Trail not main target, but royal commission still concerned about remuneration

The royal commission’s interim report has not come out against trail payments, but it does raise other issues relating to how brokers are paid, what their responsibilities are and whose interests they serve in a transaction.

“The case studies undertaken in the first round of hearings showed that there had been occasions when profit has been allowed to trump compliance with the law, and many more occasions where profit trumped doing the right thing by customers,” the report said.

In the report released last Friday afternoon (28 September), the commission wrote that in order to understand the misconduct that took place, two questions must be considered: for whom do intermediaries act and what are the effects of value-based remuneration?

Brokers represent lender or borrower?
On the first point, the royal commission expressed concerns that while a borrower may believe and expect an intermediary to act in their best interests, their statutory duty is only need to determine whether a loan is unsuitable. This was a sticking point for the Productivity Commission as well. The PC recommended that the government impose a best interests duty on mortgage brokers, as was done in the financial planning space in 2013.

“There is no doubt that in the eyes of at least some lenders, the broker’s task is to sell that lender’s products,” the royal commission wrote.

The Combined Industry Forum has agreed to expand its definition of a ‘good consumer outcome’ to incorporate a ‘customer first duty’, which it said is based on putting the customer’s interests first and matching their needs with the right home loan product and lender. The details of that are still being worked out.

The royal commission said it’s unclear how a ‘customer first duty’ differs from a ‘best interests duty’.

“If the two forms of duty are to be given different content, why the duty a mortgage broker owes to a borrower should differ from the duty a financial adviser owes a retail client.”

Where does the RC stand on remuneration?
The royal commission considered the Sedgwick review into retail banking remuneration, the ASIC review into mortgage broker remuneration and the submissions from banks, aggregators and broker groups, but it still seems to be grappling with many questions around broker remuneration.

The interim report provides no recommendations, so it’s difficult to get a sense of what it might conclude on this front in its final report, due out on 1 February.

What is clear is it did not attack trail like the Productivity Commission did in its August report. The latter recommended that trail be banned.

That said, the royal commission is not going easy on brokers.

“What is plain, however, is 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 royal commission stated.

During the first round of hearings, both CBA and ASIC identified some of the consequences of value-based remuneration, including higher leverage, higher incidence of interest-only loans, higher LVRs, and over time, an increased likelihood of borrowers falling into arrears, the report said.

The Commission noted that while the Combined Industry Forum has pledged to make changes to broker remuneration, including paying commissions based on the amount of funds drawn down and used by the customer and some lenders have already begun doing so, “the reforms announced are limited”.

This echoes the sentiment of the Productivity Commission, which said evidence of actual implementation of the CIF’s reforms were “thin on the ground”.

“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. As noted elsewhere in this report, value-based remuneration conflicts directly with customers’ interests,” the royal commission said.

While the CIF has not released a statement in response, the MFAA said the CIF’s package of reforms was aimed at removing some incentives and addressing others that could lead to poor customer outcomes “in a way that is appropriate to the industry, and protects competition and customer choice”.

“Through the reforms recommended by the Combined Industry Forum, volume-based bonus payments have now ceased throughout the industry, but the MFAA does not believe there is value in entirely removing the correlation to the economic value which brokers produce in the loans they originate for lenders.”

Now what?
The royal commission’s next round, starting on 19 November in Sydney, will focus on policy questions arising from the first six hearings. Those questions are listed at the end of the interim report.

In regards to intermediaries, the Commission will look at a number of issues, including on whose behalf they act and what duties they owe customers; how they should be remunerated; and whether the ‘not unsuitable’ test is enough. It will then provide recommendations to government.

The public is welcome to make written submissions on policy issues identified in the interim report by 26 October.