The Royal Commission Report – Short term pain for SMEs should be followed by long term gains

The extensive media coverage of the Royal Commission’s findings contain very few references to the SME sector. This is possibly because the report contains only six recommendations, four of which relate solely to the farming sector.

We briefly discuss these recommendations then explain why for the foreseeable future SMEs can expect continued pain before exploring what needs to happen to achieve the longer term gains the RC offers.

The recommendations relating to SMEs.
The first recommendation is a non-recommendation i.e. the National Consumer Credit Protection Act (NCCP) should not be amended to extend its operation to lending to small businesses.

I believe small business borrowers should be afforded the same level of protection as consumers who borrow. It is illogical to assume that anyone who operates a business is somehow automatically more financially literate than a consumer who chooses to earn income by being an employee.

The second recommendation is that the Australian Bankers Association (ABA) should amend the definition of “small business” in the Banking Code of Practice so that the Code applies to any business or group employing fewer than 100 full-time equivalent employees, where the applied for is less than $5 million.

It would certainly be helpful if all stakeholders agreed on what constitutes a small business but this is hardly an issue that is going to make life any easier.

The remaining four recommendations relate solely to the farm sector:

1. A national scheme of farm debt mediation should be enacted.
2. Inject greater independence into the valuation of agricultural properties.
3. Prohibition of charging default interest rates on loans secured by agricultural land in an area declared to be affected by drought or other natural disaster.
4. Improved processes when dealing with distressed agricultural loans.

No-one would dispute the need for the farm sector to be dealt with more fairly by banks, but why stop at farm businesses? For instance, why should distressed non-farm small business borrowers not be able to benefit from “greater independence into the valuation of properties” and “improved processes”?

Commissioner Hayne’s approach is best summarised by his statement that “With some exceptions, I generally do not favour altering the rules that govern lending to SMEs” adding that “the chief protection for small business borrowers has for some time been, and remains, the Banking Code.” If banks breach the Code this could constitute a breach of the law.

Where does this leave SMEs?
All parties have been concerned that the RC could lead to a credit crunch but the fact is that since the RC hearings began just over nine months ago, it has already become harder for SMEs to access credit from banks and it is taking longer to get decisions.

It has become particularly difficult for those SMEs who pledge residential property as security for their business loans because banks now delve into personal financial spending patterns as as well as assessing the capacity of the business to services and repay debt.

For the short team at least, whilst the banks are adjusting to life after the RC, SMEs are not going to find it any easier to access bank credit nor will decision making times improve.

Do the banks want to lend or not?
The banks say they are open for business and the reason why lending is flat is that businesses just aren’t applying to borrow. Both these statements are true but it’s important to delve into why this is the case.

Banking is a high fixed cost business and making loans is central to bank profitability. Banks have to lend to be profitable, they can’t shrink to greatness so they must remain open for business.

So if the banks do want to lend, why is demand for bank credit flat?
Rather than there being an absence of demand for bank credit, an alternative proposition is that some SMEs are no longer bothering to approach banks. This could be due to the belief that the process is too onerous and elongated. These businesses often use trade creditors and the ATO to fund their working capital needs or alternatively turn to family and friends. Others are prepared to pay more to borrow from alternative lenders because they are easier and quicker to deal with.

According to a recent survey commissioned by SME challenger bank Judo Capital and conducted by East & Partners, the unmet demand for SME credit is estimated to be in excess of $80b. This provides the incentive for the establishment and growth of a myriad of non-bank lenders who aim to fill this lending gap.

The challenge for non-bank SME lenders.
The non-bank SME lending sector has the opportunity to learn from the mistakes of the big banks. This sector is highly fragmented and less regulated than the big banks. To date, it has not been exposed to the same level of scrutiny but this is changing and rightly so because not all these lenders are “squeaky clean.”

Industry self-regulation and engagement with regulators, SME associations and other stakeholders is a preferable approach to what we have seen over the years from the banks and the ABA. In this respect, the proactive efforts of a number of fintech balance sheet lenders to develop their own Code of Lending Practice is to be applauded. Hopefully, under the auspices of Australian Financial Industry Association, this industry self-regulation can be expanded to include other non-bank SME lenders.

Will more regulation and enforcement help SMEs?
Commissioner Hayne found the problem was not the laws but that the laws had neither been obeyed by the banks nor adequately enforced by the regulators.

The banks don’t want more regulation and maintain that the revised Banking Code of Practice, which was signed off by ASIC last year and will come into effect in July this year, will provide adequate protection for bank customers. In my view the new code still does not go far enough but the bigger issue is “will they actually comply with it?”

In a newsletter published in March 2018 “Will the new Banking Code of Practice make any difference to SMEs?” I concluded that the code will make a difference if:

1. Banks abide by it.
2. Regulators enforce it and
3. Customers are prepared to hold the banks to account for breaches.

Left to their own devices the banks have placed the interests of their executives and shareholders ahead of their customers. Whilst they say this will change and customers will now come first, can they be relied upon to mend their ways?

The survival imperative alone should be sufficient incentive for the banks to change. If they fail to heed the lessons from the RC they could render themselves irrelevant within ten years. Compliance and enforcement costs will continue to erode profits in what is already a challenging market for the banks. In the past year, $75b has been wiped off the combined market values of the big four banks representing an average share price fall of 17 per cent.

And from now onwards, there will no more arrangements with the regulators culminating in enforceable undertakings, which are a “corporate slap on the wrist”.

So there should be no shortage of motivation for the banks to lift their game and comply with the Code and there will be no shortage of incentive for the beefed up regulators to do their jobs.

The importance of customers holding banks to account.
The RC has shown that the banks failed in their duty of care to customers. We can now expect the regulators to make a better fist of holding the banks to account but bank customers need to do the same. One of the many positives from the RC is that customers can see that they are no longer powerless against the big four bank homogenous oligopoly. To date, aggrieved customers have been reluctant to hold banks to account because of the view that making a complaint is time consuming and besides “nothing is going to change anyway” but now they have recourse via the new Australian Financial Complaints Authority (AFCA) which has the ability to award SMEs damages of up to $1m for bank misconduct.

It is going to be really important that aggrieved customers take advantage of all the avenues of redress available including internal bank dispute resolution options and AFCA.

COMPETITION & EDUCATION.
Regulation and enforcement are not enough on their own to improve SME access to finance and to protect them from bank misconduct. The two other critical components are:

1. Encouraging competition.
Government has finally got the message that the best way to enhance competition is not to try to force the big four banks to change but rather to encourage the establishment and growth of new entrants such as fintechs, challenger banks and neo banks and then allowing market forces to do the rest.
Recent government initiatives that will inject more competition into the SME lending market include:
The $2b Government Securitisation Fund.
Open banking reforms.
Comprehensive Credit Reporting.
The Australian Business Growth Fund.

2. Education.
Technology and innovation are rapidly changing the way SMEs access debt finance. It is an enormous challenge for time poor and often financially unsophisticated SMEs to keep abreast of all the developments in this area. Trusted advisors including accountants, finance brokers and lawyers owe it to their clients to understand what is happening in the ever changing SME finance market place.

Recently, in conjunction with the Australian Small Business & family Enterprise Ombudsman (ASBFEO), we published a guide “Borrowing from fintech lenders” and the ASBFEO will also shortly release a guide to financial products available and what stage of the business cycle each product is designed to fit.

A final comment on Brokers.
The shift to a borrower pays system has huge implications for a sector which is already in turmoil. Without getting into the merits of either side, banks and borrowers need each other and most critically SMEs need brokers because the banks are just not equiped to provide the service that SMEs want and need but to date have not had to pay for.

CONCLUSION.
The nation owes Commissioner Hayne and his team a debt of gratitude for providing the blueprint that gives the banks the opportunity to begin the long task of restoring lost trust. Tellingly, he identified six norms of conduct being:
1. Obey the law.
2. Do not mislead or deceive.
3. Act fairly.
4. Provide services that are fit for purpose.
5. Deliver services with reasonable care and skill and
6. When acting for another, act in the best interests of that other.

If all bank employees, be they a director, CEO or a teller, live by these norms then we will get the banking system we need and deserve.

Comments and feedback are invited.