Review of Code of Banking Practice

Submission to the Review of Code of Banking Practice.

September 2008 Moving from negative to comprehensive credit reporting

Over the last 25 years greater competition and widespread innovation in credit products have contributed to a widening of the number of people able to access credit from mainstream lenders1.

Overwhelmingly, this has been used to build up wealth, with the Reserve Bank estimating 90 per cent went to acquiring assets,2 and the biggest increase in credit use by the highest income group and people in the 45-64 age demographic.

As an Access Economics study commissioned by Veda points out:

One of the main motivations behind the deregulation of the Australian financial system in the 1980s was the lack of access to credit for many Australians. Credit was only readily available to those with either high incomes or long banking histories…many mortgages in the late 1970s and early 1980s involved a combination of finance…so called ‘cocktail’ loans.

Access Economics3

However, rising interest rates since 2001 has led to concerns about over- commitment. While the question of ability to repay debt is more critical than the quantum of household debt, there is the broad question “do lenders have the best information to assess if a person can service additional credit repayments.”

The evidence is clear. Current laws prevent lenders identifying a borrower who is overcommitted and struggling to make payments – potentially resulting in yet more credit being given.

An allied concern is for people who have overcome financial difficulties.

1“In short, deregulation, innovation and lower inflation have simultaneously increased the supply, and reduced the cost, of finance to households, and not surprisingly, households have responded by increasing their use of it.” Address by Ric Battelino, Deputy Governor to Finsia- Melbourne Centre for Financial Studies 25 September 2007. 2 Ibid 3 Pg 6“The benefits of broadening access to credit via comprehensive credit reporting.”Access Economics Pty Ltd Report commissioned by Veda Advantage, May 2008 Credit reporting laws prevent a person demonstrating they are once again financially stable and able to meet commitments. They remain hamstrung by defaults listed on their file for up to five years.

Amongst the OECD, Australia, New Zealand and France are the only countries without comprehensive credit reporting.

In the past five years Belgium and Greece have introduced comprehensive credit reporting models and following an EU directive in early 2008, Spain is also moving to comprehensive reporting.

Having gained agreement on other aspects of uniform consumer credit protections, the European Commission is now forming an Expert Group on Credit Histories to harmonise the operation of credit throughout the EU.

More broadly, comprehensive reporting has been introduced in India, Brazil and Hong Kong.

Hong Kong’s recent move to comprehensive credit reporting is instructive. Its previous negative credit reporting regime failed to prevent a huge surge in consumer bankruptcies in 2002, with bankruptcies peaking at 25,3284.

Positive data sharing was introduced in stages from 2003 and by 2004 the number of bankruptcies dropped by 45 per cent5.

“…financial institutions are in a better position to avoid lending to borrowers on the verge of bankruptcy.”

Hong Kong Money Authority following the introduction of positive credit reporting

Average indebtedness of bankrupts also declined from over 35 times a bankrupt’s monthly income to 25 times – described by the Hong Kong Money Authority (HKMA) in a 2006 review of comprehensive reporting as a “conspicuous improvement in the problem of over-indebtedness”6.

4 Official Receivers Office, Hong Kong Compulsory Winding Up and Bankruptcy Statistics 5 Ibid 6 Hong Kong Money Authority Quarterly Bulletin March 2006. The success of other jurisdictions who have recently introduced comprehensive reporting is reassuring - and emphasises the need for Australia to embrace comprehensive credit reporting.

In August 2008 the Australian Law Reform Commission Review of Privacy Laws recommended important changes to legislation governing credit reports.

The ALRC report recommended credit reports include:

I. When the account was opened; II. The type of credit granted; III. The current limits; IV. The date an account was closed; and V. The account repayment history over the past two years7.

The recommendations are welcome and timely.

ARCA (the Australasian Retail Credit Association) has modelled all five elements, working from a theoretical 100% accurate predictive score.

This model assesses the predictive value of Australia’s current negative-credit reporting regime at 10 per cent.

By allowing the first four recommendations, the predictive value of a credit report lifts to 33 per cent (about 23 per cent more than the current system)

Including account payment history on a credit report - overdue payments and missed payments - lifts the overall predictive value to 74 per cent.

In other words, detailed account payment history is worth more than the other four elements combined.

Industry expects further announcements from the Government in early October as part of COAG, with a view to legislation being introduced by December 2009.

Recommendation: 7 The ALRC recommended this last and most critical element is contingent on the introduction of responsible lending obligations. The Banking Code Review recognises the crucial role credit reporting plays in supporting responsible lending and supports all five data elements being simultaneously implemented. The sub-prime crisis and credit reporting

Consumer groups often point out the United States, with its very liberal laws on use of credit files, is nevertheless suffering heavily from the consequences of the sub- prime crisis.

However, the causes of the sub-prime crisis are not related to allowable content on, or use of, credit files. Indeed, even a cursory examination of the US sub-prime crisis shows that had lenders, and particularly mortgage brokers, paid attention to the content of credit files, many of these loans would not have been made.

The Reserve Bank cites four reasons for the current US ills and Australia’s much more resilient performance.

In the United States, sub-prime loans have a 13 per cent share, yet made up more than half of foreclosures in the Oct-Dec quarter of 2007.

In Australia, non-conforming loans – the equivalent to sub-prime loans – are less than 1 per cent of housing loans.

In the United States, the rate of mortgage delinquency for sub prime loans is 20 per cent, and even prime mortgages are at 3.25 per cent.

In Australia, non performing loans stood at 0.3 per cent (Dec 2007) and the RBA notes “most non-performing housing loans are considered by banks to be well covered by the value of collateral”8.

In addition, three other factors differentiate the Australian economy.

 The Uniform Consumer Credit Code enabling courts to set aside mortgage agreements where a lender could reasonably know a borrower could not repay without substantial hardship9;

8 Pg 25 Financial Stability Review, RBA March 2008 9 In contrast, USA lending laws allowed the HCL Finance to offer the now notorious NINJA loans – no income, no job and no assets.  In Australia mortgages are full recourse – unlike some states in the USA, a distressed borrower in Australia cannot extinguish the debt by handing over the house;  Very low interest rates in the United States and rising housing prices encouraged lending despite a borrower’s poor credit history10.

10 “Ratios of non-performing loans to total loans remain at low levels with arrears rates having declined over the past six months. While lending criteria were relaxed over recent years, credit standards in Australia did not fall by nearly as much as they did in the United States.” Pg 2 Financial Stability Review, RBA March 2008 Responsible lending

While Australian lending practices are generally sound, as evidenced by the comparatively low rate of defaults on mortgages, the collapse of the US housing market has brought the question of lending practices into sharp focus.

Veda recognises that, of its own, comprehensive reporting does not automatically lead to better lending or marketing practices.

Veda notes the Review of the Banking Code is considering a proposal to include in the Code general principles of responsible lending similar to the British Banking Code.

Similarly, the Credit Union Code of Practice contains provisions for responsible lending, and the Australian Retail Credit Association is working on a draft code encompassing responsible lending.

These are timely in view of the Productivity Commission’s recommendation (and COAG’s subsequent endorsement) for the Commonwealth to assume responsibility for the Uniform Consumer Credit Code.

The Productivity Commission’s Review of Australia Consumer Policy Framework has suggested that all credit providers be subject to an ASIC registration or licensing scheme and that part of that scheme include an obligation to assess capacity to repay.

Whatever the regulatory regime introduced, responsible lending is a limited tool in reducing the extent of over indebtedness.

International studies point to the more likely causes of household stress:

“it can be concluded that over indebtedness is more often due to the occurrence of an event in an individual’s personal life that disrupts the households budgetary equilibrium and makes repayment difficult, than the simple accumulation of debt “11

11 Information Sharing and its implications for consumer credit markets:United States Vs Europe, Jentzsch, N and Riestra A May 2003 A study for the Hamburg Institute noted various European studies cite divorce as the second most common cause of over-indebtedness after unemployment12 and that:

“Unemployment, working fewer hours, loss of income when changing jobs, divorce and accidents cause debt overload in more than 80% of cases.”

While all parties share a commitment to responsible lending, finding expression in successful statutes or self regulation is a significant challenge.

It is desirable that responsible lending obligations cover all lenders equally, to ensure competitive neutrality between different financial organisations.

Recent moves to regulate finance brokers and include requirements for brokers to assess a consumer’s ability to repay credit, emphasises the difficulties created by a piecemeal approach, and the challenge inherent in drafting a precise expression of responsible lending.

However, together with our industry body ARCA, we believe the effort is warranted, particularly at a time when community and government want the issue addressed.

It is therefore highly desirable that various self regulatory and possibly regulatory provisions contain uniform or at least consistent principles. Whatever the outcome of these various initiatives, their provisions should recognise the essential role of credit information as a critical operational and evidentiary element of responsible lending obligations.

Responsible lending and pre-screening

12 Pg 18 Various studies cited in “An Economic analysis of the EU Commission’s proposal for a new Consumer Credit Directive” Wim Kosters, Stephan Paul and Stefan Stein The debate about responsible lending - “assessing a person’s capacity to pay” – is too often confused with responsible marketing.

Making offers that compete on price and features is fundamental to the market economy. While some guidelines and disclosures may be reasonable, the fundamental importance of marketing to competition must be acknowledged.

In the USA, credit files can be used to identify and target higher risk profile borrowers for marketing purposes.

In Australia, this is not and would not be permitted, and ARCA has unequivocally stated its support for this prohibition to remain.

In Australia, there is also a harm reduction measure often undertaken, known as pre-screening, whereby people who have defaulted on credit are not mailed any further offers of credit.

No list of people with defaults is ever released by the credit reference association.

Typically, Australian lenders obtain a list of names from direct marketing companies.

This list is sent to a credit reference association, where the names of people who have recorded defaults are removed.

The list, now ‘pre-screened’ is then sent by the credit reference association to a mailing house, posted and the list destroyed.

This process ensures no disclosure personal credit file information, nor targeting of risk profiles for credit offers.

While a bad risk borrower with defaults will normally be picked up at application stage, the process of pre-screening ensures they do not receive direct marketing offers of credit in the first place.

Recommendations:  Consistent principles of responsible lending obligations must apply to all credit providers;

 Proposed responsible lending principles should recognise the critical role of credit reporting information;

 Measures to limit marketing of credit products to people in clear financial difficulty should be implemented, including the use of pre-screening mailing lists for people with poor credit profiles.