Treasury — in its most comprehensive outline of its thoughts on broker remuneration since ASIC’s remuneration review — has told the royal commission that industry reforms on broker remuneration “could address the most significant misconduct with the current remuneration model”.
In a new background paper to the financial services royal commission, Background Paper 24: Submission on key policy issues (Treasury), the government department outlines its thoughts on several issues and areas of concern that were brought up during the royal commission, including broker remuneration.
While the submission does not make recommendations, it “seeks to set out the issues involved, the current regulatory framework and how it developed, and the trade-offs involved in various responses to these matters that the commission could consider”.
Looking at mortgage brokers, Treasury said that brokers, among other things:
- “assist consumers to match their borrowing needs with suitable loan products”;
- “help consumers navigate a crowded and dynamic loan market where pricing — interest rates and fees — can be hard for consumers to identify, understand and negotiate”;
- “assist consumers to understand features of different mortgage products and facilitate the loan application process”;
- “act as a distribution channel for lenders (particularly in regional areas) and facilitate competition, exerting downward pressure on home loan pricing more generally”;
- “reduce costs related to the direct loan channel”; and
- “allow smaller lenders to gain geographic diversification in their lending portfolio”.
In its 60-page report, Treasury highlighted that the royal commission’s hearings have brought out conflicts of interest that exist in residential mortgage broking — and “the poor customer outcomes that can result from the failure of firms to appropriately manage such conflicts”.
It stated that as remuneration is “principally determined as a function of loan size, brokers have an incentive to arrange larger loans, irrespective of the borrowing capacity of a consumer and the suitability of the loan product for that consumer”, but added that the clawback arrangements and responsible lending obligations prohibiting unsuitable loans “seek to temper the risks created by these incentives”.
It further added that trail commissions can also “discourage switching, for example, where they increase over the life of the loan, or if they incentivise the broker to prioritise signing up additional customers (leading to additional upfront and trail commission payments) over switching existing customers (with only additional upfront commissions)”.
The government department highlighted that ASIC’s review of broker remuneration found that home loans arranged through a broker may be larger, have higher arrear rates and loan-to-value ratios and more likely to be interest-only loans, and it stated that the differences could reflect “the difficulties in statistically controlling for differences between brokered and direct channels, as well as brokers achieving outcomes actively sought by customers”.
Treasury continued: “These average differences are prima facie not so significant that they provide compelling evidence of major problems that require a wholesale change to the existing standard commission structure given the industry reforms currently underway.”
Treasury argued that “advice and intermediary services, such as those provided by mortgage brokers and financial advisers, play an important role to bridge the information gaps and lower the search costs consumers face, and assist in dealing with complex choices”, and that any potential conflicts in remuneration could be fixed with the current work and reforms that are taking place at the moment.
Treasury “welcomes” CIF package
It noted that the broking industry, through the Combined Industry Forum, has been taking unprecedented steps to unite and produce changes to broker remuneration that aim to improve the commission structure and make it more transparent.
The Treasury submission states: “The CIF proposals are positive developments which Treasury welcomes. Whether the adoption of these reforms by individual firms is sufficiently widespread and remains in place will need monitoring, as will the risk of other arrangements being developed to replicate the discarded elements under a different form or name.”
The risks of other models
Looking at some of the suggested reforms to broker remuneration that have been put forward, Treasury suggested that lender-paid flat fees could provide brokers with an incentive to “service only those customers with straightforward needs, disadvantaging those with more complex needs such as first home buyers”, should the industry belief that a larger loan size correlates with greater complexity and hence effort on the part of the broker be true.
“It would create some other misaligned incentives that would also need to be managed, such as the need to limit the splitting of a loan into multiple loans to generate additional broker fees,” the submission warned.
Looking at the suggestion of removing trail to provide greater incentive to assist customers to refinance was also considered, with Treasury saying that it “would have the potential advantage of removing incentives for brokers to inappropriately recommend larger loans that take longer to pay back”, although it argued that it was “unclear” how significant this incentive is in practice, and that brokers would have greater incentives to assist customers to refinance.
However, it warned that removing trail could also “reduce incentives for brokers to guard against arranging non-performing loans and to not unnecessarily switch consumers to alternative loans that do not provide for a better deal”.
“Refinancing is not a costless exercise, with real costs for both lenders and borrowers,” it said.
Touching on a borrower-paid model, Treasury noted that this would be “most radical” and that while it would mean brokers’ loan products and lender recommendations would be “more likely to align with the consumers’ best interests or be more transparent if they do not”, there were risks with this option.
“The risk is if customers switch to obtain home loans from lenders directly rather than paying brokers an upfront fee, threatening the viability of the mortgage broker distribution channel. Estimates of what most consumers may be willing to pay a broker, of no more than $1,000, are well below the average value of commissions currently paid by lenders,” Treasury said.
Then it warned: “If mortgage broking activity contracted, this could have a significant detrimental impact on competition in the mortgage market.”
Treasury continued: “If a further change in the standard commission structure was supported by the commission, consideration would also need to be given as to how best to achieve it. These changes, alone or in combination, have the potential to be disruptive to an industry already facing significant change in light of the CIF proposals and tighter lending standards, and involve significant costs in transitioning to and bedding down any changes.
“As the discussion above brings out, the standard commission structure represents a balancing of commercial interests and responsibilities between lenders, aggregators and brokers, as well as the interests of consumers. Too prescriptive and fixed a model risks being commercially inefficient, particularly as the market develops over time and technological and other innovations arise, and negatively affecting competition.
“While the online and technology-based mortgage broker start-ups remain nascent, they are also innovating with remuneration structures (such as rebating commissions to customers) as a point of competitive advantage. It would, therefore, be worth considering flexible and less prescriptive approaches.”
Treasury also highlighted that ASIC is being given more powers to “intervene in this area to target aspects of remuneration structures where ASIC is satisfied that there has been or is likely to be significant consumer detriment”.
The government department went on to say that brokers are “a key distribution channel for mortgages, and by assisting consumers’ search for a better deal, mortgage broking also has a vital role in facilitating effective competition and better outcomes for consumers that needs to be taken into account in assessing reform options”.
“Following a comprehensive report by ASIC in 2017 on mortgage broker remuneration, the industry is progressing reforms that could address the most significant misconduct with the current remuneration model, and ASIC is to obtain powers to intervene when satisfied that there has been, or is likely to be, significant consumer detriment.”
More to come.
[Related: CIF proposes package of commission changes]