How responsible lending should look – an interview with Professor Kevin Davis

Former member of the Financial Systems Inquiry, Professor Kevin Davis, has set out his expectations for responsible lending obligation (RLO) reform in Australia.

Davis advocates a shared buyer and seller accountability model, which protects consumers from financial illiteracy and cognitive bias, at the same time, retaining much of the economic benefit of a market based system.

His suggestions have come in the wake of Federal Treasurer Josh Frydenberg’s bid to revive pre-Royal Commission (RC) lending standards, including a shift back to ‘buyer beware’ – from the existing ‘seller beware’ framework – and the removal of RLOs introduced in 2010. This is despite the RC exposing numerous examples of consumer detriment from unsuitable financial products.

“A buyer beware model will not work because many borrowers lack the financial sophistication needed to assess suitability, risks and costs of financial products marketed and sold to them,” said Davis ahead of the Responsible Lending & Borrowing Summit.

“It is based on the assumption that education, advice, and disclosure requirements are enough to enable appropriate borrower choices. However, Psychology tells us that consumer biases are notoriously hard to counteract with information alone.

“Moreover, the T&Cs for financial products are written by lawyers, for lawyers. It is unreasonable to expect everyday consumers to have a solid grasp of complex product terms.

“That said, the integrity of a market based economy relies on transactions being mutually beneficial. To get the best of both worlds, borrower and lender should share responsibility in terms of the suitability of credit being granted,” he added.

The changes being proposed by Frydenberg will include some safeguards, including restrictions for consumer leases and small amount credit contracts. Additionally, lenders will be bound by APRA standards; debt management firms will need to hold licenses; and there will be greater temporary bankruptcy protection for business borrowers during COVID-19.

However, lenders will not have to assess individual suitability of a financial product, leaving that determination solely up to the borrower. This could mean that, instead of genuine affordability, lenders may focus on the ability to recover loan repayments from collateral.

Davis said the rationale for watering down consumer protections to the degree being proposed by government is weak – particularly in the aftermath of RC revelations that bank customers were put at risk from the pre-existing set-up.

“It seems strange that this is happening at the moment, fresh out of a Royal Commission, where we heard lots of examples of consumers being financially harmed; and where the expert recommendations point in the opposite direction,” Davis continued.

“Aside from the unsubstantiated belief that lifting RLOs may improve the flow of lending, there is not really a strong case for removing these consumer protection regulations – particularly at this time. ASIC reviewed RLO implementation in 2019 and we need time to examine the consequences of the resulting changes.”

Davis says the government’s lean towards free market principles is a concern in the context of consumer finance.

“Whilst reliance on the free market works in some industries, it doesn’t where consumers don’t know what they’re getting into,” he said.

Meanwhile, the argument that APRA can ensure suitable lending is a misunderstanding of the role and focus of a prudential regulator, he added.

“It is unreasonable to assume that a prudential regulator will be able to focus on the best interests of consumers. To me this suggestion is more ideological than logical,” he said.

Davis would also like to the see the continued application of RLOs for intermediaries, such as advisors and brokers; and – on the receiving end – small businesses that lack financial expertise.

Likewise, the definition of credit should include all arrangements for deferred payment – not just those involving explicit interest rates, he said.

“Any product where a consumer has to make a payment in the future puts them at risk, particularly products that incur penalties for late payment,” Davis continued.

“By and large, the fees in such products can translate to very unfavourable deals. A $5 late penalty may not sound like much, but for a $100 short term product it is a very steep interest rate. Consumers that lack financial sophistication may not realise this.”

Compounding the threat of weakened consumer protection, Davis notes it is now easier for lenders to defend a charge of irresponsible lending.

He cites the recent ‘Wagyu and Shiraz’ case, in which Justice Perram concluded that current living expenses were not necessarily an important indicator of whether a consumer could afford a loan.

“The Wagyu and Shiraz judgement implies lender defence against charges of non-responsible lending is becoming easier,” Davis said.

“This weakens many industry arguments about the adverse effects and costs arising from RLOs.”

With the recent growth of fintech and open banking, Davis argued that the case for RLO retention is enhanced.

“On the one hand these developments reduce the cost of gathering information to determine loan suitability. On the other hand, it is getting easier and quicker for consumers to borrow money.

“I am concerned that, without stringent safeguards, we will relive many of the horrors exposed just a couple of years ago during the Royal Commission – an event that was meant to be a positive turning point for the industry.”

Join Professor Kevin Davis for a heated discussion on this topic at the Responsible Lending & Borrowing Summit due to take place 29-30 March 2021.

Learn more and register.

Kevin Davis is Emeritus Professor of Finance at the University of Melbourne, having retired at the end of 2020. Until December 2018 he was Research Director of the Australian Centre of Financial Studies (of which he was the Inaugural Director) and also a Professor at Monash University.

Davis’ primary research interests are financial regulation, banking, financial innovation and corporate finance. He is co‐author/editor of 20 books/government reports in the areas of finance, banking, monetary economics and macroeconomics and has published numerous journal articles and chapters in books. 

He is currently a member of the Australian Competition Tribunal, has undertaken an extensive range of consulting assignments for financial institutions, business and government, and held a number of Board positions (currently a board member of FMAA and Superannuation Consumers Australia). He is an active contributor to public policy debate.

Davis is a Senior Fellow of Finsia and holds Bachelor of Economics (Hons I) from Flinders University of South Australia and a Master of Economics from the Australian National University. He was appointed by the Federal Treasurer in December 2013 as a panel member of the Australian Financial System Inquiry chaired by Mr David Murray which reported in November 2014.