Where to from here? - May 2016

Human psychology dictates that we are likely to become defensive if somebody asks us to justify our choices, our beliefs or the way that we do things.

It can be as harmless as someone mocking your favourite television shows or your apparently boring lunch choices. On a more personal level, your lifestyle habits, your family structure or the way you run your business can also come under criticism.

Therefore, it comes as no surprise that some brokers have been shaken by the Australian Securities and Investments Commission’s (ASIC) announcement that broker remuneration structures and incentives could be in the firing line.

Having the corporate watchdog, at the request of the federal government, look into your livelihood, how you are paid, and whether you’re compromising consumer outcomes in order to get a bigger pay packet has the potential to make even the calmest, most professional broker sit up and pay attention.

Where have you been?

In August last year, ASIC flagged the possibility that brokers could be driven by commissions to recommend bigger mortgages to borrowers.

Speaking at the release of a report into interest-only loans on 20 August, ASIC deputy chair Peter Kell said the regulator was not suggesting all problems identified in the report were caused by broker remuneration structures, but it was aware that brokers could be tempted to recommend larger loans.

“That is something that both lenders and brokers need to keep in mind and then to ensure is not influencing their behaviour,” Mr Kell said.

“They also need to ensure that it’s not overriding their responsible lending obligations.”

One of the problems identified in the report was the incentive for brokers to recommend an interest-only home loan. Borrowers in these loan structures do not initially pay down the principal part of the loan, so the trail commission will be paid on a higher balance for a number of years.

The report also revealed that, on average, consumers borrow more under an interest-only home loan, possibly because of the lower initial repayment figure under this type of loan and the effect of ‘present bias’.

The corporate regulator, Mr Kell warned, was keeping “a close watch on the broker channel”.

In recent years, ASIC has taken action against approximately 30 brokers. Mr Kell said ASIC found that many of the issues and wrongdoings stemmed from “a desire to generate more commissions”.

Perhaps foreshadowing the current investigation into broker remuneration and incentives, he warned, “So it is an area that we are quite active in. If we see it leading to a problem here, we will call it out”.

The report and Mr Kell’s warning came after ASIC’s investigation into 11 lenders – nine banks and two non-banks – which formed part of a broader crackdown on responsible lending. The ASIC investigation was also driven by the Australian Prudential Regulation Authority (APRA) and the Reserve Bank of Australia (RBA).

Earlier in 2015, the RBA warned that the increased use of mortgage brokers as a distribution channel was creating risks for lenders and borrowers.

“The more banks use brokers, the greater is the risk that a misaligned broker incentive structure would generate significant amounts of lending that is outside their risk tolerance or is otherwise inappropriate,” the RBA said in its March 2015 Financial Stability Review.

In October 2015, the federal government announced ASIC would officially investigate the remuneration of mortgage brokers, in response to concerns flagged in the Financial System Inquiry. The government tasked the corporate regulator with reviewing “misaligned remuneration incentives” in the third-party distribution channel.

Shortly after the announcement, Assistant Treasurer Kelly O’Dwyer told The Adviser the review would help determine the effect of current remuneration structures on consumer outcomes.

“The government’s response to the Murray Inquiry [the FSI] emphasised the need to better align the interests of consumers and the financial services industry,” Ms O’Dwyer said.

“The review by ASIC will help determine the extent to which misaligned incentives may be creating a conflict of interest between mortgage brokers and consumers.”

Taking direction

Where will the investigation lead the corporate regulator and what, if any, changes will it implement? How will the industry’s leaders and influencers react? These questions are probably at the forefront of your mind – how will this impact my business model, my service proposition and how much I earn?

Several prominent lender, aggregation and brokerage heads have pledged their support for the review and reassured diligent, professional and honest brokers that they have nothing to worry about.

NAB’s executive general manager of broker partnerships Anthony Waldron said the bank is “looking forward to working with both the government and ASIC” as it investigates the third-party distribution channel.

“We fully support the government’s plan to ensure mortgage brokers sufficiently disclose their relationships with associated entities and we look forward to working with ASIC in their examination of remuneration structures in the mortgage broking sector,” Mr Waldron said.

Mortgage Choice CEO John Flavell also welcomed the government’s response to the FSI, as long as the eventual results improve both the industry and consumer outcomes.

“We actively support any reforms aimed at maintaining or increasing consumer protections,” Mr Flavell said.

“At Mortgage Choice we have always actively encouraged Australians to ask their broker how they are paid. We have also gone beyond legal requirement and operate under a ‘paid-the-same’ rate of commission regardless of which lender the consumer chooses.”

While a majority of stakeholders are supportive of the review, speculation about the potential outcomes of the investigation has already begun, with many defending the current model.

Aggregator AFG has gone so far as to call on borrowers to support brokers and created a website – MyBrokerMyChoice.com.au – to educate consumers about the review and highlight the sector’s importance.

The website includes a petition which supports the current commission model for brokers, which clients can sign and share online.

In January, AFG managing director Brett McKeon wrote to the group’s 2,600 brokers, saying he was “disappointed to read recent reports denigrating the use of commissions to remunerate brokers”.

“AFG has not seen any reports that use hard data to support these negative assertions,” Mr McKeon wrote.

“I have repeatedly made the point that brokers are required to disclose any commission and fee payments they may receive from the recommendation of a product.”

Mr McKeon warned that any removal of upfront commissions would have a “massively negative impact on the sector if enacted” as a result of ASIC’s inquiry.

“Brokers would, in effect, derive no income for two years. This is not a sustainable model for employment.

“If this were to occur, ultimately new mortgage brokers [coming] into the marketplace would be limited as there would be a significant ramp-up before regular income is generated.”

As well as potentially impacting brokers, some have warned that any significant commission changes could have a negative impact on borrowers.

Blake Buchanan, eChoice’s general manager of aggregation said the current model is clearly working.

“We welcome this review because it will finally remove speculation around commission payments and we can get on with the business of what we do best, and that is providing exceptional service to the borrowers of Australia,” Mr Buchanan said in March.

“In general terms, there is not a great deal of difference in the value of upfront commissions offered by lenders. Present remuneration structures are considered appropriate and there is absolutely no doubt that the service and system is working for the consumer as well as the industry. The fact that brokers write in excess of 50 per cent of all new loans is clear evidence of the success.”

He warned that changes to commissions could benefit the larger banks at the expense of competition.

“The potential for the competitive mortgage marketplace to be impacted is very real and could play to the strengths of the big four in delivering an oligopoly.”

Where are we going?

Speculation may be rife about what will happen next, but brokers need not panic.

Banking veteran Steve Weston – who has served as CEO of mortgages at Barclays and held roles in NAB, St George Bank and Challenger – told The Adviser that ASIC’s review isn’t necessarily indicative of an inherent problem in the third-party channel. Instead, it’s about the regulator staying one step ahead.

“The review isn't about a problem they’re trying to solve,” Mr Weston says. “What they’re saying is over half of mortgages in Australia are now sources through mortgage brokers where there is a commission payment. Rather than find out there are problems down the track, why don’t we go and have a look now and make sure that we find out that there is absolutely no problem. They don’t want to be caught off guard and find out retrospectively ‘Oh my goodness, there’s a problem, maybe we should have done something first’.

“So it’s about looking at what’s happening in the broking industry and seeing if any changes need to be made.”

Mr Weston says he understands the industry’s concerns, and supports the current model, but reassures brokers they have nothing to fear at present.

“Look, if anyone talks about reducing your income, you’re not going to be very happy about it. But when you peel back the onion and think, ‘Well, what is it that ASIC will be looking at?’ – and that is, ‘Is the customer still getting an appropriate outcome? Or is there any way that commissions are going to influence brokers, potentially from a negative perspective so that customers won’t necessarily get the best deal because of commission payments and the way they’re structured and the way that they’re made?’

“And as long as brokers can show that customers are getting appropriate advice then it should be fine.”

Removal of trail commissions?

In addition to their client database, a broker’s trail book is considered by many to be one of their greatest assets. With some speculating that ASIC may look to remove trail commissions, brokers could be forgiven for questioning how their business would continue to function in this environment.

Mr Weston – who spent years working with the third-party channel in the UK where 70 per cent of loans are written through brokers – says as long as brokers nurture their existing customers, receiving trail commissions is justified.

“In the UK, they don’t have trail and their upfront commission payments average around 0.35 to 0.40 per cent,” he explains.

“I’m a strong advocate of trail for a number of reasons… and the UK broking industry would love to receive trail because it enables brokers to professionalise their business. Trail gives brokers an asset that they build and they’re more likely to look after their customers rather than just put them in a home loan and tell them goodbye.”

Trail commissions also give aggregators an additional income stream which enables them to invest in technology, compliance and training, Mr Weston says.

He speculates that trail commissions will come under the scope of ASIC’s review as many comparable mortgage markets do not structure broker remuneration this way.

Mr Weston says the regulator may question why Australian brokers are any different to those in New Zealand (where one bank has just reintroduced trail) and South Africa (where brokers get paid 1.4 per cent upfront, but no trail).

“We do a wonderful job of stimulating competition, rather than a customer just going to a single bank and getting the best product they have on the day – but we as an industry are going to need to show that we are doing something to justify payment of trail commissions.

“So the question would be, ‘What is it that the broker is doing to justify the payment of trail?’ And most brokers will be following up with customers, doing health checks and the like, but some won’t.”

Mr Weston warns that brokers who put clients into a loan only to ‘set and forget’ will not sit well with the regulator. He says ASIC will look at that and question whether the product remained the most appropriate for the borrower throughout the life of the loan and why the broker continued to earn money off the client.

He offers an anecdote to demonstrate the differences between the UK’s mortgage market and Australia’s, and highlights a potential problem with trail commissions which the regulator may take issue with.

A customer needed $400,000 to buy a home but it was recommended they borrow $600,000 and leave $200,000 in an offset account. The idea was to give the customer flexibility and, in the event that they need an advance in the future, they would not need to reapply.

The customer, as it turned out, had little self-discipline and spent the additional funds for living expenses and holidays.

“Now, our approach in Australia is, well if the customer’s done that, that’s the customer’s fault,” Mr Weston says.

“But the UK regulator will say, it is absolutely not the customer’s fault. As a credit adviser, whether it be a broker or through a bank branch, you put the customer in a structure that would work for nine out of 10 people, but for one out of 10, it may not have. But you put no controls in place to see if that product was still appropriate for them at a later date. They ended up using that $200,000. Had you simply just given them a $400,000 mortgage in the first place, they wouldn’t have had to pay back the extra $200,000 plus the interest on that. That is a big issue.”

Mr Weston says this ties into ASIC’s broker remuneration review because brokers who are being paid trail commissions need to prove that they’re doing something to earn it.

“The most important thing is that as an industry we can look the public in the eye and say, ‘There is a benefit to you the consumer in me, Mr or Ms Broker, being paid a trailing commission, and that is, I will do something for that commission. I will regularly be in touch to make sure whatever structure we put you in is still working for you. If the lender we put you with changes rates, and you’re paying more, maybe we will look at getting a better deal for you.’

“And if we do that, I think we should be pretty safe. I’m just not 100 per cent confident that all brokers are doing enough to justify the paying of trail commission,” Mr Weston says.

“If you are being paid a trail, ultimately that trail commission could have been given to the customer in the form of a lower interest rate, so what is it that as a professional, as a credit professional, you are doing to provide value back to that customer?”

Despite his concerns, Mr Weston stresses he is a strong proponent of trail commissions, especially after witnessing some worrying trends in the UK market caused largely by brokers scrambling for more income.

“Removing trail isn’t necessarily a good outcome for consumers,” he says. “In the UK market, the most common mortgage is a two-year fixed rate. If you look at the level of broker sales of two-year fixed rates, they are higher as a proportion of all their business than the bank-based mortgage advisers who have more five-year fixed rates.

“And my concern that I raised in the UK is – is the reason so many customers are being put into a two-year fixed rate because the commissions are so low, that every two years some brokers feel the need to move a customer from one lender to another simply to survive, to earn enough income to survive?

“That is not a good customer outcome. So my argument was, if you’re paying a trail, the customer is more likely to be put into a product that is more suitable.”

He says this trend provides a counter-argument for proponents of the UK system and a closer inspection of that market will uncover “the likelihood… that some customers are not being put in the most appropriate product for them”.

Fee-for-service?

Will broker remuneration be more acceptable to ASIC if the industry moved towards a fee-for-service model?

In his letter to brokers, AFG’s Mr McKeon suggested that a fee-for-service structure will have a negative impact on both brokers and consumers.

“Under a fee-for-service model, it is likely that potential customers will seek to avoid this payment by engaging directly with a mortgage vendor at a branch level where no fee would be applicable,” he said.

“Real choice would be lost which is not in the interests of the consumer.”

Mr McKeon said significantly altering the current model will stifle competition and drive consumers back to the banks.

“Corralling mortgage customers into bank branch networks will have an extremely detrimental impact on Australia’s remaining second-tier lending institutions.”

Mr McKeon said any loss of the broker-based distribution network will leave non-major lenders with a significant disadvantage.

“The resources required to establish a physical branch network to compete with the large banks creates an almost impassable barrier to entry.

“By undermining the broking model, the result will be a significant reduction in competition in the mortgage sector, to the detriment of the consumer. Every mortgage customer will pay for reduced competition throughout the life of their loan.”

Todd Hunter, founder and director of wHeregroup – which offers mortgage and buyer’s agency services – is confident his business will survive any changes imposed by ASIC, but he cautions that a fee-for-service based model will make life difficult for many brokers.

“If you take trail commission out of the scenario, you will see mortgage brokers walk out of the industry left, right and centre,” Mr Hunter says. “I think you would probably see at least a 50 per cent reduction in brokers.”

He says a key risk with a fee-for-service model is brokers will be tempted into a race to the bottom on price.

“It could become about who will offer a smaller fee. You’re going to find brokers who are going to do it for $100 or $200 just for a deal, just scrambling for any deal they can get.

“I know there are brokers out there who charge a fee for service already and that’s fine and their clients are happy to pay that, but if everyone is forced down that path, then the brokers are going to hang a noose around themselves.

“It will start off where you might charge $2,000 for a deal. And then it’s going to come to $1,800, $1,700, $1,500, $1,200. Next thing it’s $1,000 to do the bank deal. Next thing it’s going to be $500. That’s just the nature of the beast and that’s what will happen.

“The strong brokers will survive but I think you’ll see a mass exodus and then you’ll see very little entry into broking as well.”

Mr Hunter believes brokers will need to charge a significant fee if trail commissions are removed simply to cover their workloads which have increased in recent years.

“Mortgage broking over the past probably three or four years has quite easily doubled in the time it takes for a broker to submit a loan, what with putting all the proposals together, the paperwork and keeping up with ASIC and APRA guidelines.

“So our return on investment is actually, to be honest, probably half.”

General manager of Oxygen Home Loans Alan Hemmings is also confident his brokers and business will survive any change, but he says they will have to look at how they structure their operations.

“From what I understand, there are only one or two countries left which have trail commission,” Mr Hemmings says. “So in most other countries, brokers do charge a fee. Would it be sustainable? Well, they operate elsewhere on an upfront [commission] and a fee.

“But determining what that fee is would be an issue. We’d still be operating, our service proposition would remain. But certainly the numbers would change.”

Mr Hemmings speculates that a fee-for-service model will result in fewer self-employed brokers in the industry, with their numbers being replaced by salaried brokers.

He says it is unnecessary for ASIC to make the industry switch to fee-for-service because consumers are more than happy with the current commission model.

Are we going the way of financial planners?

The financial planning sector has perhaps been more publically marred by scandal and corruption than the broking channel, but parallels have been drawn between planners and brokers. Questions have also been raised on whether the business models of the two different industries will become more similar.

Mr Weston says the regulator could respond to claims that brokers ‘need’ trail by using the financial planning sector as an example.

“It could be said that financial planners here in Australia… well, they had commission upfront and trail and it’s gone now. So as much as we as a mortgage broking industry say we think that trail is something that can be very good for customers because of the way that it allows brokers to professionalise their businesses and the way it allows aggregators to invest… the planners would have had all those arguments and they don’t have trail anymore,” he says.

To provide the strongest case for maintaining the current system, Mr Weston says brokers must continue to be professional, honest operators and show the corporate regulator how they are earning their trail.

Gadens partner Jon Denovan cautioned that scrapping commissions and implementing a fee-for-service model would be a “disservice” to Australian borrowers.

In March, he warned that regulators investigating brokers’ remuneration must avoid the outcomes of the Future of Finance Advice (FOFA) reforms, which he believes disenfranchised a majority of Australians from seeking financial advice.

“[Financial planners] are making a sterling effort to try and provide financial advice in a cost-effective way but they still have to charge to make a dollar,” Mr Denovan said.

“The rules and regulations are so extensive that it’s quite a big dollar. It would be a great disservice to the community if you had to pay to see a mortgage broker.”

Mr Denovan also cautioned that brokers who are selling the wrong products for higher commissions will run into trouble.

“If they go in there and find people are being sold the wrong product because of higher commissions, then they have a problem. If there is a material number of people who are doing the wrong thing, then we’re in trouble.”

Connective’s director Mark Haron said in January that he was confident that any review of remuneration structures in mortgage broking would have a similar outcome to the recent review faced by the insurance industry.

“If you look at a mortgage product, it’s very similar to an insurance product. The insurance industry has just gone through a change in their remuneration structures, moving away from mostly an upfront [commission] option to a balanced upfront option with a trail and clawbacks,” Mr Haron said.

“What they’ve settled on is very similar to how mortgage brokers currently get paid so I’m pretty confident that any review would push towards something similar.”

The federal government announced on 6 November, 2015 that it would begin “phasing down” commissions in the life insurance industry.

From 1 July, 2016, upfront commissions will be phased down to a maximum of 80 per cent, dropping to 70 per cent from 1 July, 2017 and then to 60 per cent from 1 July, 2018, along with a maximum 20 per cent ongoing commission.

The government will also introduce a two-year clawback period to 100 per cent of the commission on the premium for the first year of the policy, decreasing to 60 per cent in the second year of the policy.

Mr Haron said it won’t be as simple as removing an upfront commission and replacing it with a fee-for-service model – “it’s just not that simple a solution”.

“Investment advice is a whole different kettle of fish, and I guess that’ll be a big part of what engagement with industry bodies and the banks will be given to this inquiry. Someone giving you $500,000 to invest and it all getting lost is completely different to arranging a mortgage or arranging an insurance product,” he said.

“I don’t see the advice provided by mortgage brokers to be compared to investment advice – it will be compared more to insurance advice.”

Where to from here?

Brokers looking for direction or certainty on what’s around the corner may be left with more questions than answers, but for now, we just await word from the corporate regulator.

The general consensus seems to be that professional, honest and hardworking brokers will survive and thrive no matter what happens, and the industry should be able to prove its importance in the financial lives of Australians, as well as why they deserve their trail commissions.

Mr Denovan stressed ASIC has approached the review – which he expects will continue until the end of the year – with “no preconceptions and no bias”, adding that the corporate regulator is well aware that there is a big difference between credit and financial advice.
We continue to wait.