Westpac has reached a settlement with the corporate regulator after admitting its automated loan assessment system breached responsible lending laws, issuing more than 10,000 home loans that should not have been automatically approved.

Key points: Westpac's fine punishes the bank for approving loans customers potentially couldn't afford

Westpac's fine punishes the bank for approving loans customers potentially couldn't afford The bank was also accused of not assessing the long-term viability of interest-only loans for customers

The bank was also accused of not assessing the long-term viability of interest-only loans for customers Westpac has since changed its lending policies and the way it assesses customers' living expenses

The bank will pay a $35 million civil penalty and the regulator's legal costs to settle the case, brought by the Australian Securities and Investments Commission (ASIC).

ASIC said this would be the largest civil penalty awarded under the National Credit Act, if approved by the Federal Court.

Westpac admitted its automated system used the Household Expenditure Measure (HEM) — a relatively low estimate of basic living expenses — to calculate potential borrowers' living costs.

The bank used the HEM instead of actually evaluating the customers' declared living expenses, and admitted this practice breached the National Consumer Credit Protection Act.

This meant affected customers were approved for home loans they potentially could not afford to repay without financial hardship.

ASIC launched the case in March last year, using seven case studies to demonstrate the bank's use of the lower HEM benchmark rather than a customer's higher declared living expenses.

The ASIC action also alleged that Westpac did not properly assess whether interest-only borrowers could continue to afford their mortgage without financial hardship when the interest-only period ended and principal and interest payments had to be made.

The switch over to principal and interest can add as much as 40 per cent to the monthly repayments on a mortgage.

ASIC offered the example of a $500,000, 10-year, interest-only period at an interest rate of 5.24 per cent, where Westpac's method of assessment assumed repayments of $2,758 a month, while the actual principal and interest repayments would be $3,366.

In a statement, ASIC said Westpac used the automated decision-making system on about 260,000 home-loan approvals between December 2011 and March 2015.

Of these, about 50,000 used the HEM even though the applicants' declared living expenses were higher, and a further 50,000 used the incorrect interest-only repayment-calculation method.

ASIC said about 10,500 of these loans should not have been automatically approved.

Westpac does not admit loans were unsuitable

In a statement, Westpac said ASIC has not alleged that any customers suffered specific loss or damage as a result of these admissions, and the bank made no admission that any of the loans were unsuitable for customers.

"From a credit quality perspective, loans approved under these circumstances have continued to perform similar to, or better, than the rest of the group's home loan portfolio," said the bank's head of consumer banking George Frazis.

"Nevertheless, Westpac has committed to proactively monitor the active loans and to provide tailored hardship assistance if necessary."

Westpac said around 5,400 of the loans were still active, representing 0.4 per cent of the bank's mortgages.

The bank changed its lending policies in 2015, meaning that all borrowers are now assessed against the higher of their declared living expenses or the HEM and interest-only loan serviceability is assessed using the full principal and interest repayment.

Tougher lending standards

ASIC chairman James Shipton said the penalty sent a strong message non-compliance with responsible lending obligations would not be tolerated.

"This outcome, and ASIC's actions in relation to responsible lending, reinforce that all lenders must obtain information from individual borrowers about their financial situation to ensure that they can properly assess the ability of the customer to repay the loan," he said in a statement.

"Lenders must then verify the information to ensure that it is true, and then assess whether the loan is unsuitable for the borrower."

The banking royal commission examined these issues in its first block of hearings, finding that other banks, including ANZ, were potentially too reliant on the low-ball HEM estimates when evaluating loan applications.

Documents released by the royal commission also showed that a 2017 review of the four major banks by the bank regulator APRA found Westpac was an "outlier" in its home loan approvals and risk assessment processes.

APRA has tightened home lending standards, forcing banks to make genuine inquiries into loan applicants' expenses.

Banking analysts say these moves may have reduced some customers' borrowing power by up to 42 per cent.

The bank analysts at UBS have also warned on the related issue of "liar loans", where borrowers or their mortgage brokers underestimate their expenses or overestimate their incomes to get access to bigger loans than they would be able to get otherwise.

The very low level of the HEM meant that borrowers who understated their actual spending could be approved for much larger loans than they should have been.

The investment bank has warned there may be up to $500 billion of outstanding home loans that were approved based on inaccurate information.

UBS also warned that many borrowers with interest-only loans appeared not to realise that they were not paying off any principal and that their loan repayments would jump when the interest-only period ended.