By Byron Kaye and Renju Jose

SYDNEY (Reuters) -Australia said it would regulate buy-now-pay-later services as a consumer credit product under new laws, forcing BNPL providers to carry out background checks before lending in what would be one of the world's toughest regimes for the startup sector.

The move would put companies like Afterpay, owned by Jack Dorsey's Block Inc, and Zip Co under the watch of the Australian Securities and Investments Commission (ASIC), and Australia behind only Britain among countries that have sought to regulate BNPL as a standard credit product.

BNPL companies typically offer on-the-spot interest-free short-term loans with minimal credit checks that spread payments over weeks or months and are largely used by cash-strapped people taking debt, sometimes more than they can afford.

The absence of interest charges has so far exempted BNPL providers from consumer credit regulation and the sector has seen its business surge amid an online shopping frenzy spurred by COVID-19 stimulus payments and ultra-low interest rates.

But concerns about repayment have been rising as Australia battles high inflation, which now sits at near 30-year highs, with Australia's centre-left Labor government saying BNPL must be considered credit since it has the same impact on borrowers.

"BNPL looks like credit, it acts like credit, it carries the risks of credit," Financial Services Minister Stephen Jones said in a speech in Sydney on Monday.

"Our plan prevents lending to those who cannot afford it, without stopping safe, prudent BNPL use."

Home to about a dozen listed BNPL providers, Australia had about 7 million active BNPL accounts that resulted in A$16 billion ($11 billion) of transactions in 2021-22, up 37%, data showed.

Australians spent A$63.8 billion shopping online in 2022, with 26% of Australians saying they used BNPL to pay for purchases, retail industry figures show.

BNPL firms make most of their money charging a percentage of sales revenue to merchants, in exchange for directing shoppers to them. They charge borrowers late fees, but say they encourage on-time repayment with the promise of higher credit limits.

BNPL firms say they closely monitor borrower activity but the new Australian law would require them to follow "responsible lending" obligations that include running credit checks before lending, notifying customers when credit limits increase and following dispute resolution processes that are bound in law.

The government will unveil the draft legislation for consultation later this year and the bill will be introduced into parliament by the end of this year.

'STRONG FIRST STEP'

An Afterpay spokesperson said the change was a "strong first step in the development of a fit-for-purpose buy-now-pay-later regulatory framework".

Zip Chief Operating Officer Peter Gray said the change would mean "business as usual" since the company already complied with Australian credit law for some products.

A spokesperson for ASIC, the regulator which had advocated for the toughest possible regulation of BNPL, was not immediately available for comment.

The Australian Finance Industry Association, which had hoped its BNPL code of conduct would form the basis of self-regulation, said it would "continue to work collaboratively with the government on the details of future regulation".

Shares of Australian-listed BNPL providers were mixed by mid-session as investors digested the regulatory development that was largely expected. Local-listed shares of Afterpay owner Block were down 1.5% while shares of the biggest standalone BNPL provider, Zip, fell 5%.

"The buy now, pay later business model is still a structural growth model," said Shaun Ler, a Morningstar analyst.

"You end up in a situation where everyone is suffering but your competitors are suffering even more and the demand is still there," Ler added.

Andrew Grant, a finance lecturer at University of Sydney Business School, said the regulations "should help to create transparency for credit providers in the industry, without harming the majority of users who have a great experience with BNPL products".

($1 = 1.4743 Australian dollars)