The Banking Royal Commission Implementation Roadmap & Agri Lending

The Treasurer today announced the Banking Royal Commission “Roadmap.”

The roadmap document, available here, provides a response to each of the recommendations made by the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.

The recommendations relevant to Agricultural Lending, and the response today, are set out below:

Recommendation 1.11 – Farm debt mediation – A national scheme of farm debt mediation should be enacted.

Roadmap:

The Government is working with states and territories through the Agriculture Ministers’ Forum (AGMIN) to progress work on the establishment of a national farm debt mediation scheme

A National Farm Debt Mediation scheme is a universally supported measure, which has been recommended by numerous inquiries over several years. Implementing such a popular and well-supported measure should be relatively straightforward.

Recommendation 1.12 – Valuations of land – APRA should amend Prudential Standard APS 220 to:

require that internal appraisals of the value of land taken or to be taken as security should be independent of loan origination, loan processing and loan decision processes; and
provide for valuation of agricultural land in a manner that will recognise, to the extent possible:
- the likelihood of external events affecting its realisable value; and
- the time that may be taken to realise the land at a reasonable price affecting its realisable value.

Roadmap:

On 25 March 2019, APRA released for public consultation proposed revisions of Prudential Standard APS 220 Credit Quality. Consultation closed on 28 June 2019. APRA intends to finalise the standard in the second half of 2019 with a view to it becoming effective from 1 July 2020.

An independent internal valuation will add some cost and delays for some remote customers, but otherwise should not be controversial, or difficult to implement.

As discussed here in greater detail, it is harder to understand how valuers will change their practices to implement the second recommendation around “external events.”

Recommendation 1.13 – Charging default interest – The ABA should amend the Banking Code to provide that, while a declaration remains in force, banks will not charge default interest on loans secured by agricultural land in an area declared to be affected by drought or other natural disaster.

Roadmap:

The ABA has announced the amended Banking Code, incorporating recommendations 1.8 and 1.13, will be implemented by March 2020.

Recommendation 1.14 – Distressed agricultural loans – When dealing with distressed agricultural loans, banks should:

ensure that those loans are managed by experienced agricultural bankers;
offer farm debt mediation as soon as a loan is classified as distressed;
manage every distressed loan on the footing that working out will be the best outcome for bank and borrower, and enforcement the worst;
recognise that appointment of receivers or any other form of external administrator is a remedy of last resort; and
cease charging default interest when there is no realistic prospect of recovering the amount charged.

Roadmap:

The Government expects that banks will implement recommendation 1.14 as soon as possible.

Banks will believe that they already manage every distressed loan on the footing that working out will be the best outcome for bank and borrower, and enforcement the worst and recognise that appointment of receivers or any other form of external administrator is a remedy of last resort. In my opinion they will be untroubled by those recommendations, and comfortable with immediate implementation.

A requirement to offer farm debt mediation as soon as a loan is distressed may be problematic – depending on what is meant by distressed, which is not otherwise defined. For example, in Victoria a lender can only initiate FDM by serving a notice that they “intend to take enforcement action.” If the recommendation is intended to make FDM available in situations where enforcement is not planned, then the respective FDM legislation will require amendment.

A mandatory requirement to ensure Agri loans are managed by experienced agricultural bankers will have banks working to understand what “managed” means. Often the banker in contact with the customer is not the banker making the final credit decision. Does the recommendation require the customer contact to be an experienced agri banker, or the credit approver, or both?

New rules from APRA? A draft APS220 update

In March 2019 APRA released a draft Prudential Standard APS 220 Credit Risk Management. The new standard is intended to replace the current APS 220 Credit Quality.

The revised standard, available together with a discussion paper here, represents the first significant update since 2006. It provides APRA with the opportunity to respond to both the Banking Royal Commission, and also to recent guidance issued by the Basel Committee.

The change in the name of the standard is intended to emphasise the importance of a ‘whole of loan life’ approach, rather than just focus on origination. Some noteworthy points include:

The cost of bank recognition of borrower hardship

The definition of restructured loans will expand. Currently, restructured loans are those where loan terms have been modified “for reasons related to the financial difficulties of an entity.” Under the draft standard this would expand to loans for which “a borrower is experiencing temporary financial difficulty or hardship in meeting its financial commitments.”

Further, the rehabilitation period – the length of time for which loans must meet those modified terms to be considered as performing – will increase from 6 months to 12 months, likewise increasing the time period in which a higher risk weighting penalty is applied.

These two measures have the potential to make it more expensive for banks that grant hardship relief. Applying a cost overlay if hardship relief is granted is probably technically sound, and conservative, but might surprise those who believe that banks should be encouraged to provide hardship relief, not penalised.

Use of covenants

The draft standard makes it mandatory for banks to consider the use of “covenants designed to limit the ADI’s exposure to changes in the future risk profile of the borrower.”

The most common covenants are based around financial ratios such as interest cover ratios and loan to valuation ratios. The use of such covenants was heavily criticised by another arm of government – the office of the Small Business Ombudsman – with the result that the 2019 Banking Code of Practice no longer allow banks to use them (except in relation to specialised lending) as an event of default.

It seems that lenders to small business might need to choose between complying with the draft APS220, and complying with their own Banking Code of Practice – because they may be unable to comply with both.

Valuation methodology

The discussion paper notes that the draft standard implements one of the recommendations of the Royal Commission, requiring valuations of agricultural land taken as security to:

take into account the likelihood of external events, such as drought and flood, which may impact the valuation of the land

Prior to the Royal Commission, valuations were widely understood to be point-in-time assessments of current value under current conditions, and were not thought to be estimates of future value. In most cases, reliance beyond a three month period from the date of valuation is specifically excluded by a written disclaimer.

It will be interesting to see how valuers respond to the change if it proceeds as proposed. Some may expand their reports to include commentary on the likelihood of external events for the three month period in which the valuations are “live.” Others may add (more!) boiler-plate text to make it even clearer than they do not provide a view as to future value.

Next steps?

The period for feedback closed on 28 June 2019. Market feedback suggests that further, less formal, consultation processes may already be underway.

Concessional RIC loans for farmers impacted by Drought or Flood

The Federal Government established the Regional Investment Corporation in March 2018 to administer concessional farm business loans. This began with Farm Drought loans, and in 2019 was expanded to also include AgRebuild loans for farmers affected by the North Queensland floods.

The AgRebuild loans are very tightly targeted, but eligibility for the Farm Drought loans is broader than many might expect.

Loans for working farmers

The loans are available owners of farms that are Australian citizens or permanent residents – although it is important to understand that the farms can be held through companies or trusts.

Not all members of a farming partnership must work on the farm, but at least one person must contribute at least 75% of their labour to the farm business under normal circumstances, and at least one partner must rely on the farm for their income – so the loans are not available for corporates.

Terms and pricing

As of 1 August, the year loans are currently at a variable interest rate of 3.11%, with no application or other fees,

Drought loans are interest only for the first five years. AgRebuild loans are interest free for the first two years, then interest only for the next three years.

Support of the current lender

Although the loans can be used to reduce bank debt, they can’t be used to completely replace it – normally a farmer must keep 50% of their debt with a “commercial lender.”

It’s worth highlighting that RIC will often agree to take second mortgage security. This means that in practical terms the commercial lender’s security cover (i.e. loan-to-value ratio) can significantly improve, and so they might be quite happy about RIC becoming involved!

One other point is that even if the current lender isn’t prepared to confirm support, it may still be possible to get a conditional offer from RIC. With a much better LVR to offer the incoming lender it may be easier for farmers to secure a refinance.

Drought loans

Drought loans are up to $2m, available to farmers across Australia, which can be used to:

Prepare for drought or recover from the effects of drought.
Pay down debt.
Invest in productivity or water efficiency measures.

Farmers will need to provide a copy of their drought management plan.

Flood loans (AgRebuild)

The AgRebuild loans have a much tighter eligibility criteria. They are for farmers affected by the flooding caused by the Monsoon Trough from 25 January to 14 February 2019 North Queensland.

The AgRebuild loans are for a maximum of $5m, but rates and other terms are the same.

There are some key differences to the drought loans:

As noted, the loans are interest free for the first two years.
RIC might waive the requirement that 50% of the debt stays with a commercial lender – but only in cases of “extreme hardship,” and will be assessed on a case by case basis.
The loans are only available until 30 June 2020.

Restrictions

There are some restrictions:

RIC is not a lender of last resort and will not lend unless it is satisfied that the farm is viable and has capacity to repay the loan.
RIC will require a drought management loan for drought loans.
As above, the ongoing involvement of a commercial lender is required, although this can be a new lender in some cases.

Summary

For eligible farmers the RIC loans can be a great option and it is well worth checking availability. There is a lot of useful information at www.ric.gov.au, or you can contact the author on 0404 885 062. You can also get structured assistance through a website that I have a link to, via my involvement with Ecosse Capital Partners: ricloan.com.au.

This article first appeared on my Harbourside Advisory website