Government response to the Financial System Inquiry is good news for limited recourse borrowing arrangements

The government response to the Financial System Inquiry (‘FSI’) was released today. It is good news for limited recourse borrowing arrangements!

Background — why the concern?

The final FSI report — released in December 2014 — recommended that the government:

Remove the exception to the general prohibition on direct borrowing for limited recourse borrowing arrangements by superannuation funds.

More specifically, it stated:

Government should restore the general prohibition on direct borrowing by superannuation funds by removing Section 67A of the Superannuation Industry (Supervision) Act 1993 (SIS Act) on a prospective basis.

It described the problem as follows:

… growth in superannuation funds’ direct borrowing would, over time, increase risk in the financial system … the Inquiry notes an emerging trend of superannuation funds using LRBAs to purchase assets. Over the past five years, the amount of funds borrowed using LRBAs increased almost 18 times, from $497 million in June 2009 to $8.7 billion in June 2014.

Although the limited recourse nature of LRBAs is supposed to limit risk, the FSI report was sceptical, stating:

Because of the higher risks associated with limited recourse lending, lenders can charge higher interest rates and frequently require personal guarantees from trustees. In a scenario where there has been a significant reduction in the valuation of an asset that was purchased using a loan, trustees are likely to sell other assets of the fund to repay a lender, particularly if a personal guarantee is involved. As a result, LRBAs are generally unlikely to be effective in limiting losses on one asset from flowing through to other assets, either inside or outside the fund. In addition, borrowing by superannuation funds implicitly transfers some of the downside risk to taxpayers, who underwrite adverse outcomes in the superannuation system through the provision of the Age Pension.

Accordingly, it appeared possible that LRBAs would be banned.

The government’s response

Naturally though, the FSI report constitutes neither law nor a commitment of what the government must do. Rather, it is merely a list of recommendations to the government (albeit very persuasive recommendations and recommendations that are more likely to be implemented by government than recommendations from ‘Joe Public’).

The government’s response was received earlier today, stating:

The Government does not agree with the Inquiry’s recommendation to prohibit limited recourse borrowing arrangements by superannuation funds.

While the Government notes that there are anecdotal concerns about limited recourse borrowing arrangements, at this time the Government does not consider the data sufficient to justify significant policy intervention.

The Government will however commission the Council of Financial Regulators and the Australian Taxation Office (ATO) to monitor leverage and risk in the superannuation system and report back to Government after three years.

This timing allows recent improvements in ATO data collection to wash through the system. The agencies’ analysis will be used to inform any consideration of whether changes to the borrowing regulations might be appropriate.

Naturally, this is good news. It is particularly good news for SMSFs that have entered into off-the-plan purchases where they are unable to draw down on the loans for lengthy periods as the announcement provides greater certainty.

Is it all smooth sailing?

However, it is not all smooth sailing. Again, the government has said that it will revisit this issue in three years’ time. Further, we are aware that various banks are becoming stricter in their lending criteria to lend to SMSFs, particularly for residential properties. Accordingly, those SMSFs that want to borrow — all things being equal — should do so sooner rather than later and also allow for generous settlement periods in which to organise finance.

More information

We will discuss this announcement and much more in the next SMSF Strategy Seminar, being held all around Australia (http://www.dbanetwork.com.au/dbalawyers/seminars3/face2face/SMSF-Strategy-Seminars.html).

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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.