Moving to greater clarity on HEM

  • By James Zhu

The landmark Westpac decision provides timely support to inject safety and speed back to the nation’s credit flow, writes Deloitte’s James Zhu.

It has been a difficult time for lenders navigating the murky waters of responsible lending. The need to balance commercial concerns of quickly and efficiently completing credit assessments while meeting responsible lending obligations has been difficult in the face of the unsettled regulatory interpretation.

Following years of growth and rising property prices, non-performing loan ratios are naturally sitting at historical lows.

This creates practical challenges for policy makers, regulators and lenders when it comes to deriving a consistent approach to the application of the responsible lending provisions.

The landmark judgment handed down in the Federal Court in ASIC v Westpac on 13 August 2019 by Justice Nye Perram is a legitimate line in the sand towards helping to clarify and balance the legitimate regulatory and commercial concerns.

Case Background

Between 2011 and 2015, Westpac has used the Household Expenditure Measure (HEM) as well as a percentage buffer, to identify the declared living expenses in its serviceability calculation rule for mortgage serviceability.

In cases where the declared living expenses were higher than the HEM benchmark, ASIC challenged that the ‘higher’ position should be adopted to calculate serviceability.

Clarity on usage of HEM

Justice Perram drew a distinction between making reasonable inquiries about the consumer’s financial situation under s130(1)(b), and any inferred necessity to use that same information for conducting substantial hardship assessment under s131(2)(a).

The act requires a lender to ask the consumer about their actual living expenses. But it does not follow that it must use their declared living expenses in deciding whether they can afford to repay the loan.

The practical impact of the judgement on application of HEM has confirmed that:

- Lenders are permitted to use HEM for assessing the likelihood of the consumer suffering substantial hardship (i.e. the unsuitability test under s131(2)(b);

- HEM can be used to measure comparative levels of hardship; and

- HEM cannot be used under s130(1)(c) to verify the consumer’s expenditure, in line with Commissioner Hayne’s view.

Unpacking the ’Unsuitability Test’

Justice Perram noted that the concept of a ‘suitability test’ can be loosely expressed as an ‘affordability test’ or a ‘serviceability test’.

He pointed out, that regardless of the language used, the focus of the ‘unsuitability test’ should be on the likelihood of suffering substantial hardship.

The judge acknowledged the relevance of analysing risk of default (credit risk) in assessing the consumer’s ability to meet their financial obligations.

Gaming the HEM? - The concept of scalability

As the contested element of the case is limited to the Serviceability Calculation Rule, the Justice Perram did not have the opportunity to elaborate on the concept of scalability, including where in individual circumstances HEM may not be sufficient or appropriate to demonstrate sound unsuitability assessment under s131.

The current industry discussions are formed in the context of reasonable inquiries and verification under s129.

While generally acknowledged by the industry, what is deemed as essential, that is not causing substantial hardship, may vary between product types and an individual’s personal circumstances.

Especially, in circumstances were the consumer displays indicators of vulnerability. This may well form an emerging concept of ‘scaled consideration of declared living expenses’ in the future application of s131 assessment.

A ‘one HEM fits all’ approach needs to be balanced with personalised assessment of circumstance and consumer vulnerability wherever possible.

ASIC is in process of conducting public hearings on Consultation Paper 309. We expect the updated regulatory guide to provide further clarity on scalability.

Next steps

ASIC has not ruled out appealing the decision. However, for now, the decision should provide added confidence for lenders when reviewing and refining their end-to-end product and distribution design.

The case also highlights the importance of sound system design, including the back end credit decisioning-tools and front-end customer interface. Both were examined in detail by ASIC and the Court in this proceeding.

Last words

The judge applied some common sense tests to the topic.

But it is important to note, that the judgement did not derail the main direction of Commissioner Hayne’s report and the spirit of the Banking Code of Practice.

A ‘one HEM fits all’ approach needs to be balanced with personalised assessment of circumstance and consumer vulnerability wherever possible.

From a product design perspective, the case deals in a mortgage product environment where the legal questions are narrowed and the concept of scalability is not contested.

Lenders of non-mortgage products need to take a more cautious view on the applicable points in their policy framework, product design and focus of monitoring program.

For example, where HEM cannot be used for verification of consumer’s expenditure, lenders need to clarify what baseline evidence is needed to satisfy ‘reasonable verification’, and to what extent do they inquiry or verify inconsistent information.

James Zhu is a responsible lending subject matter expert, Audit and Assurance at Deloitte.