Remove trail, says final Productivity Commission report

While the Productivity Commission (PC) has not recommended that consumers pay mortgage brokers directly through fees for service — as was mooted in the 640-page draft report — it has put forward a recommendation for trail commissions to be removed, despite widespread industry criticism of the idea.

As first outlined in the PC’s draft report and reiterated by the PC’s outgoing chair, Peter Harris, the commission has moved forward with its recommendation for trail commissions to be removed, largely pointing to a belief that it is a conflicted form of remuneration that creates “perverse incentives” for brokers by “rewarding” them for keeping customers in their current loan.

“Trail commissions must be abolished — as they have already been in other parts of the financial system”

Echoing thoughts made by the NSW government’s Fair Trading body earlier this week that trail is not tied to a requirement for a broker to provide any additional advice to their client, the PC's final, 686-page report reads: “The current structures of mortgage broker remuneration appear to have become entrenched more because lenders are reluctant to be a first mover in negotiating alternative approaches than because they are delivering desirable market outcomes. Evidence to the royal commission indicated as much.

“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, if customers were required to pay for broker advice. But change is required — to the role of the lender in being the paymaster — to reduce the scope for damage from conflicted advice.

“Thus, while we propose that upfront commissions remain paid by lenders, we consider that going forward, trail commissions must be abolished — as they have already been in other parts of the financial system.

“We accept that upfront commissions may rise as a consequence of such action.”

The PC continued: “Broking businesses would need to remain commercially viable.

“Industry agreement to abolish volume-based commissions (commissions based on the volume of loans written by an aggregator) must be implemented by all lenders without further delay. The absence of evidence that this is occurring affects industry credibility.”

It continued: “Current industry practice of restricting commission clawback arrangements to 18 months to two years should be imposed by ASIC in an enforceable code across all lenders and include a ban on commission clawback being passed on to borrowers. Lengthy clawback periods act against consumer interests, inducing a costly form of loyalty.

“In the absence of shifting broker remuneration from lenders to customers, which, as we note above, would diminish competition emanating from brokers, a formal best interest obligation is required as an offset to conflict, and it should be comprehensive.”

PC “unconvinced” by industry arguments on trail

While the commission acknowledged that inquiry participants had put forward a range of views as to why trail commissions are paid and what their effect is on broker behaviour (such as “providing an incentive for brokers to achieve good outcomes for their customers; influencing the level of refinancing and reduce ‘churn’; aligning the interests of the broker with those of the lender; and remunerating brokers for providing ongoing services to clients), it added that it remains "unconvinced that trail commissions serve any such purposes”.

“The evidence is not there, certainly not from the banks that pay the commissions nor from the brokers’ associations. It is most likely that a traditional form of remuneration common in the 1990s, when brokers emerged as a competitive force, has simply persisted long after it has been found detrimental to consumers in other financial product markets.

“Despite industry-led initiatives to reform broker remuneration structures, it is apparent that little change is occurring and the principal commission structures continue to create conflicting incentives for brokers,” it said.

“At its simplest, brokers have a strong incentive — regardless of what may be in their customer’s best interest — to give preference in their loan recommendations to lenders that pay higher commissions. This may be uncommon, but there is no obligation for transparency of the payment to prove it,” the report reads.

Negotiating on rate “demonstrably often not in a customer’s interest”

It goes on to say argue that remuneration structures must “also motivate at least some brokers to prefer advising new customers (with a new stream of trail commissions and potential referrals), particularly during the clawback period for an existing loan”.

Further, the PC notes that brokers and the Combined Industry Forum (CIF) “agree that brokers prefer to negotiate with a customer’s existing lender before considering refinancing with another lender”.

According to the PC this “preference for loyalty is demonstrably often not in a customer’s interest”.

“And without any ability to withhold payment as an incentive to receive competitive offers, a consumer is actually in a poorer position to receive quality on-going advice as long as trail commission persist.

“To the extent that brokers’ business models rely on them maintaining ongoing (if infrequent) interaction with customers, they are likely to provide on-going advice irrespective of commissions. We see no case for paying for something (that is, through trail commissions) that is going to happen anyway,” the commission said.

The PC has also taken aim at the market power of the big four banks, highlighting that the banks own more than 75 per cent of the market for loans, personal deposits and credit cards and are in a dominant market position.

The report claims: “There is evidence that they have sustained prices above competitive levels, offered inferior-quality products to some groups of customers, subsumed much of the broker industry and taken action that would inhibit the expansion of smaller competitors in some markets. All are indicators of the use of market power to the detriment of customers.”

The PC’s final recommendations are expected to be considered by the government alongside ASIC’s review of broker remuneration, and the findings of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry before the government makes any decision on the recommendations.

However, Treasury has already outlined in its policy report to the ongoing financial services royal commission that removing trail commissions would “have the potential advantage of removing incentives for brokers to inappropriately recommend larger loans that take longer to pay back”, but that it was “unclear” how significant this incentive was in practice.

Further, Treasury warned that the removal of trails would 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.

Moreover, the government department outlined that, in the United Kingdom, where trail commissions 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”.

It concluded: “Services provided by brokers to customers after a loan has been arranged could also be affected if trailing commissions were removed.”

Treasury also welcomed the work being undertaken by the Combined Industry Forum to reform broker remuneration off the back of ASIC’s remuneration review.

“The CIF proposals are positive developments which Treasury welcomes,” the report reads.

“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. Also relevant in mitigating risks of poor consumer outcomes are APRA’s and ASIC’s general efforts in recent years to improve bank lending standards and lenders’ compliance with responsible lending obligations,” Treasury said.

More to come.

[Related: ‘No evidence’ that brokers limit switching: NAB]