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Actuarial confirmation of approach to break costs

Through the global financial crisis we saw retail lending rates plummet at an unprecedented rate while financiers’ costs of funds increased. As a consequence, we have received in excess of 700 disputes relating to the break costs levied by financial service providers when their customers have sought to pay out or refinance their fixed interest rate loans during the fixed rate period. 

Our approach to break cost disputes was recently set out in Bulletin 60, issued by our Banking & Finance group. We will consider:

  • whether the break cost has been properly disclosed to the customer;
  • whether the break cost has been properly charged in accordance with the customer's contract with the financial services provider; and
  • if the loan is regulated by the Uniform Consumer Credit Code, whether the break cost charged in accordance with the contract exceeds a reasonable estimate of the financial services provider's loss arising from the customer's early termination of their fixed rate contract.

As explained in Bulletin 60, our policy in relation to the calculation of break or early termination costs (ETIA) was developed as a response to issues arising in the early 1990s. In the interim, our membership base has expanded from traditional banks to a variety of participants in the financial services industry, who have varying business strategies and funding sources. We therefore sought actuarial advice to assess whether our approach remained appropriate.

 

Actuary’s brief

We engaged Mercer Australia Pty Ltd (“Mercer”) to:

  • review our approach to estimating a reasonable ETIA and advise whether this approach continues to be reasonable for the banking sector; and
  • consider whether the same approach is reasonable for the non-bank sector.

Summary of advice

Mercer:

  • confirmed that our approach remains broadly reasonable for both the bank and non-bank sector;
  • endorsed the formulae we use to objectively assess the reasonableness of an ETIA levied by a member as reasonable;
  • recognised that some lenders (in the bank and non-bank sectors) may source their funds outside the wholesale borrowing market (“non-standard lenders”); even so, ultimately and over the longer term, the estimate for these non-standard lenders will broadly equate to that calculated according to our policy and formula;
  • noted that, for any given fixed rate loan that is
 

terminated, there may be additional considerations faced by a non-standard lender.

 

Our approach

Mercer described our approach as comprising two components:

  • a “difference” component, being the difference between the swap rate at the time the loan was established and the swap rate at the time the loan was terminated; and
  • the mechanics of our ETIA calculation which multiplies the “difference” by the remaining term and the balance of the principal outstanding adjusted to the present day value.

Mercer specifically did not consider it appropriate to incorporate a lender’s margin into the calculation of the “difference” as the relative movement in a lender’s margin can reflect any one of the following:

  • the lender’s standing (and consequential bargaining power in the purchase of funds) or the borrower’s standing has deteriorated;
  • the lender’s fees have increased; or
  • the lender’s profit margin has increased.

If margins were included in the ETIA estimate, this would have the effect of capitalising changes in margins, in addition to changes in the general level of interest rates.

 

Non-standard lenders

Mercer considered that, while non-standard lenders may not source their funds in the same fashion as traditional lenders, differences in their costs of funds over time will move in line with differences in the swap rate. However, for any given fixed rate loan that is terminated, there may be additional considerations. For example, a non-standard lender may have a smaller book of loans or alternative source of investment and not be able to relend or reinvest for the remainder of the terminated loan period. However, a good starting point is our approach using swap rates.

 

Conclusion

As our approach has been verified as a reasonable basis for the estimate of a lender’s loss on early repayment of a fixed interest rate loan, we will continue considering ETIA disputes in the same way we have done to date.

Should any member consider itself to be a non-standard lender, such that its particular circumstances cause its estimated loss to differ from our objective assessment, we will consider a submission regarding the appropriateness of the member’s approach. However, this may well necessitate the member providing details on its business strategies and parameters of business, its actual source of funding and its reinvestment opportunities.