It is my contention that similar provisions should be available to banks and mortgage brokers. Often, the way you assess an application for a borrower with a net worth of $2,000 compared to a borrower with $20 million will vary. Making this distinction allow lenders to apply a more common sense approach. However, unfortunately, no such distinction exists. All borrowers are subject to the same rules, irrespective of their financial position and financial literacy.
Retail versus wholesale investor rules
The Corporations Act makes a distinction between wholesale and retail clients (or “sophisticated investors” if being offered bonds or direct shares). A wholesale client is someone that meets either of the below two tests:
- Asset test – having a net worth of over $2.5 million; or
- Income test – having a pre-tax income of at least $250,000 in each of the past two years.
The Act also includes other exemptions in addition to the above including professional investor test, product value test and small business test.
These asset and income hurdles were struck back in 1991 and are now vastly outdated. Adjusting for the impact of inflation, the income threshold should now be over $490,000 and asset value over $4.9 million.
Wholesale clients are assumed to be financially savvy enough to make informed decisions and are able to protect their own interests. In short, they can decide whether an investment is appropriate so there’s less onus on the provider or advisor. Also, there are fewer obligations (on financial advisors and product issuers) when dealing with wholesale clients such as there is no need to provide a Financial Services Guide, Statement of Advice, Product Disclosure Statements, etc.
Wholesale clients are often required to confirm their status by providing a certificate from a qualified accountant.
Responsible lending rules may not be changed as planned
In September last year, the government announced that it would seek to wind back some of the responsible lending rules which I discussed here. The main proposed change was to relax the obligation for the bank to verify how much you spend (and on what items) when applying for a loan.
The Bill passed the House of Representatives in March 2021 and is currently before the Senate. It is being opposed by the Australian Labor Party, the Australian Greens and some consumer groups. However, the government has reaffirmed its intention to push this legislation through. I understand that the Bill is scheduled for a second reading next week (16 June 2021). If this Bill doesn’t succeed, there’s an even greater need for sophisticated borrowers to be recognised.
Problems with a one-size-fits-all approach
A one-size-fits-all approach to assessing loans creates some perverse and frustrating outcomes. I share two common examples that we have experienced recently.
Asset rich but income poor
We have recently been helping a client borrow $650,000 to purchase an investment property for $1.25 million (i.e. borrowing only 50% of its value). This client has approximately $20 million of assets in cash, shares and superannuation – and currently zero debt. It is the banks policy to ignore historical dividend and interest income and instead use a deeming rate of only 0.25%. As such, when calculating the client’s income for lending purposes, the bank assumes our clients will receive only $50,000 in investment income (from $20 million of assets), which is barely enough to cover living expenses.
This credit policy may be appropriate for ‘mum and dad’ borrowers that might have a small parcel of shares. But there wouldn’t be many people that would disagree that applying the same approach to a high net worth individual (like our client) doesn’t make a lot of sense. They have significant financial resources to draw upon to meet loan repayments. If you’re not going to lend to them, who will you lend to?
Large offset balances
It is common for our clients, particularly ones that are approaching retirement, to have large borrowings that are fully or mostly offset. When it comes to assessing borrowing capacity, the banks ignore money in offsets on the assumption that you could spend it, and if you did, you would incur interest in respect to the mortgage.
However, common sense suggests that someone with $2 million in an offset account has demonstrated a long history of making prudent financial decisions. As such, it is unlikely that they will spend all this money frivolously tomorrow. In fact, one could successfully argue that the mere fact that they have $2 million in their offset is the strongest evidence that they are prudent money managers and can afford to service additional debt.
It is time to introduce a new category of borrowers: sophisticated borrowers
The government began to tighten credit rules back in 2009 after the GFC. By the time the banking Royal Commission started in 2017, most of the regulatory holes had already been plugged. Of course, prior to 2009 the laws were too loose and they didn’t protect consumers adequately. It makes absolute sense that banks and mortgage brokers have an obligation to ensure clients can afford a loan.
But it also makes sense that different people should be treated differently. The Hawke government, which drafted the wholesale client rules that apply for investments, realised that higher net worth people have the capacity, knowledge and experience to make prudent decisions and protect themselves. As such, they don’t need the same levels of protection.
It is my view that credit laws must make the same distinctions. Higher income earners and high net worth persons are usually able to assess whether it is prudent for them to take out a new loan. Also, the approach to assess a loan for a high net worth individual should allow a bank to rely on financial resources, not income, to demonstrate the capacity to service a loan.
The current system is broken
The fact that someone with several millions of dollars in the bank is subject to the same assessment as someone with very little financial resources highlights that the current regulations are inadequate. Banks must be given a robust framework but enough discretion to operate within that framework to achieve acceptable outcomes. Distinguishing between retail and sophisticated borrowers seems to be a logical step in the right direction.