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.

The Final Report of the Banking Royal Commission

Business and Agricultural lending accounts for only 30-odd pages of the almost 500 page volume 1 of the final Report of the Banking Royal Commission.

Most significantly, the Report recommends broadening the application of the Code of Banking Practice to small businesses with debts of up to $5m (currently $3m).

Notably, the Report recommends against extending the application of the National Consumer Credit Protection legislation to Small Business.

Lending to Agribusiness

The report recommends that internal valuations should be conducted by bank staff independent of the loan origination and loan decision processes. That may add a little to costs, and cause some delays for remote regional customers, but is otherwise hard to argue against.

The Report also recommends that valuations of agricultural land should be conducted:

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

The first adjustment would seem to be a complex calculation, and arguably unnecessary – many would say that the market implicitly adjusts for such factors, and so there is no need to make an explicit adjustment.

The second adjustment seems to seek an allowance for holding costs that would result in a modest decrease in value – but it would have been very much easier if the Report had identified a specific period: six months perhaps?

Dealing with Distressed Agricultural Loans

The Report recommends that banks dealing with ‘distressed agricultural loans’ 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.

The Report does not provide a definition of ‘distressed,’ and it is not a technical term defined in APS 220, and so unfortunately the practical application of these recommendations is probably not as clear as its author intended.

Currently Farm Debt Mediation is only available where enforcement action has commenced. The call for earlier availability – which will be supported by banks – will require legislative amendment.

Lastly, least surprisingly, Commissioner Hayne adds his voice to the unanimous calls for a National Farm Debt Mediation Scheme. The Government has said that it will ‘take action on all 76 recommendations.’ Perhaps we will finally see a National Farm Debt Mediation scheme.

Banking Royal Commission: SME Lending & Personal Guarantees

The use of personal guarantees to secure SME lending has been the subject of special focus by the Financial Services Royal Commission, especially where the guarantee is provided by an person not directly involved in the business (an ‘Outsider’) – typically a family member who does not receive any real benefit for providing the guarantee.

The Interim Report (available here) raises a number of specific questions around possible changes to the use of guarantees, which are reproduced at the bottom of this post. The main options are:

Better Information for guarantors

If there is concern that some guarantors are blindly taking a greater legal risk than they realise, then better information might be part of the solution. In theory, a document like a Product Disclosure Statement could help, but how likely is it to be read and genuinely understood? A more concrete step might be to make it mandatory for a guarantor to take independent legal advice.

If the concern is that guarantors underestimate a financial risk, then the Royal Commission might recommend that guarantors be given the same financial information that is used by the lender to make its decisions. But not all guarantors will have the skills and training to understand financial information – perhaps there will be a requirement for guarantors to also take independent financial advice?

The argument against such measures is that certificates of independent advice will add to costs, and may not change much in reality: as Commissioner Hayne has already highlighted, a parental desire to help family members can outweigh all other considerations.

Prohibiting enforcement of Outsider guarantees

A far more radical option would be to flatly prohibit the enforcement of guarantees given by Outsiders.

The key issue is whether or not lenders would reduce the availability of credit if Outsider guarantees were no longer enforceable, or whether they would continue to lend as they do now.

The argument that regulatory changes will not impact lenders’ willingness to provide credit was used to support the Code of Banking Practice prohibition against the use of financial covenants in SME lending. Lived experience shows that it was a wildly optimistic argument then, and it should be subject to more scrutiny now.

It is important to recognise that a blanket prohibition would not just be an issue for new lending. Unless there are grandfathering arrangements, it would apply to current loans as they expire, and so the potential impact could be massive if lenders decide that they cannot carefully and prudently extend credit to renew those loans.

Case by case?

The commission asks whether their might be circumstances that might justify the release of an Outsider’s guarantee – even if the lender had met the Code of Banking Practice standard of a ‘diligent and prudent banker.’

It might be simple to quickly answer that question with a ‘yes,’ but it is harder to identify examples of such situations and it will be more difficult to develop a new standard that will not impact the availability of SME finance.

Applicability to non-bank lenders

One of the questions that the Royal Commission will need to deal with is whether any new or higher standards should also be applied to non-bank lenders. If not, many borrowers denied finance by the application of a higher bank standard will turn to non-bank lenders, and take the same loan – but at a higher interest rate.

The Next Phase

The executive summary explains that the next round of public hearings will address the questions raised in the interim report.

The Interim Report of the Financial Services Royal Commission is available here.

7.2 Guarantees

If established principles of judge-made law and statutory provisions about unconscionability would not relieve a guarantor of responsibility under a guarantee, and if, further, a bank’s voluntary undertaking to a potential guarantor to exercise the care and skill of a diligent and prudent banker has not been breached, are there circumstances in which the law should nevertheless hold that the guarantee may not be enforced?
What would those circumstances be?
Would they be defined by reference to what the lender did or did not do, by reference to what the guarantor was or was not told or by reference to some combination of factors of those kinds?
Is there a reason to shift the boundaries of established principles, existing law and the industry code of conduct?
If the guarantor is a volunteer, and if further, the guarantor is aware of the nature and extent of the obligations undertaken by executing the guarantee, is there some additional requirement that must be shown to have been met before the guarantee was given if it is to be an enforceable undertaking?
Should lenders give potential guarantors more information about the borrower or the proposed loan? What information could be given with respect to a new business?

Discussion of how the Interim Report deals with Agricultural Lending is available here.

Financial Services Royal Commission: How the Interim Report deals with Agricultural Lending

The Interim Report of the Financial Services Royal Commission (available here) was tabled in Parliament yesterday.

Section 6 deals with Agricultural Lending, and concludes by identifying a list of ‘key questions’ for further consideration. The full list is reproduced at the bottom of this post, but for me the most important are:

Farm Debt Mediation

Should there be a national system for farm debt mediation?
If so, what model should be adopted?
Should lenders be required to offer farm debt mediation as soon as an agricultural loan is impaired (in the sense of being more than 90 days past due)?

There is mandatory FDM in South Australia, Victoria, Queensland and New South Wales, and a voluntary scheme in Western Australia. There is no legislative scheme in Tasmania, the Northern Territory or the ACT.

To replace the current patchwork coverage with a national scheme would be one of the most widely supported and least-opposed recommendations that the Royal Commission could make. It will be easier for lenders to comply if they do not need to manage up to seven different regimes, but there is more to it than that. Some borrowers will have farms either side of a state boundary, or will cross a State border to sign loan documents, and it will be easier for them too if only one regime applies.

The NSW system is the most well established, and best developed – it is the model that should be adopted. There is one feature of the Victorian scheme which should be applied nationwide however: assistance with the cost of mediation so that farmers can always afford to engage.

A current problem is that FDM regimes are only available where there is a default. It would be helpful if mediation schemes could be accessed prior to that point, but the proposed linkage to the loan being ’90 days past due’ does not go far enough. A better option would be to also allow access to the scheme where a lender has determined that it is not prepared to extend a current loan.

Conduct of valuations

How, and by whom should property offered as security by agricultural businesses be valued?
If prudential standard APS 220 is amended to require internal appraisals to be independent of loan origination, loan processing and loan decision processes, when should that amendment take effect?

To those of us in capital cities the answer seems clear and obvious: a banker originating a loan should never be involved in valuing the security.

A farmer west of Longreach however, might be frustrated to be told that their loan approval will be held up until someone can get out from head office, and that they will need to meet the travel and accommodation costs.

There does need to be some allowance for a local banker with appropriate training in remote locations to conduct valuations for relatively small loans or small increases to existing loans.

Should LVR ratios be capped?

Is the possibility, or probability of external shock sufficiently met by fixing the loan-to-value ratio?

A maximum LVR sounds like a practical way of ensuring that borrowers retain some level of buffer to allow them to cope with external shocks – but it will be a double-edged sword. A hard-coded LVR limit would also stop lenders from providing carry on funding – potentially forcing the sale of farms.

Enforcement only as a last resort

In what circumstances may a lender appoint an external administrator (such as a receiver, receiver and manager or agent of the mortgagee in possession)?
Is appointment of an external administrator to be the enforcement measure of last resort?

Each of the banks that gave evidence would agree that the appointment of an external administrator should be the last resort. The difficulty arises in practice: what does ‘last resort’ actually mean, and when has that point been reached?

It is significant that all but one of the case studies were either from states without mandatory FDM, or pre-dated the current FDM. There is good reason to think that FDM has played an important role in avoiding the need to enforce at all.

Not only does FDM provide an unmistakable signal to all parties that the point of ‘last resort’ may be approaching, at the same time it provides them with an alternative to enforcement.

The Next Phase

The executive summary explains that the next round of public hearings will address the questions raised in the interim report.

The Interim Report of the Financial Services Royal Commission is available here.

5.0 Issues that have emerged

All agricultural enterprises are subject to the effects of events beyond the control of the individual farmer. Occurrence of any of these events, let alone a combination of them, will affect cash flow and profitability and, hence, the ability to service debts. Their occurrence will often have profound personal effects on those who conduct the business.

Four issues emerged: about revaluation of securities; difficulties in obtaining access to banking services and appropriate support; changes to conditions of lending; and, enforcement by appointment of external administrators.

The particular questions can be identified as including:

How are borrowers and lenders in the agricultural sector to deal with the consequences of uncontrollable and unforeseen external events?
Does the 2019 Banking Code of Practice provide adequate protection for agricultural businesses? If not, what changes should be made?
How, and by whom should property offered as security by agricultural businesses be valued?
- Is market value the appropriate basis?
- Should the possibility, or probability of external shocks be taken to account in fixing lending value? How?
- Should the time for realisation of security be taken to account in fixing value? How?
- Is the possibility, or probability of external shock sufficiently met by fixing the loan-to-value ratio?
- If prudential standard APS 220 is amended to require internal appraisals to be independent of loan origination, loan processing and loan decision processes, when should that amendment take effect?

Should distressed agricultural loans be managed only by experienced agricultural bankers?
Do asset management managers need more information (such as the cost to the lender of holding the loan) to make informed commercial decisions about management of distressed agricultural loans?
Are there circumstances in which default interest should not be charged?
- In particular, should default interest be charged to borrowers in drought declared areas?
- If it should not, how, and where, is that policy to be expressed?
- Should the policy apply to other natural disasters?
In what circumstances may a lender appoint an external administrator (such as a receiver, receiver and manager or agent of the mortgagee in possession)? Is appointment of an external administrator to be the enforcement measure of last resort?
Having regard to the answers given to the preceding questions:
- Is any regulatory change necessary or desirable?
- Is any change to the 2019 Code necessary or desirable?
Should there be a national system for farm debt mediation?
- If so, what model should be adopted?
Should lenders be required to offer farm debt mediation as soon as an agricultural loan is impaired (in the sense of being more than 90 days past due)?

Restructuring & Turnaround professionals and the Royal Commission

In December (here) I suggested that the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (‘FSRC’) had the potential to become the seventh inquiry in the last seven years to examine the conduct of Restructuring and Turnaround practitioners.

The third round of hearings which commence on 21 May specifically allocates time (the agenda is here) to considering the “approach of banks to enforcement, management and monitoring of loans to businesses.”

On 7 May the FSRC published its 10th background paper: Credit for small business – An overview of Australian law regulating small business loans. The paper does extremely well to condense a very broad subject into 41 pages but surprisingly makes no mention whatsoever of the PPSA – which is surely significant, if only for the fact that it imposes a duty comparable to section 420A.

Two days later the FSRC released background paper 11 (both papers are available here) prepared by Treasury at the request of the Royal Commission to provide an “overview of reforms to small business lending.” There is likewise no mention of the PPSA regime, but the paper does include comment about the ILRA legislation, as well as brief reference to safe harbour and ipso facto.

There have not yet been any reports of Restructuring & Turnaround professionals being asked to appear – but we may be getting closer.

Will the Banking* Royal Commission impact restructuring and turnaround professionals?

The Senate Select Committee on Lending to Primary Production Customers was the sixth inquiry in the last seven years to examine the conduct of Restructuring and Turnaround practitioners – will the recently announced Royal Commission be the seventh?

Unlike both the Senate Select Committee Inquiry, and the Parliamentary Joint Committee Inquiry into the Impairment of Customer Loans before it, the terms of reference released on 15 December 2017 (available here) do not directly refer to ‘insolvency practitioners’ or ‘insolvency’ at all.

However, the first term of reference directs inquiry into ‘the nature, extent and effect of misconduct by a financial services entity (including by its directors, officers or employees, or by anyone acting on its behalf).’ Whilst there may be technical legal discussion about the extent to which a receiver is acting on behalf of a lender, at a practical level it seems likely that the work of receivers may well be under review.

The definition of ‘financial services entity has been extended to cover ‘a person or entity that acts or holds itself out as acting as an intermediary between borrowers and lenders.’ This has been described as extending the Royal Commission to include the work of finance brokers – but in fact the broadened scope would appear to potentially also include the work of the “Non-mainstream advisers” who concerned the Senate Inquiry.

The terms of reference specifically allow the Commission to choose to not investigate matters where to do so would duplicate the existing work of another inquiry or civil proceeding.

That power to avoid duplication may assist the commission to meet its tight deadline, but it has the potential to frustrate those who see their previous failure in Court as defining a ‘broken’ legal system, and who use each fresh inquiry as an opportunity to re-litigate those failures.

The Commission may submit to the Government an interim report no later than September 2018, and must submit a final report by 1 February 2019.

*Although headlines have referred to a ‘Banking Royal Commission’ in fact the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry specifically extends to non-bank lenders, as well as insurance companies, and Superannuation Funds.

Posts about the Senate Select Committee Inquiry into Lending to Primary Production Customers: