Royal Commission: Round 1 - experiences with consumer lending practices

Interim Report – consumer lending practices

Written by Partner Alexandra Mason and Associate Keerthi Ravi

In examining the topic of consumer lending, the Commission considered issues arising from the sale of credit products – including residential mortgages, car finance and credit cards – by reference to case studies involving the four major banks as well as Aussie Home Loans and Citi. During the course of her examination, Senior Counsel Assisting the Commission posed questions to witnesses about: employee remuneration structures, incentive and commission arrangements with intermediaries such as mortgage brokers and introducers; compliance with responsible lending obligations; customer remediation programs; and interactions with regulators.

Key points

The hearings explored questions including:

• the nature of the relationship between banks and intermediaries in the sale of credit products. In particular, the Commissioner was interested in understanding who intermediaries are acting for (the consumer, the financial institution, themselves?) and who consumers think intermediaries act for;
• whether third-party (broker) commission arrangements, in particular upfront and trailing commissions, give rise to conflicts of interest that lead to poor customer outcomes;
• whether consumers are owed a duty of disclosure in relation to the commissions paid to third parties;
• compliance with responsible lending obligations and whether the processes adopted by the banks are sufficient for discharging these obligations, particularly around the verification and assessment of income and expenditure;
• the delegation of responsible lending obligations to third parties and whether internal processes and controls (including automated processes) for monitoring and supervising third parties are sufficient;
• the marketing, sale and distribution of add-on products, in particular consumer credit insurance, to customers who may not be eligible to access the benefits of these products; and
• the adequacy and timeliness of reporting breaches to regulators such as ASIC.

What's next? Interim report: Key themes and findings

1. The Interim Report makes strong criticisms of the conduct of institutions involved in consumer lending, based on a central finding that the entities involved have continuously preferred the pursuit of profit over the interests of the consumer. The Commissioner has found that 'there has been occasions when profit has been allowed to trump compliance with the law, and many more occasions where profit trumped doing the right thing by customers.'
2. As expected, central to these findings are criticisms around remuneration structures within the consumer lending industry which may incentivise conduct that is adverse to the interests of the consumer. The Interim Report also criticises banks' compliance with the responsible lending requirements and makes some robust statements that, assuming they feed into the final report, could have significant impacts on the credit approval processes adopted by lenders in the future.
3. Amongst the (interim) findings made in the Interim Report, some of the most significant include:
   1. in relation to lenders' relationships with intermediaries (including brokers and introducers):
      1. third-party remuneration: value (upfront and trail commissions) and volume-based remuneration has been an important contributor to misconduct, conduct falling short of community standards and expectations, and poor customer outcomes in the home loan industry. The Commissioner found that some remuneration structures may have amounted to a breach by lenders across the industry of their obligation under s47(1)(b) of National Consumer Credit Protection Act (NCCPA) to have in place adequate arrangements to manage conflicts of interest.
      2. duties and obligations: responsibility for compliance with the requirements of the NCCPA, including the responsible lending obligations, cannot be delegated – lenders are responsible for an intermediary's failures to make relevant inquiries of a customer and verify relevant information. This finding highlights the difficulties faced by lenders in practice when it comes to monitoring and supervising third parties, and focuses attention on lenders' processes for verifying information provided through brokers.
      3. conflicting messages: there is confusion both within the industry and amongst consumers about whom intermediaries act for when assisting consumers to obtain credit products. The Interim Report raises the possibility of imposing a 'best interests' duty on brokers akin to those imposed on financial advisers.
   2. In relation to lender's compliance with the responsible lending requirements:
      1. verification of expenses: to comply with responsible lending obligations, lenders must not only verify income but must also take active steps to verify a customer's expenses. Relying on a benchmark such as HEM does not discharge this requirement.
      2. scalability of requirements: the responsible lending requirements cannot be scaled down to zero. This finding may require lenders to re-examine their processes around credit card approvals and credit limit increases.
      3. add-on products: the Interim Report queries whether some add-on insurance products in particular are inherently poor value propositions for customers. The alleged miss-selling of these products is already the subject of threatened class actions by plaintiff law firms.
      4. interactions with the regulator: banks have failed to comply with their obligations under s912D of the Corporations Act to report significant breaches of s912A of the act in a timely manner (within 10 days). The Commissioner is critical of ASIC for failing to take action in relation to these alleged failures. This finding highlights the difficulties associated with the operation of this requirement in practice, and will no doubt provide further support for the Government's current proposal to amend the legislation in accordance with the recommendations made by the ASIC Enforcement Review Taskforce.
4. In addition to these matters, the Interim Report raises questions about lenders' communication with consumers, including around the disclosures made to borrowers about financial arrangements with third parties, as well as approaches to customer-remediation activities.
5. What is clear from the Interim Report is that when undertaking consumer-lending activities, banks are now expected to have regard to community expectations, and the interests of consumers as well as shareholder returns. This appears to be an extension of the requirement already imposed on credit providers to act efficiently, honestly and fairly. Simply complying with the law will not be sufficient for this purpose – lenders must also 'do the right thing' by consumers. Underpinning this expectation is the idea that banks have a social licence to operate. The Commissioner deals with the tension this raises for the directors of financial institutions (who owe duties to the company) by arguing that it is in the best interests of the entity long term to engage in credit activities in a manner that preserves and enhances the entity's reputation.
6. The Interim Report remains largely silent on issues of consumer personal responsibility, including in cases where borrowers have deliberately misled lenders. Instead, it appears to suggest that there is an asymmetry of power and information between bank and customer that favours the bank in such a way that it is properly the role of the bank to protect the customer's interests. Assuming this is reflected in the recommendations made in the final report, this may result in banks applying stricter requirements on customers when determining whether credit contracts are unsuitable.