To HEM or not to HEM? Is that the question?

When the first round of hearings for the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry took place in March, a case study involving ANZ’s lending practices in connection with home loans was brought into focus.

Specifically, ANZ’s general manager of home loans and retail lending practices, William Ranken, admitted that the bank did not further investigate a borrower’s capacity to service a broker-originated mortgage.

Ms Rowena Orr, the senior counsel assisting the commission, highlighted a guide by the Australian Securities and Investments Commission (ASIC) that tells banks they are “obliged to take reasonable steps to verify consumers financial situation” to ensure that a loan is not unsuitable.

Ms Orr concluded that it was open to the commissioner to make a range of findings of misconduct against ANZ, including that “ANZ’s policies and procedures relating to broker-initiated home loans are inadequate as they do not provide a system for ANZ to take reasonable steps to verify a consumer’s financial situation insofar as that verification relates to a customer’s general living expense”.

This question of verifying a borrower’s expenses was brought to the fore once again recently, after Westpac agreed to pay a $35 million civil penalty to resolve Federal Court proceedings under the National Consumer Credit Protection Act 2009 (NCCP).

ASIC and Westpac jointly approached the Federal Court seeking orders that the bank contravened the responsible lending provisions of the NCCP because its automated decision system did not have regard to consumers’ declared living expenses when assessing their capacity to repay home loans, and instead used a benchmark (the Household Expenditure Measure), among other allegations.

While ASIC’s Regulatory Guide 209 outlines that “benchmarks can be useful tools in the process of determining whether a particular consumer will experience substantial hardship as a result of meeting the obligations of a credit contract”, it adds that “automated systems and tools are not a substitute for making inquiries about the consumer’s current financial situation”.

Indeed, the statement of agreed facts between Westpac and ASIC outline that Westpac accepts that, for the loans in question under the ASIC case, it should have had regard to the declared living expenses in its serviceability calculation in the automated decision system.

But — herein lies the rub — the statement of agreed facts also show that the loans conditionally approved under the automated system actually had a “lower rate of hardship applications than manually approved home loans” originated during the same period.

No judgement has yet been made on the Westpac case, with Justice Nye Perram still considering whether the Westpac case even is a breach of the NCCP (reportedly stating that “there is no fact before [him] that any unsuitable loans were made”). He has reserved his decision on the Westpac case until December.

Meanwhile, Commissioner Hayne has also recently questioned the use of HEM.

In his interim report for the financial services royal commission, Commissioner Hayne wrote: “It follows that using HEM as the default measure of household expenditure does not constitute any verification of a borrower’s expenditure. On the contrary, much more often than not, it will mask the fact that no sufficient inquiry has been made about the borrower’s financial position. And that will be the case much more often than not because three out of four households spend more on discretionary basics than is allowed in HEM and there will be some households that spend some amounts on ‘non-basics’.”

He added: “Using HEM as the default measure of household expenditure assumes, often wrongly, that the household does not spend more on discretionary basics than allowed in HEM and does not spend anything on ‘non-basics’.”

As such, Commissioner Hayne asked: “Should the HEM continue to be used as a benchmark for borrowers’ living expenses?”

He also questioned whether the “processes used by lenders, at the time of the hearings, to verify borrowers’ expenses meet the requirements of the NCCP Act”.

I’ll leave the legal readings and arguments to the lawyers and judges in regards to whether the lenders have (or have not) breached responsible lending obligations, but surely, this whole argument looking at the relevance of expenses and benchmarking is glossing over one crucial factor: whether or not the loans being issued under HEM are actually “unsuitable”.

Given that arrears rates are still well below 1 per cent, there does not seem to be an abundance of people affected by unaffordable loans — which you would expect if the loans being approved using HEM were unsuitable.

Further, the arguments that having more information and benchmarks to refer to is a compelling one.

Speaking to our sister publication, The Adviser, the director of broker industry compliance firm QED Risk Services, Greg Ashe, recently outlined that he “completely disagreed” that HEM should be removed, arguing that more information, not less, is required to adequately and accurately understand a borrower’s financial situation.

To me, it seems that HEM has been demonised in the furore of responsible lending. While I agree that lenders should not be neglecting their obligations and relying solely on HEM when calculating serviceability, I think we need to see more proof in the pudding before determining that the benchmark is flawed and scrapping it completely.

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[Related: Major bank admits to responsible lending breaches, fined $35m]