In the second part of our blog series on the rise of small lenders in Australia, KR Peters director Peter Nicolls talks with commercial financer Mark Pallot at Hayline Finance.



Peter - The major banks are being challenged like never before by new lenders entering the market offering low rates backed by an online service meaning they have low overheads and little or no staff costs. What do you think has contributed to this proliferation in small lenders?



Mark - Basically the majors have been battered by, among other things, the Basel Committee on Banking Supervision (BCBS) III and IV* driving up capital requirements to levels that I think are not justified by recent Australian experience. We are paying for system failures elsewhere. BEARS, or Bank Executive Accountability Regime, legislation is making the executives of the majors too risk averse. Smaller lenders do not present “systemic” risk so APRA don’t ride them as hard. It will likely take some years before governments and regulators realise the perverse consequences of this legislation.



Peter - What about the taxation system? The small banks are catering to both owner occupiers and investors who, despite what COVID has done to the economy, seem as hungry as ever to access capital to add to their investment portfolios and take advantage of negative gearing. The current heat in the market is being driven, in part, by investors having access to cheap money.



Mark - Most economists realise our taxation system is stuffed. In Australia we tax income too heavily, especially for a shrinking percentage of the population who are working, while rewarding property profits with lower or no tax rates. But no one has the political courage to tell the public this. Capital Gains Tax concessions and the lack of a capital gains tax on the family home, coupled with little or no inclusion of the family home in the assets test for the pension, mean the older generation have priced the younger out of the market as property becomes a store of wealth and yet the young will have to pay higher marginal income tax rates to pay for our expanded welfare system. It's just not sustainable. In 30 years economic reality will force the above actions on us. I believe the “consumer protection” legislation is really a back door way of quieting the home market. There is the beginning of a systemic push by governments/regulators (without much fanfare) to discourage property speculation as such a prominent source of wealth creation.



Peter - You mentioned APRA and their role in the rise of small lenders. Will APRA move on these small lenders and make doing business more difficult for them in future?



Mark - APRA will never allow too much of the loan market to drift out of its regulatory orbit. These new lenders will over time be regulated more and more. That’s a key finding for regulators, especially the US Fed from the Global Financial Crisis, where they allowed the banking sector to become only 15% of the financial sector.



Peter - The major banks enjoy the position of being “too big to fail” and will always be backed by the federal government as they were during the GFC and other economic disturbances. Are these small lenders likely to survive market disturbances as robustly as the big four?



Mark - In return for being so heavily capitalised and regulated, the government and the RBA will always support their liquidity over these smaller players whom often tap securitisation markets which tend to freeze up in market disturbances like the GFC. “Warehouse” funding was made far less attractive to banks due to Basel 2 and 3 and as such means no entity can get too big without accessing the securitisation market or enjoying the support of big players like Merrill’s, Macquarie etc. whom tend to tap the same sources and so tend to go missing when times get tough too.



Peter - What is your advice to those borrowers considering one of the smaller lenders over the more established sources of finance?



Mark - These players use a commoditised risk graded approach which best serves the employed, not self employed markets. They compete primarily on price so beware the commodity trap. RedZed is a player which has grown consistently servicing the self employed market predominantly (say 95%), once an area dominated by NAB and the others.



Given the strictures placed on the majors it will, I predict, be good times for these lenders for say 5 to 10 years when governments and regulators wake up and go “oops, we went too hard”. What will drive this will partly be what percentage of the banking system these small lenders take up. Much more than 30% and APRA will act. This country’s regulatory framework is pretty much one of the most admired in the world. They will not allow too much "leakage” from it.



* Basel III is an internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007-09. The measures aim to strengthen the regulation, supervision and risk management of banks. Basel IV is changes to global bank capital requirements agreed to in 2017 and are due for implementation in January 2023.