For those who do not know, a mugwump is “a bird who sits with its mug on one side of the fence and its wump on the other.”
That came to mind as I read the Treasury submission to the Royal Commission into Financial Services misconduct which was released recently on three matters:
- the culture and governance of financial (and other) firms and the related regulatory framework;
- the capability and effectiveness of the financial system regulators to identify and address misconduct; and
- conflicts of interest arising from conflicted remuneration and integrated business models.
They say these three issues were drawn from the case studies to date that point to: numerous failures by firms to adhere to existing regulatory obligations and deal openly and honestly with the regulators; an indifference by a number of firms to delivering good consumer outcomes, as well as a lack of investment by some firms in systems and processes to monitor product performance and staff conduct; and at times an unsatisfactory attitude and approach to remediation where issues have been identified.
These outcomes reflect instances of failures of leadership, governance and accountability at an industry, firm and business unit level. Where misaligned incentives and conflicts of interest have been present, the underlying failings and the poor outcomes have been exacerbated.
Competitive forces have been unable to fully temper these problems and hold firms to account. In part this is due to the advantages of incumbency and continuing barriers to entry for new firms. It also reflects a lack of effective demand-side pressure. Consumers, when interacting with the financial system, face products and services that are inherently (or by design) complex, opaque and typically have long durations; conflicted advice can worsen the problem. With ineffective competition, profitability can remain high for financial firms even if consumer outcomes are poor. Their shareholders (both retail and institutional) can remain largely complacent about governance and culture, and consequently poor conduct can persist.
The evidence suggests that while financial system regulators have been alert to the problems and have taken action, they have not yet been able to change the underlying behaviours of many of the firms and industries involved.
In our view, the financial system and the regulatory framework cannot perform efficiently when there is a disregard by financial firms to adherence to the law and broader community standards and expectations regarding their trustworthiness. Fundamentally, responsibility for complying with the law rests with those to whom the obligations apply.
Turning the the Mugwump in Action.
They say that ASIC and APRA are world class regulators, and they were across the issues. The problem lies within the culture of the firms. And, by the way, the Council of Financial Regulators (of which Treasury is a member) is acting just fine. “At a structural level, Australia’s ‘twin peaks’ model of financial regulation – where responsibility for conduct and disclosure regulation lies with ASIC and responsibility for prudential regulation with APRA – has clearly served the financial system and economy well and remains appropriate. Similar architecture has been adopted in other jurisdictions and ASIC and APRA are well-regarded by peer-regulators in other countries and by international standard setting
bodies and organisations.
They do say it is clear that the current regulatory framework and its enforcement are not delivering satisfactory outcomes and that shareholders’ interests do not necessarily coincide with customers’ interests, particularly in the short-term; indeed much of the misconduct has generated significant returns to the firms that have flowed through to healthy dividends. But the problem is accountability in firms and the complexity of the law. Extending the BEAR, or a like regime, to a wider range of entities may be one way to lift standards of behaviour and conduct across the financial sector. But the fundamental limitation of such reform is that it relies on shareholders to agitate when remuneration policies do not serve consumer interests — and they may not do so.
But they also warn that over time, a financial system that is overburdened by regulation will fail to deliver on its objectives of meeting the financial needs of the community and facilitating a dynamic, stable and growing economy. Thus reforms to ensure consumer confidence through strong respected regulators must balance the efficiency and ability of the financial system as a whole to succeed.
With regards to conflicted remuneration, again they acknowledge that wrong incentives can lead to bad customer outcomes, yet fall short of supporting the idea of, for example, removing broker commissions and trails, warning darkly of unintended consequences.
All remuneration structures and business models can give rise to conflicts of interest, even if its form differs or the parties concerned vary. When markets function well, commercial practices evolve to best manage the multiplicity of interests and potential conflicts. Hence, overly prescriptive interventions —not taking account of all the trade-offs involved — can give rise to costs and unintended consequences.
Our judgment — subject to evidence in future hearings — is that recent structural changes in the industry, recently introduced or soon to be introduced reforms, other potential reforms the Commission could recommend, and heightened attention by firms and ASIC, should be sufficient to mitigate the systemic risks involved — subject to further ongoing scrutiny by regulators. Structural separation would also be complex and disruptive, and could have unintended consequences.
That said, There is clear evidence from the hearings and ASIC that vertically integrated firms have often not appropriately managed these conflicts, despite general legal obligations to do so.
Brokers are currently paid by lenders (via aggregators) using a standard commission model. This model includes upfront and trailing commissions which are proportional to the size of the loan, and subject to clawback arrangements which allow lenders to recover some or all of upfront commissions if a loan goes into significant arrears or is terminated within a specified period. These commissions have also been supplemented by volume and campaign-based bonuses, as well as non-monetary benefits that are predominately determined by volume targets. These features of the standard model give rise to conflicts of interest for brokers that could lead directly to poor consumer outcomes and reduce competition.
There is a risk that brokers working under vertically integrated aggregators may recommend specific in-house loan products that may not provide the best outcome for a consumer. Again, they are also suggestive of a potential negative effect on competition in the mortgage market at the expense of customers more generally.
Proposals for upfront, flat fees can involve up to three distinct changes to current industry practices:
- a move away from remuneration set by reference to loan size, to one of a fixed dollar amount per loan (possibly still varying with loan or lender type or characteristics);
- ending the practice of trail commissions; and
- requiring the payment to be made by the consumer and not the lender.
The first of these would directly target the incentive to encourage customers to take out larger loans, though in practice the consequence of this incentive may be quite limited. 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 industry argues that a larger loan size correlates with greater complexity and hence effort on the part of the broker. If this is correct, brokers could have an incentive under a flat fee to service only those customers with straightforward needs, disadvantaging those with more complex needs such as first home buyers. The correlation between loan size and broker effort is, however, not obvious and commissions can already vary according to product and lender characteristics and flat fees could also do so.
The second change, of removing trail commissions, would have the potential advantage of removing incentives for brokers to inappropriately recommend larger loans that take longer to pay back (though, again, how significant this incentive is in practice is unclear), and brokers would have greater incentives to assist customers to refinance.
The removal of trails would, however, 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. In the United Kingdom, where trails are not used, concern over churn has led lenders to pay retention fees to brokers to encourage consumers not to switch lenders but refinance at a different rate.
Services provided by brokers to customers after a loan has been arranged could also be affected if trailing commissions were removed.
The third change, of requiring consumers rather than lenders to pay the broker, would be the most radical. Without any significant remuneration from lenders, brokers’ loan products and lender recommendations are more likely to align with the consumers’ best interests or be more transparent if they do not. Some specific payments from lenders to brokers may, however, need to be retained if they were to continue to provide specific services to the lender.
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.
As brokers act as trusted advisers for customers with respect to housing finance, there is an in-principle case for introducing a positive duty on brokers to act in the interests of their customers. While responsible lending obligations provide protection against customers being recommended loans that are too large or otherwise not suitable for them, the purpose of a positive duty would be to counteract incentives to, for example, recommend a particular lender and loan type because the commission available to the broker is higher or because the loan is an in-house or white label product.
Applying a positive duty to brokers would not, however, necessarily be best achieved by attempting to replicate the financial advice best interests duty given differences between brokers and financial advisers, and the existence of responsible lending and other obligations. If it was to be introduced, careful consideration would again need to be given to an approach that mitigates conflicts of interest risks while avoiding unnecessary compliance costs, and to what extent it can rely on industry efforts or providing ASIC with some discretion or rule-making power.
Finally, with regard to employee incentives, the Treasury paper says that given the impending introduction of new powers for ASIC and the efforts of the banking industry to undertake significant reform itself, it is not clear that further regulatory interventions are merited at this stage. While the policy focus has traditionally been around remuneration, it is also relatively easy for firms to reward staff that are high-sellers (or to penalise poor-sellers) without resorting to a direct link to remuneration. As general obligations already exist to manage such conflicts, the broader issue raised is that of firm culture and governance.
S0, reading the submission, I felt the Treasury was firmly sitting on the fence, acknowledging the issues raised (they could do no other), but falling back to incremental changes, warning of unintended consequences, and pointing the figure at cultural bad practice in financial firms. The regulators escaped scot-free.
Frankly I found the submission all rather embarrassing… and rather missed the point!
I expect the Royal Commission will do better.
