Consumer credit reforms announced by Australian Federal Treasurer, Josh Frydenberg, on 25 September 2020 have received extensive media attention recently. The proposed measures, which will come into effect in March 2021, subject to the passing of legislation, encourage consumers to spend and organisations to invest, as we exit the worst of the economic slowdown triggered by the COVID-19 pandemic.
The proposed reforms include six key elements, one of which would remove the larger component of the responsible lending obligations contained in the National Consumer Credit Protection Act 2009 (NCCP). As a result, most of the financial commentary has focussed on the impact this would have on individuals who are exposed to the predatory practices of lenders and are caught in a spiralling debt trap. Protections for these vulnerable individuals must exist – there is consensus on that.
What has been missing from media coverage to date, though, is discussion about the remaining five elements. A few of them are just common sense, such as “ensuring that authorised deposit-taking institutions will continue to comply with the Australian Prudential Regulation Authority’s (APRA) lending standards”, but the sixth and final point has largely gone unnoticed.
Small businesses need clarity when it comes to lending
The Treasurer recommended “removing the ambiguity regarding the application of consumer lending laws to small business lending”. Ever since the introduction (and enforcement) of the National Consumer Credit Protection Act, there has been a steady creep towards applying these laws to small businesses. Arguably, this shift started in 2015 with the legislation giving birth to the new Australian Small Business and Family Enterprise Ombudsman role.
The inaugural Ombudsman, Kate Carnell AO, has perhaps unintentionally created some of the very issues she is now trying to fix. Her 12 December 2016 report on the Inquiry into Small Business Loans set in motion a negative change in the availability of credit for small and medium businesses. Of her 15 recommendations, two stand out as having far-reaching consequences past what was intended.
The first was Recommendation 3, which sets out that banks have no right to default a small business’s loan if it is less than $5,000,000, other than if there is a missed payment.
Very few banks accepted the $5,000,000 threshold, with most opting to go with $3,000,000. However, the absence of covenants and the inability to require financial reporting to monitor performance and seek updated valuations on assets, has increased the risk of lending into the small business and family enterprise sector. In her report, Ms Carnell recognised this would be a potential problem, but focussed on the cost of debt (i.e. the interest margin), even suggesting this was unlikely to change. Her reasoning was that “these conditions are rarely triggered (by banks)”.
Rather than increase the cost of debt to small businesses, banks have simply reduced their willingness to lend because of the heightened risks. In her November 2017 Barriers to Investment report, Ms Carnell recognised loans to small businesses are often more risky and identified this sector had difficulty accessing loans from traditional banks for a range of reasons, including:
- The high cost to service these clients by traditional lenders
- Riskiness of small business lending (noting success may be medium-term, rather than the short-term, impacting loan repayment periods)
- The (in)ability of many small businesses to provide real estate security to support their loans
- The prudential impacts on loans to small businesses.
The second recommendation with far-reaching consequences was Recommendation 11, which outlined that the banking industry must fund an external dispute resolution one-stop-shop to resolve disputes relating to loans of up to $5,000,000.
Ms Carnell recommended increasing the size of facility the Financial Ombudsman Service can consider (now morphed into the Australian Financial Complaints Authority) to $5,000,000. Again, the banks broadly supported a limit of $3,000,000, but to no avail. The dispute resolution determinations are binding on banks.
Overlaid on top of this was the Hayne Royal Commission into Banking, which was finalised in February 2019. Hayne’s report covered many areas, but also touched on small business. One of his recommendations included formalising the definition of a small business to include loans up to $5,000,000.
How banks have responded
As a result of this shifting sentiment, the banks themselves came together under the Australian Banking Association to agree a new Banking Code of Practice to uniformly apply the myriad of recommendations that had emerged in relation to how they lend to small businesses.
Overall, we’ve seen a much more conservative approach to small business lending during the past five years. Under the Banking Code of Practice, the banks have changed their approach. Without financial reporting or covenants, with limited ability to amend lending parameters once a loan is drawn, and with a complaints authority able to make binding decisions on a customer’s claim – it’s not surprising banks are more circumspect in lending to small businesses. If Ms Carnell is correct in her statements that small businesses are riskier than many other businesses, and the pathway to profitability may extend well beyond the typical loan term, banks will continue to avoid lending to them in the first place, unless they have an abundance of security.
With a more standardised approach to small business lending, banks have started treating these types of customers in the same way they treat home loan or credit card customers, running them through standard processing. While there is no legislative or formal requirement for banks to extend the provisions and protections of the NCCP Act to small businesses, it seems that this is what is happening.
In fact, it’s such a clear and visible outcome that it was covered by Hayne in the Royal Commission into Banking. His recommendation confirmed that the NCCP Act should not be amended to cover small businesses. Hayne determined, “extending the responsible lending obligations in the NCCP Act would likely increase the cost of credit for small business and reduce the availability of credit.”
It has never made sense that a business large enough to have debt of $5,000,000 needed the same lending protections as a 70-year-old pensioner or a single-parent on welfare.
What the future holds
While there may have been adverse consequences from some of Ms Carnell’s earlier actions, her support for Australia’s small businesses and family enterprises has been strong. In her June 2018 report, Affordable Capital for SME Growth, she explored credit availability to small businesses and highlighted a number of potential solutions. These included:
- Having the Australian Prudential Regulation Authority allow lenders to have more flexibility in the amount of capital they hold against small business loans
- Having the Australian Federal Government step in and provide a government guarantee to support and extend small business lending in the absence of better security (introduced during the COVID-19 pandemic)
- Encouraging small businesses to work with their trusted advisers to get their business finance-ready.
A mountain of good work has been done and many opportunities exist to do more. Top of the list is the need for lenders to recognise the financial acumen of many small businesses, and lend to them accordingly. Therefore, the Federal Treasurer was right to recommend, “removing the ambiguity regarding the application of consumer lending laws to small business lending”.
Until banks feel comfortable enough to make commercial decisions and lend to small businesses as they did in the past, we’re going to continue to see a shortfall in capital available. In the meantime, as per Ms Carnell’s recommendations, small businesses should work with their trusted advisers to get their business finance-ready to have the best shot at getting a loan.
If you have any questions about the reforms and their impact on small businesses, or you have any other concerns, please contact a member of our Debt Advisory team.