Trust and prudence in lending: Making it easier to borrow, but at whose cost?

By Professor Paul Kofman

What happens when banks are able to relax their lending regulations? Does the economy really benefit and how does it impact society and trust in banks in the long-run?

The origins of the Global Financial Crisis can be traced to aggressive bank-lending practices. These, together with the collapse of the US sub-prime market caused widespread economic devastation and necessitated large-scale government-funded bank bail-outs in many countries. In the wake of this, responsible lending laws were put in place to prevent banks extending loans to retail consumers and small businesses regardless of their ability to service those loans, essentially stopping a further sub-prime crisis and its devastating impact.

Change for the worse?

Those laws were as much aimed at protecting the banks as their customers from irresponsible lending. Although strict lending rules were imposed on the banks, the 2019 Hayne Banking Royal Commission (BRC) unveiled that ongoing lending problems over the following decade continued. So why is the government now proposing to unwind these responsible lending laws?

The government’s proposal to ease lending restrictions is well-intentioned. It is aimed at post-COVID-19 economic recovery by making credit available to consumers and small businesses to boost economic growth. This proposal will make loans more accessible, but two important questions arise:

  • Firstly, can we be sure that those loans will fund economically productive investments?
  • Secondly, will consumers and small businesses be able to service the loans?

The government emphatically affirms the first question, but is silent on the second question.

Not surprisingly, banks and other financial institutions are more interested in the potential for increased activity – and therefore profit potential – in extending loans than the perceived economic benefits. When asked to comment on the government proposal by The Sydney Morning Herald (September 25, 2020), an investment manager said: “It’s a mild positive but I don’t think given the fairly insipid demand for loans it will suddenly spur on an increase in activity…” This is clearly a case of quantum over impact.

Lender beware

Unfortunately, these new rules lessen the need for banks to do due diligence before approving a loan, leaving it to the borrower to assess whether the loan is in fact affordable. The banks’ reduced compliance cost could then be passed on to borrowers through lower interest rates and everyone wins – but do they?

Borrowers are typically not best-placed to critically assess their own creditworthiness. That is seemingly not (or no longer) a concern for banks. According to a wealth manager interviewed for that same article in The Sydney Morning Herald “… we’re moving to a middle ground [where].. [t]hose who borrow must take some responsibility to fund their loans.” It seems to suggest that in the aftermath of the responsible lending laws and the BRC recommendations, responsibility shifted entirely onto the lender.

Do you know how much you can really afford to borrow?

Alongside paying off mortgages, household saving has increased significantly during COVID-19’s stimulus and support package. While existing loan payments have been deferred by banks, demand for new loans has also plummeted. Amidst a recession and mounting uncertainty for the future, households are acting prudently.

But do banks have a role in prudent household income stewardship? Not according to the relaxed lending rules. Lenders have always left prudent financial management – a comparative advantage for a financial institution – to their customers. The new rules could mean that they now also no longer have to consider the legal requirements on loan applicant documentation, and can simply extend loans-on-loans-on-loans… to unwitting borrowers who neither have the knowledge nor the skills to properly judge affordability and suitability. This was probably not what Justice Hayne had in mind.

Damaging long-term effects

Perhaps what is most damaging is how these relaxed rules will have impact on public trust in banks. Prudence is an important dimension of a banker’s professional competence. Take that away and you erode the public perception of ethics and integrity. Attracted by low thresholds of diligence, an adverse selection of ‘bad risk’ borrowers will creep into banks’ lending portfolios.  Ultimately, this will lead to an increase in impaired loans and borrowers in financial distress. In the long run, shifting the responsibility to the customer will only make customers more disillusioned with banking ethics.