Pottinger Small Business Review

Pottinger's Independent Review of the definition of Small Business

The Code of Banking Practice came into effect on 1st November 1996. Since then, it has been updated and revised on several occasions, most recently through a comprehensive rewrite following the findings of the Khoury Review and the Hayne Royal Commission, as well as other subsequent reviews.
The Banking Code of Practice (2019) (the “Code”) is published by the Australian Banking Association (ABA) and sets out standards of behaviour that banks should follow in their dealings with consumers and small business customers. It includes specific protections for small businesses, including simplified loan documentation, greater notice of enforcement action and enhanced transparency.
The Code is the first substantive industry code to be approved by ASIC under the Corporations Act, and the ABA has sought and obtained approval for all subsequent changes to the Code. ASIC’s original approval of the Code was subject to the ABA agreeing to commission an independent review of the definition of ‘small business’ in the Code within 18 months of the Code’s commencement. Accordingly, in September 2020, the ABA appointed Pottinger to conduct an independent review of the definition of small business under the Banking Code of Practice. The definition is of fundamental importance to small businesses, as it defines whether any individual organisation qualifies for the protections that the Code provides.

We provide a brief introduction to our independent review below. A copy of our report is available at the bottom of this page. We have also included links to other relevant reports for ease of reference.

What is a small business?

Australia has at least 13 different definitions of 'small business'. These are employed by different organisations and/or regulatory and/or legislative regimes and use different combinations of revenue tests, employee number tests and borrowings tests, including eight which use just one measure.

The definition of 'small business' in the Banking Code of Practice

The Banking Code of Practice is the Australian banking industry’s code of practice. It sets standards of good banking practice for banks to follow when dealing with their individual and small business customers and their guarantors. The latest version for the Code is known as the Banking Code of Practice (2019) and a link is provided to this document below.

The Code is applicable to individual and small business customers, as well as to their guarantors. Whether or not a business is covered by the provisions of the Code is determined by reference to the definition of ‘small business’ in the Code. Currently, the Code defines a business as a “small business” if, at the time that it obtains the banking service in question, all of the following apply:

It had an annual turnover of less than $10 million in its previous financial year; and
It has fewer than 100 full-time equivalent employees; and
It has less than $3 million total debt to all credit providers including any undrawn amounts under existing loans, any loan being applied for and the debt of all its related entities that are businesses.

Further information on the new Code is available from this link. The ABA's brief introduction to the Code is below.

How many small businesses are there?

This sounds like a simple question. The answer, of course, depends on how 'small business' is defined. This is why the definition of small business used in the Code (and in other places too) is so important. The many different definitions of small business refer to one or more of employee numbers, revenues and borrowings, so let's look at these in turn.

First, as we show below, Australia has about 2.4m businesses. Of these, about 2.3 million have fewer than 100 employees. Indeed, 1.49 million of them have no employees at all. As at 30th June 2019, only 884,821 businesses had any employees at all. 823,715 or 93% of these companies employed fewer than 20 employees, and only 4,271 or 0.5% employed 200 or more people. Data is not available for the number of businesses with fewer than 100 employees (as ABS does not report this figure) - this is the number used by many definitions, including the Code.

Meanwhile, there are over 2.2 million businesses with revenues of less than $10m (the value used by the Code). Although there is no data to show how many companies have under 100 employees and under $10m of revenue, they must account for at least 95% of all businesses and most likely around 97%.

Definitions of small business in the banking sector often refer to the level of credit/borrowing involved, whether at an individual facility level or an aggregate borrowings level. The Code uses the latter. Data collected by ASIC shows that, at 30th June 2020, ABA members had approximately 1.54 million loans outstanding to entities with a total credit exposure of less than A$3m (ie which would qualify as a small business customer under this element of the definition). At that time, the total loan amount outstanding was some A$214bn, equivalent to roughly 32% of total business lending by ABA members (ie A$660bn) at the same date. These figures imply an average loan size of roughly A$140k.

One challenge faced by previous reviews has been the lack of precise data on how the three criteria used by the Code interact as, to qualify for protection under the Code, a business must meet all three criteria. To address this issue, since 1st January 2019, ASIC has collected quarterly data from members of the ABA on their lending to smaller businesses.

Our approach to the review

The scope of our review was developed by the ABA in consultation with ASIC. The objectives of our review were to determine whether, and if so how, the definition of small business should be updated, including consideration of a variety of important issues:

The relevance of the criteria used by the definition, ie annual turnover, employee numbers and borrowings outstanding;
The values used in the criteria, currently A$10m for annual turnover, 100 for full-time employee numbers and A$3m for borrowings;
Whether the criteria should be applied at an individual entity or group level, as well as the definitions used to determine which related entities should be taken into account in defining a group;
Whether the criteria related to borrowings should apply solely to the facility in question or to the aggregate of all outstanding facilities; and
The potential impact of any proposed changes to the criteria and/or the values, both in terms of overall materiality in the context of the banking system and in relation to the practicalities of implementing any proposed changes.

Importantly, whilst Pottinger was appointed by the ABA and the ABA has funded the review, under the terms of our appointment the banking industry has not had any influence over the findings and options identified by us, beyond its input as a participant in the review. Pottinger has acted independently and not in the interests of, or on behalf of, the ABA or its members.

To assess these issues, we have undertaken our own desktop research and analysis, taking into account data sourced from the Australian Bureau of Statistics, the Australian Prudential Regulation Authority and ASIC as well as a variety of other sources. We also considered the previous recommendations and observations on relevant matters made by the Hayne Royal Commission, the Khoury Review, the ASBFEO Inquiry into Small Business Loans and the Council of Financial Regulators.

In addition, we gathered perspectives from the public via a stakeholder questionnaire and consulted with a wide range of stakeholders as summarised below.

Our findings

As an important overarching observation, there is widespread support for the Code and widespread recognition of its importance in providing protection to small businesses in Australia. Importantly, most stakeholders consulted believe the Code represents a set of minimum standards of behaviour to be observed by banks in dealing with their small business customers.

There is broad consensus that the criteria used in the definition (turnover, employee numbers and aggregate borrowings) are both reasonable and appropriate, and that these tests should be assessed at a group level, rather than at an individual legal entity level. Not all stakeholders support these views, with some preferring to reduce the number of criteria that are used in the definition and/or recommending that the aggregate borrowings criterion should be applied at an individual facility level.

Meanwhile, there are several areas where there is broad support for the Code to be refined, including in relation to:

Improving the precision of some of the terminology used, so that there is greater clarity and consistency regarding which enterprises are treated as small businesses;
Giving small businesses greater confidence and transparency regarding whether or not they are (and will continue to be) treated as a small business by any particular bank; and
Contributing to reducing the number of different definitions of small business that are used in Australia and clarifying why different definitions are used by different bodies.

Almost every stakeholder expressed the view that there are too many conflicting definitions of small business. There is near unanimous agreement that this causes considerable confusion for customers and that there would be considerable merit in reducing the number of definitions in use in Australia. In practice, however, there is no simple way to do this, as the various definitions are used for a variety of different purposes. No stakeholder made recommendations as to how simplification could be achieved.

In addition, we identified several areas which represent, or may be perceived to represent, loopholes in the definition of small business and how this is applied by banks. These have potential to cause further confusion to customers and to create reputational risk for banks which subscribe to the Code. One particular issue is that it is not straightforward for an enterprise to determine whether or not it qualifies to be treated as a small business under the Code, as this requires knowledge of the Code, the Corporations Act 2001 definition of related entities and aspects of the Australian Financial Services regime.

Given the importance attached to the issues of simplicity and transparency, we have included in our report suggestions as to measures that could be implemented by stakeholders to help to help mitigate these challenges.

Finally, there is also broad support for increasing the borrowing limit to A$5m in due course. Some banks have already made this change. We acknowledge that there is little consensus regarding whether this change is worthwhile, and two medium-sized banks have expressed the view that any such change could have an adverse impact on competition and access to credit, though these views were neither definitive nor supported by specific evidence.

We note that most stakeholders consider supporting more small businesses, rather than fewer such enterprises, to be an appropriate guiding principle. This is especially relevant having regard for the challenging operating environment brought on by the COVID-19 crisis. This approach is consistent with the operating practice of many banks to apply just one, rather than two or all, of the criteria used in the current definition of small business to determine a customer's eligibility for protection under the Code.

Our recommendations

The recommendations set out below address the issues we have identified, whilst giving appropriate consideration to the extent of impact (or otherwise) that any proposed change might have on the number of customers protected, the level of transparency achieved, and the cost, complexity and risk of implementation for the banks and other relevant stakeholders. Much more detail and context is provided in our full report, which is available at the bottom of this page.

In relation to implementation, two recommendations, namely the application of all three criteria at a group level (rather than an individual legal entity level) and the exclusion of certain types of sophisticated enterprise can readily be implemented more rapidly and accordingly we recommend that the Code be updated to address these in the near term. Meanwhile, implementation of the other recommendations can commence following completion of the upcoming review of the Code, thus allowing sufficient time for banks to prepare and to ensure that all relevant implications are properly considered in advance.

Our report

A copy of our report is available here or by clicking the cover image. Our report sets out:

A summary of our overall findings, recommendations and additional measures that could be implemented to support the Code
Background on the purpose of our review, the framework we adopted for examining the issues and to engage with stakeholders
Our findings from desktop research and analysis
A summary of relevant matters raised by previous reviews
An overview of the results of our stakeholder engagement exercise
Our overall results and recommendations.

Thanks to data gathered by ASIC over recent years, we have been able to identify and present new information that provides further clarity on the number of businesses that benefit from the Code, as well as how this would increase as a result of our recommendations.

We would like to acknowledge the various government bodies, financial institutions, companies, representative bodies, consumer advocates, small businesses and individuals who contributed to our review. Every conversation, submission and survey response has provided useful information and perspective and has contributed to our findings. We greatly appreciate the time that each stakeholder has taken to provide their input.

Download the full report

Further background information

The Australian banking sector has been subject to a number of reviews over the years. We provide links to a variety of reports and background papers which may be useful in considering your views on the issues that are being addressed by our independent review.

The Australian Banking Association

https://www.ausbanking.org.au/

The Hayne Royal Commission (2018/2019)

https://financialservices.royalcommission.gov.au/Pages/default.html

The 2016 Independent Review of the Code of Banking Practice (the Khoury Review)

http://cobpreview.crkhoury.com.au/

The ASBFEO Inquiry into Small Business Loans (2016)

https://www.asbfeo.gov.au/inquiries/small-business-loans-inquiry