Westpac and the corporate regulator have returned to court for the first day of a potential eight-day hearing on responsible lending, which could have wide ramifications for other banks and the home loan market.

Key points: ASIC sued Westpac for irresponsibly approving loans that it shouldn't have

ASIC sued Westpac for irresponsibly approving loans that it shouldn't have Both sides agreed to settle the case, but the Court refused to approve the deal

Both sides agreed to settle the case, but the Court refused to approve the deal $35m would have been a record penalty for breaching national credit laws

The Australian Securities and Investments Commission (ASIC) accused Westpac of breaking the law when it approved loans using the Household Expenditure Measure (HEM) — a relatively low estimate of basic living expenses — rather than customers' actual declared living costs in its automated loan approval system.

The regulator also alleged Westpac failed to properly assess whether applicants could afford to repay interest-only loans after the loans switched to higher principal and interest repayments.

Both parties reached a settlement last year, with Westpac admitting it breached the National Consumer Credit Protection Act and agreeing to pay a record $35 million civil penalty.

But the Federal Court, in a highly unusual move, refused to approve the settlement, forcing both sides to re-litigate their case.

ASIC's lawyers delivered their opening arguments today, saying Westpac breached the law in relation to 261,987 home loans approved through its automated system between December 2011 and March 2015.

Of those loans, 154,351 were interest-only.

And ASIC alleged that all uses of the HEM benchmark, instead of customers' declared expenses, were a breach — not just the instances where customers' declared expenses were higher than the benchmark and could have led to the loan not being approved.

The regulator also argued that all of the more-than-260,000 loans breached the law, regardless of whether customers' declared expenses were above the benchmark or not, as use of the HEM did not count as a proper assessment as required under the Credit Act.

'The elephant in the court room'

When he rejected the settlement in November, Justice Nye Perram's main criticism was that ASIC and Westpac did not actually agree on how the law had been broken.

Specifically, both sides were unable to agree on how many breaches Westpac had committed, and failed to adequately explain why the $35 million penalty was appropriate.

"Admirable ingenuity has been applied by the parties' advisers to the task of drafting the consent orders so as to gloss over the very real differences which exist between them," Justice Perram said in his decision.

"The court should not be expected to approve a (record) penalty without being told why the HEM benchmark was used by [Westpac] in preference to declared living expenses.

"That missing fact is, with respect, the elephant in the court room."

In the ultimately rejected settlement, Westpac had admitted that about 100,000 loans used the HEM in instances where customers' living expenses were higher than the benchmark, or incorrectly assessed interest-only repayments.

Of those 100,000, Westpac agreed it should not have automatically approved 10,500 loans, which should have instead been referred for manual assessment.

While the regulator acknowledged Westpac did gather other information about a customer's expenses and financial situation during the period, it said it did not count as a proper assessment, as it was only the HEM that was used in the automated calculation of whether a customer could service a loan.

Delivering the bank's opening arguments, Westpac's lawyer said ASIC's case was based on a "19th-century" notion of loan assessments being a simple formula of income minus expenses and argued that the bank's "21st-century" assessment system was more complex.

Westpac also argued that for 80 per cent of the 261,000-odd loans, the customer's declared expenses were lower than the HEM benchmark, meaning the loans would have been even more likely to be approved if HEM was not used.

The hearing is scheduled to run until mid next week.