As you know, the Royal Commission handed down its Interim Report on Friday 28 September (Interim Report), which has addressed important issues within financial services, consumer credit and mortgage broking. You will have received our initial MFAA statement late last Friday, and we are now providing a more thorough communication, having had the opportunity to consider the report in greater detail.
The next round of hearings (Round Seven) will focus on policy questions arising from the first six rounds, which included consumer credit, in Sydney and Melbourne during November. Details about topics and case studies to be heard will be published prior to the commencement of the hearings.
There is now an opportunity to make submissions to the Royal Commission during October - which the MFAA will be doing - and we will also be discussing the implications of potential policy decisions with key stakeholders and decision makers within Government over the coming months.
Key Points
- The Royal Commission has raised concerns over “value- and volume-based remuneration for intermediaries in the home loan industry”, and pointed out that mortgages written by brokers have higher leverage, more interest-only loans, higher debt-to-income and loan-to-value ratios, higher interest costs and an increased likelihood that borrowers will fall into arrears.
- The Interim Report raised issues relevant to the mortgage broking industry from a misconduct perspective. The Royal Commission has not prioritised competition, consumer choice and access to financial and credit services for marginalised groups, and as such, many of the questions it has posed and considerations it has suggested would not have taken account of wider potential unintended consequences.
- We believe that any significant policy changes - particularly in relation to commission structures for mortgage brokers - must hold competition, consumer choice and access to credit services as the highest priority, to effectively protect outcomes for consumers.
- We also note that when the Royal Commission considered the differences between proprietary and intermediary channels, it did not identify that greater complexity within each customer demographic has tended to automatically gravitate towards the broker channel, as customers with more complex financial situations turn to brokers for solutions.
- The MFAA will continue to stress that the broker channel is critical to the health of Australia’s mortgage lending market. As has been noted in recent reviews by ASIC, the ABA (Sedgwick Review) and the Productivity Commission, brokers play a vital role in bringing competition to the home lending market by acting as a shopfront for smaller lenders, and vastly increase access to credit services - especially for rural and regional customers.
- The Royal Commission Interim Report was silent on the specific transformational reforms the industry is undertaking in regard to the governance of activities of mortgage brokers, aggregators and lenders. These reforms, based on data-driven reviews and designed by the industry to ensure better consumer outcomes, will provide a pathway to enforce better conduct, culture and compliance. This package of reforms will see the progressive introduction between 2018 and 2020 of a comprehensive governance framework, and a series of new measures designed to address many of the issues – including the product strategy conflict inherent in broker remuneration – raised by the Interim Report.
- In discussing the issue of conflicted remuneration, the report references the views of a major lender, in considering the potential extension of regulations such as Future of Financial Advice (FoFA) to mortgages (consumer-based fee-for-service) or de-linking incentives from the value of a loan (lender-based fee-for-service). Both of these options would lead to significant consolidation in the broker market as many brokers would no longer have viable businesses – impacting smaller lenders the hardest – and in the case of a lender-based fee-for-service, would not in any way resolve the lender choice conflict.
- The business model of lenders that are heavily invested in branch infrastructure would benefit from customers being driven away from brokers and back into the branch network, so while commentary on a fee-for-service is understandable, it is entirely self-serving, would not benefit consumers, and is not reflective of the broader industry view.
The Report: Key Issues for Mortgage Brokers
The key issues for the mortgage broking industry raised in the Royal Commission Interim Report include the finding that “value- and volume-based remuneration for intermediaries in the home loan industry has been an important contributor to misconduct and conduct falling short of community standards and expectations and poor customer outcomes.” The Interim Report has posed the questions “How is a value based commission consistent with acting in the interests, or best interests, of the client? Should intermediaries be subject to rules generally similar to the conflicted remuneration prohibitions applying to the provision of financial advice?”.
The Interim Report states that commission payments explain why mortgages written by brokers have higher leverage, more interest-only loans, higher debt-to-income and loan-to-value ratios, higher interest costs and an increased likelihood that borrowers will fall into arrears. The Report goes on to state that “nor is there any reason to doubt that value-based upfront and trail commissions to third parties contribute to those outcomes.”
Compounding this issue is the Interim Report finding that there is confusion about who mortgage brokers actually work for, and that “the broker owes the borrower no duty larger than not to negotiate an unsuitable loan.” The Interim Report posed the question “Is it desirable to prescribe that some or all of those who are not employees of banks, but deal with bank customers, must act in the interests, or the best interests, of the client?”
The Interim Report has also stated that the reforms undertaken by the Combined Industry Forum are ”limited”, and that ”while basing those commissions on funds drawn down removes an incentive for brokers procuring a loan larger than the borrower will use, the change does not deal with the more basic problem of borrowers being encouraged to borrow more than they need.”
In essence, the Interim Report argues that brokers remuneration is inherently conflicted, that the broker has no legal duty to act in the customer’s best interests, and therefore posed the question as to “whether value- and volume-based remuneration of intermediaries should be forbidden?”.
The MFAA’s Response to Key Issues
At the outset, it is important we remember that while this report raised many issues which the industry is dealing with, its core remit is misconduct. The Royal Commission has not prioritised competition, consumer choice and access to financial and credit services for marginalised groups, and as such, many of the questions it has posed and considerations it has suggested would not have taken account of wider potential unintended consequences.
We believe that decision makers in considering any significant policy changes - particularly in relation to commission structures for mortgage brokers - must hold competition, consumer choice and access to credit services as their highest priority, in order to effectively protect outcomes for consumers. It will be the Government’s role to balance the findings in the Interim Report with the need to preserve competition and access to credit assistance in the financial services industry as it begins to formulate policy.
It is worth noting that over the course of two significant reviews, the ABA (Sedgwick Review) and the data-driven ASIC Broker Remuneration Review, neither made findings of systemic consumer harm. In addition, when ASIC controlled the data on channel differences for borrower characteristics and loan features, it demonstrated much less pronounced differences between the broker and proprietary channel.
We also note that when the Royal Commission considered these channel differences, what was not discussed was the greater complexity within each demographic that automatically gravitates towards the broker channel. We believe that brokers are not systemically driving customers into risky loans, but rather that complexity gravitates to the broker channel, producing the controlled differences noted by the Report. Customers with more complex financial situations seek out brokers to help them secure credit from lenders.
This trend will have been exacerbated in 2018 as lenders tightened credit requirements. For example, some customers are being forced to switch from interest-only to principal and interest, while other customers must find a new solution as their lender ceases to offer finance to self-managed super funds. In all these circumstances customers and complexity will tend to gravitate towards non-major lenders via the broker channel in search of solutions to fill a very important need. Ultimately, this creates excellent outcomes for many where their primary lender is unwilling or unable to assist.
During the June quarter of 2018, the broker channel saw the largest single quarter increase market share in more than three years (51.4 per cent to 53.9 per cent), with a growing share of that going to smaller lenders. Notably, this gain occurred during the height of the Royal Commission hearings.
Further, the MFAA believes the issues raised around remuneration can be effectively dealt with by the specific reforms being proposed by the Combined Industry Forum (CIF), a stronger customer duty and a governance framework with an enforceable industry code focused on conduct and culture.
The Data Portrays a Strong, Consumer-Focused Industry
As we go through the process of responding to the Interim Report and discussing the implications of potential policy decisions with key stakeholders and decision makers within Government over the coming months, the MFAA will continue to stress that the broker channel is critical to the health of Australia’s mortgage lending market. As has been noted in recent reviews by ASIC, the Sedgwick Review and the Productivity Commission, brokers play a vital role in bringing competition to the home lending market by acting as a shopfront for small and medium sized lenders, and vastly increase access to credit services - especially for rural and regional customers.
Throughout the past few years – and even during the Royal Commission hearings earlier this year - customers have continued to flock to brokers in record numbers, reflecting their confidence in the broker value proposition and the outcomes brokers are producing for them.
Consumers’ Net Promoter Score of brokers is in excess of +70, and more than 90 per cent of customers have reported that they are satisfied with their broker’s performance. This data tells a compelling story of an industry which does not have misconduct at its core.
As noted in a recent report by Deloitte Access Economics, The Value of Mortgage Broking, “mortgage brokers make mortgage markets work better…(they) increase choice and competition between lenders, leading to better service levels and competitive mortgage pricing.”
If conflicted remuneration was causing systemic harm to consumers, then the data should show complaints and relative arrears high and rising, competition and consumer support shrinking and prices inevitably rising. But this is not the case.
The available data shows that over the past 10 years, complaints made to the MFAA, CIO and FOS about brokers have dropped significantly relative to broker numbers and market share and in the case of complaints to the MFAA, in absolute terms as well. When reviewing arrears, ASIC data showed there is no significant difference between the broker channel and the proprietary channel.
At the same time, brokers continue to foster competition and consumer choice. Mortgage brokers bring competition to the mortgage industry, specifically by improving access to smaller lenders that do not have a branch network. The broker channel over the past year has comprised between 53.6 and 55.7 per cent of all mortgage lending in Australia (depending on seasonality of the quarter), and the share of broker-originated loans concluded through lenders not affiliated with the four major banks increased from 21.4 to 30.2 per cent in just four-and-a-half years between 2013 and 2018.
This ongoing effect on competition has contributed to a three percentage point decline in net interest margin paid by consumers over 30 years.
Industry Reforming to Ensure Improved Customer Outcomes and Stronger Governance
The MFAA believes the issues raised in the Interim Report around remuneration and culture can be effectively dealt with through the specific reforms proposed by the Combined Industry Forum (CIF) – including a governance framework with an enforceable industry code focused on conduct and culture, combined with a stronger customer duty.
In addition, one of the key reforms proposed by the CIF, which is in the process of being adopted by lenders, is the guidance to only pay upfront commission on funds drawn down and utilised net of offset, so brokers are not rewarded for encouraging customers to borrow more than they need. This directly addresses the 'product strategy conflict’ inherent in broker remuneration, whilst focusing on the major product attribute which could be exploited should a broker be influenced by this conflict.
The industry has also ceased providing volume-based bonus commissions and campaign-based commissions, and is well progressed in implementing significant soft dollar remuneration reforms aimed at reducing the incidence for both lender choice conflict and product strategy conflicts. The CIF has also recommended a number of new and improved disclosures (that will be consumer tested) and an improved public reporting regime that will increase transparency, allow more informed choices and reduce potential for lender choice conflict.
The Royal Commission Interim Report was also silent on the specific transformational reforms the industry is undertaking in regard to the governance of the activities of mortgage brokers, aggregators and lenders. These reforms, being undertaken by the CIF, are based on data-driven reviews and designed by the industry to ensure better consumer outcomes, provide a pathway to enforce better conduct, culture and compliance. This package of reforms will see the progressive introduction between 2018 and 2020 of a comprehensive governance framework, and a series of new governance measures designed to address many of the issues raised by the Interim Report.
The Interim Report stated there was confusion about who mortgage brokers actually work for, and that “the broker owes the borrower no duty larger than not to negotiate an unsuitable loan.” The MFAA agrees with the report’s view that a higher customer duty is required to augment the existing legislation. That is why the industry is well-progressed in expanding the definition of a ‘Good Consumer Outcome’ to incorporate a ‘Customer First Duty’. The industry is also exploring ways in which the role and obligations of a broker can be better explained to a customer.
Whilst the CIF reforms are comprehensive, we will be highlighting the strongest mitigant against both the product strategy and lender choice conflict – the fact that broker businesses rely predominantly on a relationship model and referral business. Approximately 70 per cent of a broker’s business comes directly or indirectly from existing customers which provides a strong natural incentive to behave appropriately and produce strong customer outcomes.
Consequences of a Fee-For-Service
In discussing the issue of conflicted remuneration, the report also references the views of a major lender, in considering the potential extension of regulations such as Future of Financial Advice (FoFA) to mortgages (consumer-based fee-for-service) or de-linking incentives from the value of a loan (lender-based fee-for-service). Both of these options would lead to significant consolidation in the broker market as many brokers would no longer have viable businesses – impacting smaller lenders the hardest – and in the case of a lender-based fee-for-service, would not in any way resolve the lender choice conflict.
The business model of lenders that are heavily invested in branch infrastructure would benefit from customers being driven away from brokers and back into the branch network, so while their commentary on a fee-for-service is understandable, it is also entirely self-serving, would not benefit consumers, and is not reflective of the broader industry view.
A consumer fee-for-service model would harm customers (especially in rural and regional Australia), damage competition and threaten viability of broker small businesses. It would significantly benefit the major lenders, providing them with an unassailable stranglehold on the home lending market and interest rates.
A consumer fee-for-service is not a viable solution to improve transparency around broker commissions and help consumers to make more informed choices. It would tip the balance back in favour of branch-based lending by making it significantly more expensive for a customer to use a broker rather than a bank branch to obtain a home loan. Smaller lenders that do not have branch networks would be pushed out of the market, stifling competition, and allowing major lenders to restore the massive net interest margins they imposed on mortgage products before broking made access to competitive credit services a reality.
Indeed, as noted by the Productivity Commission’s Inquiry Report, Competition in the Australian Financial System, ”fixed fees paid by customers rather than commission structures have been proposed, and would eliminate conflicts, but the cost to competition would be high. Consumers would desert brokers, and smaller lenders (and regional communities with few or no bank branches) would suffer much more than larger lenders.”
Self-Regulation Must Continue
The self-regulatory approach the industry is taking through the CIF remains the best way to improve customer outcomes, standards of conduct and culture, while preserving and promoting a vibrant and competitive mortgage broking industry that encourages consumer choice.
Whilst the Royal Commission has labelled the CIF’s achievements to date as “limited”, we must remember that the CIF has been operating for just over 12 months and is focused on reforming where required, whilst ensuring that the broking industry remains sustainable. Some proposed reforms are limited - deliberately so - to ensure the industry is reforming to solve key issues, while retaining competition and consumer choice.
The MFAA will be calling on all policy makers to consider the impact of any proposed regulatory response to the Royal Commission, particularly on issues such as competition and access to financial and credit services. We will also be promoting the fact that there is no evidence of systemic misconduct, and that our industry is focused on making the changes required to continue to improve customer outcomes. We know we must ensure that the strong consumer trust and confidence in the broker channel is underpinned by governance and transparency for the long-term sustainability of our industry, and ultimately, in the service of competition in the mortgage lending market.
