstrated to at times devastating effect, a dysfunctional financial system can bring with it a whole host of serious economic problems.

Back in 2014, the Financial System Inquiry (FSI) argued that an effective Australian financial system – which it defined as one capable of ‘supporting a vibrant, growing economy that improves the standard of living for all Australians’ - needed to have three characteristics. It should be:

1. Efficient - allocating scarce financial and other resources to maximise the economic benefit from their deployment;
2. Resilient - able to adjust to changing circumstances including severe shocks; and
3. Fair – such that ‘participants act with integrity, honesty, transparency and non-discrimination.’

The GFC and its aftermath had already demonstrated that there were major shortcomings relating to all three of these characteristics at a global level: poor cultures in key institutions and markets had contributed to a serious misallocation of lending which in turn helped undermine the resilience of the system overall, to nearly catastrophic effect.

Both national and international regulatory responses to the crisis involved an increased focus on banking sector risk and resilience, placing a heavy emphasis on the need to strengthen banks’ liquidity and capital buffers. Internationally, key changes included requirements aimed at increasing both the amount and the quality of bank capital and boosting bank liquidity. Likewise, here in Australia the FSI made several recommendations aimed specifically at improving the resilience of the financial system in order to strengthen the economy (one of five specific themes addressed in the final report). The Australian Prudential Regulation Authority (APRA) has now introduced changes to capital and liquidity requirements which, according to a relatively recent assessment by the RBA, have improved banks’ resilience to adverse funding shocks or credit losses.

Despite strengthened capital and liquidity positions, however, the resilience of the Australian banking system has faced questions around its exposure to the housing market. Between early 2012 and early 2018, Australian capital city house prices jumped by about 50 per cent, boosting the value of residential property to more than five times gross household disposable income, and seeing household debt soar to around twice disposable income. Fears about the implications for both overall macroeconomic stability (though the health of household balance sheets) and for financial stability (given the large exposure of Australia’s banking system to the housing market) prompted the regulators to tighten prudential policies. For example, APRA pushed banks to improve their mortgage lending standards, with a focus on investor lending, high loan-to-valuation ratios and high debt to income lending. In 2014, it imposed benchmarks on investor lending, followed in 2017 by a similar benchmark for interest-only lending. Similarly, the Australian Securities and Investments Commission (ASIC) increased its scrutiny of lenders' compliance with responsible lending obligations, including the appropriateness of interest-only lending.

Source: RBA Chart Pack, February 2019

However, as the RBA’s October 2018 Financial Stability Review made clear, even as regulatory initiatives had seen Australian banks improved their resilience across several key metrics, the Royal Commission was highlighting the fact that the ‘challenges for banks in embedding a strong risk culture have become more apparent.’ The Commission’s findings and reported case studies, as captured in the Interim Report, pointed to major shortcomings with the fairness of the system. Hayne called out a whole slew of egregious examples of poor behaviour by Australian financial institutions, including but not limited to inappropriate lending, fees for no service, and dubious activities around insurance sales and claims, all of which were attributed to ‘the pursuit of short-term profit at the expense of basic standards of honesty.’

The Interim Report also questioned the ability of regulators to enforce existing rules and regulations, as well as fretting about the banks’ compliance with responsible lending laws and management of conflicts of interest.

Hayne’s initial findings therefore went right to the heart of the ‘fairness’ requirement for a well-functioning financial system, and found it badly wanting. That in turn raised questions about the other two requirements: if lending was being misallocated due to the presence of poor incentives and bad behaviour, that could also undermine the efficiency of the economy and threaten the resilience of the system.

Given the critical role of the financial sector, Hayne’s recommendations were always going to be important for economic performance. But the timing of the final report raised the stakes even further. The regulatory initiatives noted above plus changed market conditions had already seen a marked tightening of credit conditions in the economy, and that – along with several other factors (including the impact of high prices on domestic demand for investment in housing, a slackening in overseas demand and a substantial increase in housing supply) had contributed to a sizeable – and ongoing – fall in house prices. Moreover, as acknowledged in the latest Statement on Monetary Policy, the past year had not only seen continued efforts targeted at improving lenders’ assessment of potential borrowers’ expenses, but there was also evidence that the increased scrutiny on lenders prompted by the Commission had encouraged some loan assessors to apply lending criteria that were even stricter than those required by official lending requirements.

Source: RBA Chart Pack, February 2019

That backdrop prompted concerns that if the Commission proposed major changes to lending, the consequence would be further tightening in the availability of credit, turning what was already a credit squeeze into an outright credit crunch, and risking substantial collateral damage to the economy in general and the housing sector in particular.

In this context, two sets of recommendations were expected to be especially important: those relating to banks’ lending to consumers (particularly home loans, but also car loans and credit cards) and those relating to bank loans to small and medium-sized enterprises (SMEs).

In terms of consumer lending, the Interim Report had highlighted two key issues:

1. The provisions of the National Consumer Credit Protection (NCCP) Act 2009 relating to responsible lending, including the requirement for lenders to assess whether a credit contract might be ‘unsuitable’ for the consumer if a contract was made or a credit limit increased. The Banking Code (the banking industry’s code of practice) likewise requires lenders to ‘exercise the care and skill of a diligent and prudent banker’, a provision which also applies to bank lending to small businesses. In the Interim Report, Hayne concluded that here had been conduct that ‘might amount to a contravention of the NCCP Act.’ He also noted that some consumer advocacy groups were pushing for the assessment requirement for lenders under the Act to be tightened, replacing ‘not unsuitable’ with ‘suitable.’
2. As part of determining that a loan is ‘not unsuitable’, lenders are expected to take reasonable steps to verify the consumer’s financial situation to allow an assessment of borrower’s ability to meet his or her financial obligations. The Interim Report found that while the major banks did take steps to verify the income of home loan applicants, ‘the evidence also showed that much more often than not none of them took any step to verify the applicant’s outgoings.’ Instead, lenders frequently relied on the so-called Household Expenditure Measure (HEM) as a benchmark for assessing loan suitability, implying a much less rigorous assessment process.

In addition, Hayne also discussed whether it made sense to change the legal framework governing lending to SMEs by bringing some or all of them within the application of the NCCP Act.

In the event, the recommendations across all three issues turned out to be quite conservative.

1. The Commissioner’s view of banks’ obligations under the responsible lending provisions of the NCCP Act (and the parallel provision of the Banking Code) boiled down to a judgment that lenders needed to ‘apply the law as it stands.’ Hayne did not favour amending the Act to require lenders to determine whether a loan contract was ‘suitable’ (as opposed to ‘not unsuitable’) for the borrower, arguing that while the inquiries and verifications regarding consumer income and expenditure required by the Act should allow the lender to be able to verify whether a loan was ‘not unsuitable’, the same information was not suited to assessing the potential benefits from borrowing.
2. Hayne determined that the banks were already strengthening their approach to verifying a borrower’s financial position, possibly in response to prior concerns expressed by APRA, and were likewise reducing their reliance on the HEM. He also noted that these changes were being taken to improve compliance with the responsible lending obligations.
3. Hayne concluded that ‘I generally do not favour altering the rules that govern lending to small and medium enterprises (SMEs) . . . I do not favour extending the provisions of the NCCP Act to small business.’

The Commissioner was clearly mindful of the potential economic fallout from his recommendations. For example, with reference to direct lending to consumers, Hayne cited comments from Treasury’s response to the Initial Report (pdf), highlighting the observation that ‘the housing market has the capacity to absorb some adjustment in the application of lending standards necessary to meet the requirements of existing [responsible lending obligations] without imposing unwarranted risks to macroeconomic outcomes’ and again, from the same source, noting Treasury’s assessment that ‘if appropriately managed, ensuring the industry consistently meets the requirements of existing laws will likely enhance rather than detract from macroeconomic performance.’ Similarly, in explaining his disinclination to apply the NCCP Act to SMEs, Hayne said that ‘extending the responsible lending obligations . . . would likely increase the cost of credit for small business and reduce the availability of credit.’

This cautious approach means that the Royal Commission’s recommendations seem unlikely to trigger any additional tightening of lending standards and hence any further squeeze on credit. Rather, it has sought to lock in existing changes in bank behaviour involving a more rigorous application of underwriting standards. Indeed, it may be that the release of the final report will remove some of the uncertainty around future lending requirements that may have been squeezing the supply of credit at the margin.

Of course, those existing changes have already helped squeeze the housing market. In its latest (February 2019) Statement on Monetary Policy, the RBA notes that housing credit conditions are currently tighter than they have been for some time, although it also reckons that ‘there is little evidence that the further tightening in lending standards over the past year or so is the main explanation for the recent decline in housing credit growth.’ This echoes the relatively positive assessment of regulators’ actions from last October’s Financial Stability Report, which suggested that while tighter lending standards had reduced the maximum loan size available to borrowers, it was only the riskiest borrowers that had been credit constrained in practice, since most borrowers tended to take out loans well below the maximum offered by lenders. While conceding that the pace of credit expansion did slow as a result, the RBA also reckoned that the larger impact of changes was to alter the composition of lending, with declines in the share of investor lending, interest-only lending, and loans with very high loan to valuation ratios.

While the short-term implications of the Commission for lending standards and credit availability look to be modest, the longer-term impact on the Australian financial system is harder to assess. That’s because it will depend on a range of factors including the precise details of how and when Hayne’s recommendations are implemented, and the scale of any associated resourcing devoted to both the recommendations and their implications (such as the capability assessments for the regulators and any subsequent outcomes). Still, measures designed to restore trust in the system by reducing conflicts of interest, simplifying legislation and beefing up enforcement and regulation have the potential to deliver a modest improvement to both the resilience of the Australian financial sector and the quality of credit allocation, all of which should ultimately be positive for the economy’s medium-term growth performance.

1 In April last year, APRA announced that banks could apply to be released from the benchmark for investor lending growth if they could show strong lending standards, and then last December it announced that the interest-only benchmark could be removed for those banks that had had the investor benchmark removed.