As I said in the Interim Report, almost every person buying a house in Australia will borrow a large part of the cost. Many Australians have home loans with one of the major lenders.[1] At the time of the Interim Report, home loans were, and they remain, the largest asset on the books of authorised deposit-taking institutions (ADIs).[2]
The mortgage broking industry is a key distribution channel for home loans, accounting for more than half of all residential home loans settled.[3] Reliance on the broker channel among the larger banks is varied. Approximately 40% of all CBA loans come through the broking channel,[4] while for ANZ the amount is around 55%.[5] Because of their smaller physical branch presence, smaller lenders are more dependent upon brokers to compete in the home loan market.[6] But brokers are not the only means by which smaller banks deal in that market. Most home loans made by Bendigo and Adelaide Bank are made through the bank’s network of community owned branches.[7] The branch receives a share of the revenue produced by the loan.[8] In addition to this, Bendigo and Adelaide Bank lends to ‘mortgage managers’ who make home loans to customers at a rate higher than the rate charged to the manager by the bank.[9]
Consideration of lending arranged through mortgage brokers must begin by recognising two facts. First, borrowers look to mortgage brokers for advice about how to finance what is, for many borrowers, the most valuable asset they will buy in a single transaction.[10] And brokers not only give advice about what they think is best for the borrower, they submit the loan application on the borrower’s behalf and, to the extent the terms are negotiable, negotiate the terms of the loan for the borrower.
Second, as already noted, it is not easy to determine for whom a mortgage broker acts. The lender pays the broker, not the borrower. Typically, the lender pays a commission, both an upfront commission and a trail commission.[11] For the lender, the broker is a channel for distributing the lender’s products including, but not always limited to, the lender’s home loan products. The lender seeks to foster relationships with brokers that will encourage the broker to recommend that lender’s products. The lender seeks to treat the broker as its broker, and have the broker treat it as the broker’s preferred lender. Yet, at the same time, the lender provides in its contracts with brokers and mortgage aggregators that they act for the borrower, not the lender.[12]
Not only do borrowers look to mortgage brokers for advice about mortgages, the brokers themselves and the Mortgage and Finance Association of Australia (MFAA, an industry association) publicly emphasise both the skills and help that brokers can offer to clients in securing the best outcome for the client.[13] As ASIC reported in March 2017, the three main reasons consumers then gave for using a mortgage broker were to ‘Access a wider range of loans’, to ‘Get a better interest rate/deal’, and because the ‘Broker is knowledgeable/an expert’.[14]
Yet, despite brokers playing this advisory role, the Corporations Act 2001 (Cth) (the Corporations Act) provisions about providing financial product advice to retail clients do not apply to giving advice about a residential home loan. Those provisions do not apply because a mortgage that secures obligations under a credit contract (not otherwise expressly included by operation of some particular sections of Chapter 7 of the Corporations Act) is not a ‘financial product’ for the purposes of Chapter 7 of the Act.[15] Hence, making a recommendation or stating an opinion about a mortgage is not giving ‘financial product advice’.[16] And it is not considered to be personal advice, even though the broker would be expected to consider the borrower’s objectives, financial situation and needs.[17] It follows that the best interests duty that the Corporations Act imposes on those who provide personal advice to a retail client[18] does not apply to a mortgage broker.
Internal papers prepared by CBA when the Sedgwick Review[19] was considering broker and other remuneration compared the fees received by a mortgage broker with the fees charged by a financial adviser for personal financial advice to a retail client. The fees charged by a broker were said to be higher than the fees charged for financial advice (the figures quoted were about $6,600 compared with $2,300).[20] No doubt the two tasks differ. The financial adviser must reduce the advice to writing, as a Statement of Advice; the broker need not. The broker will take the information provided by the client and turn that into a loan application that the broker will submit. But the difference between the fees is striking. And it is all the more striking when it is recalled, as it must be, that home loans are not complicated financial products.
For the purposes of the NCCP Act, a mortgage broker who suggests a particular home loan, or helps a borrower obtain the loan, will be a ‘credit assistance’ provider, a ‘credit representative’, or a ‘representative’ of the credit licensee that will be the lender.[21] A mortgage broker thus engages in a credit activity and must hold an Australian Credit Licence (ACL) or be an employee or credit representative of a mortgage aggregator (or other entity) that holds an ACL.[22] The holder of an ACL must do all things necessary to ensure that the credit activities authorised by the licence are engaged in efficiently, honestly and fairly, and they must have in place ‘adequate arrangements to ensure that clients … are not disadvantaged by any conflict of interest that may arise wholly or partly in relation to credit activities engaged in by the licensee or its representatives’.[23] But if a broker does suggest a particular home loan to a borrower, the broker is not bound by a statutory best interests duty.[24] Is there then a gap between what a borrower expects a broker to do and what a borrower can require the broker to do? If there is a gap, does it matter? That must be determined in light of the ways in which the broker channel of home loan origination has been shown to be operating. Two particular matters should be noted: first, the nature and extent of misconduct identified in the course of the Commission’s work and second, what is known about outcomes for customers whose home loans have been arranged through an intermediary.
2.1.1Misconduct
Use of any intermediary, be it an introducer, a mortgage broker or a mortgage aggregator, means that there is an additional level at which the intended relationship between lender and borrower can be distorted in some way. The lender is isolated, even insulated, from what the intermediary does with the borrower.[25] The intermediary may pass on information to the lender that is wrong; the intermediary may join forces with either the would‑be borrower or with one or more employees of the lender to deceive the lender. Examples of these kinds of conduct were examined in the Commission’s work and are the subject of case studies discussed in the Interim Report.[26]
Cases where the use of a broker (or other intermediary) results in the lender receiving incomplete or false information on which to assess the proposed loan are of most immediate relevance.
When the Commission first took evidence about these issues in March 2018, it was evident that in many cases brokers assembling information about a loan applicant’s financial situation either did not make sufficient inquiries, or did not seek sufficient verification of what they were told, about these matters.[27] The fact that so many home loan applications then proceeded with the lender assuming that the borrower’s living expenses were equal to the HEM, not as the borrower declared them to be, could lead only to the conclusion that the broker had not taken effective steps to inquire about the borrower’s expenses or to verify the expense information the borrower had given.
The fact that the broker is paid only if a loan application succeeds stands as an obvious motive for that kind of conduct. It is in the broker’s financial interests to have the lender approve the loan. And, as both the NAB Introducer home loans and the Aussie Home Loans broker misconduct case studies showed, payments by banks to intermediaries have induced some to engage in other forms of dishonest conduct.
Since the Commission took evidence on these matters, lenders have changed their processes and procedures to capture the financial situation of loan applicants more accurately. I am not able to say how effective those changes have been. NAB has reduced the numbers of ‘introducers’ it uses.[28] CBA is selling the Aussie Home Loans business.[29] But the financial incentive (being paid commission by the lender) for brokers to secure approval of home loan applications remains. And because the amount paid varies with the amount of the loan, it is an incentive to brokers to have the borrower take as large a loan as the borrower can afford, regardless of whether the borrower needs to borrow, or is wise to borrow, that sum.
Even when the amount of commission paid, and to be paid, to the broker is disclosed, the immediate sting of the payment is not felt by the borrower because it is the lender that pays the commission. On reflection, the borrower may recognise that the cost of commission, like all other costs of the lender, will affect the price that is charged for the loan. But there is not that immediate and direct connection that would be observed if the fees charged by the broker for the work done were charged to the borrower, either directly or by paying the fees out of the amount borrowed.
2.1.2Customer outcomes
In the Interim Report, I noted what CBA, Australia’s largest home lender, had said to the Sedgwick Review, and what had been found by ASIC, about broker remuneration driving undesirable customer outcomes.[30] In its submission to the Sedgwick Review in February 2017, CBA said that ‘the use of loan size linked with upfront and trail commissions for third-parties, can potentially lead to poor customer outcomes’.[31] In its March 2017 report, ASIC found that:
- broker loans were reliably associated with higher leverage, even for customers with an identical estimate of risk;
- loans written through brokers have a higher incidence of interest-only repayments, have higher debt-to-income levels, higher loan-to-value ratios and higher incurred interest costs compared with loans negotiated directly with the bank; and
- over time, higher leverage means broker customers have an increased likelihood of falling into arrears, pay down their loans more slowly and on average pay more interest than customers who dealt directly with the bank.[32]
ASIC’s findings were consistent with, indeed appear to have been based on, work CBA had done in October and November 2016 looking into consumer outcomes for borrowers who used brokers. CBA made a five–year longitudinal study of those outcomes and presented the results of that work to ASIC.[33] These consequences are consistent not only with value‑based commissions driving the results observed, but also with the payments being made by lenders rather than borrowers driving the results. If there are other causes of the results, they are, at least, less obvious.
Value‑based commissions paid by lenders to mortgage brokers are a form of conflicted remuneration. That is, value‑based commissions are a form of remuneration that can reasonably be expected to influence the choice of mortgage, the amount to be borrowed, and the terms on which the amount is borrowed. The evidence from CBA showed that the size of commissions has an effect on which lender the broker recommends to the borrower.[34] The size of commissions also affects the size and terms of the loan. On their face, the outcomes demonstrated by CBA’s work and described in their submission to the Sedgwick Review, and confirmed by ASIC, constitute the realisation, in fact, of the expected effect.
It is evident that, after CBA had made its study of customer outcomes, it gave very close consideration to changing the terms on which it would offer to deal with brokers. In his then capacity as head of Retail Banking Services within CBA, Mr Comyn was on the edge of announcing a change to a fixed fee model, paid by the lender, but did not proceed.[35] He decided that other lenders would not follow CBA’s lead without regulatory compulsion, and that, if CBA changed, it would suffer commercial detriment (by losing custom from brokers) for no real benefit for consumers.[36]
2.1.3More recent changes
After CBA made its submission to the Sedgwick Review and the report of that review was published, and after ASIC published its report about broker remuneration, the Combined Industry Forum (CIF), composed of industry bodies and financial services entities, considered, and published reports about, changing broker remuneration. And the submissions made to the Commission in response to the Interim Report have also considered these issues.
In December 2017, the CIF released a report setting out reforms to broker remuneration agreed upon by its members.[37] The changes included paying commissions based on the amount of funds actually drawn down by a customer (rather than the size of the loan approved), ceasing volume and campaign-based commissions, limiting the value and availability of rewards such as entertainment and overseas trips, and developing a mortgage broking industry code.[38]
In July 2018, the CIF reported that its members had eliminated volume-based commissions and mooted the adoption of a ‘customer first’ duty.[39] These proposals reflected some, but not all, of the recommendations the Productivity Commission had made about broker remuneration in its report on competition in the Australian financial system.[40]
As I said in the Interim Report, the CIF reforms announced are limited. While the perverse incentives created by volume-based commissions, which reward brokers for the number of customers placed with a lender, are to be removed, upfront and trail commissions based on loan value will remain. While basing those commissions on funds drawn down will remove an incentive for brokers procuring a loan larger than the borrower will use, the change will not deal with the more basic problem of borrowers being encouraged to borrow more than they need.[41]
Nor has it been made clear what would be the content of a ‘customer first’ duty. On its face, it appears to differ from the duty to act in the best interests of the client that the Corporations Act imposes on financial advisers. Rather, it appears to be a duty to give preference to the client’s interests in cases where the client’s interests and the broker’s interests do not coincide. That is an obligation, however, that is markedly narrower than a best interests duty. And it has not been explained why the duty a mortgage broker owes to a borrower should differ from the duty a financial adviser owes to a retail client.[42]
Further, the reforms proposed by the CIF would not alter the basic structure of brokers’ remuneration – lenders paying value‑based upfront and trail commissions in respect of loans made. It is those elements of the structure that drive poor customer outcomes.
It is important to recognise, as the Productivity Commission has in its report on competition in the Australian financial system, that ‘a credible rationale based on consumer interests for the structure of broker remuneration’ has not been identified.[43] Rather, and as the Productivity Commission also said, ‘a particular set of remuneration arrangements [has] become entrenched in the mortgage broking industry as a matter of convention’.[44] Entrenched convention may provide a sufficient explanation for current practice. But, however deeply entrenched may be the convention, it provides no answer to the more fundamental and telling observations: first, that the remuneration arrangements have no credible rationale based on consumer interests; and second, that they actually work against consumer interests.
Yet ASIC, and others, submitted that ‘it is too early to determine whether these changes to remuneration [suggested by the CIF] go far enough, and whether a complete prohibition on conflicted remuneration is necessary’.[45] And both banks and brokers have resisted change[46] even though documents produced to the Commission showed that in recent years, senior and experienced bankers had favoured moving to a system where brokers charged borrowers a fee for the services the broker provided.[47]
Brokers will undoubtedly say that the views of the bankers should be discounted. It will be said that bankers are doing no more than trying to advance the interests of banks; however, the same proposition can be applied with no less force to the views of brokers. Arguments for or against change should all be approached with a proper degree of scepticism. And, when viewed in that light, I consider that the arguments for change are compelling.
In discussing those arguments for change it is useful to begin by considering trail commissions.
[1]FSRC, Interim Report, vol 1, 30.
[2]FSRC, Interim Report, vol 1, 30.
[3]FSRC, Interim Report, vol 1, 32.
[4]Transcript, Matthew Comyn, 19 November 2018, 6558.
[5]Transcript, Shayne Elliott, 28 November 2018, 7281.
[6]ACCC, Residential Mortgage Price Inquiry Final Report, November 2018, 10, 58.
[7]Transcript, Robert Johanson, 29 November 2018, 7381.
[8]Transcript, Robert Johanson, 29 November 2018, 7381.
[9]Transcript, Robert Johanson, 29 November 2018, 7381.
[10]See Transcript, Matthew Comyn, 19 November 2018, 6561; Transcript, Shayne Elliott, 29 November 2018, 7338.
[11]FSRC, Interim Report, vol 1, 32.
[12]FSRC, Interim Report, vol 1, 57.
[13]See, eg, MFAA, Your Broker Behind You (20 December 2018) MFAA <www.mfaa.com.au/yourbrokerbehindyou>.
[14]ASIC, Report 516, 16 March 2017, 176.
[15]Corporations Regulations 2001 (Cth) reg 7.1.06(1)(f).
[16]Corporations Act s 766B(1).
[17]Corporations Act s 766B(3).
[18]Corporations Act Pt 7.7A Div 2.
[19]An independent review into remuneration practices in retail banking commissioned by the ABA in 2016. The Sedgwick Review is considered further in the chapter on culture, governance and remuneration.
[20]Exhibit 7.15, 12 April 2017, Email Comyn to Narev, 3 [4.3.1]; Transcript, Matthew Comyn, 19 November 2018, 6579–85.
[21]NCCP Act ss 8, 64 and Pt 2-3.
[22]NCCP Act s 29.
[23]NCCP Act s 47(1)(a) and (b).
[24]I say ‘statutory’ best interests duty because there may be cases where the general law would impose a duty on a broker to act in the interests of, and only in the interests of, the intending borrower. But that would depend entirely on the facts of the particular case.
[25]FSRC, Interim Report, vol 2, 24.
[26]FSRC, Interim Report, vol 2, 1–14, 16–32, 32–41, 43–51.
[27]See, eg, FSRC, Interim Report, vol 2, 24–6.
[28]Exhibit 7.80, Witness statement of Andrew Thorburn, 19 November 2018, 10 [32(a)].
[29]Transcript, Matthew Comyn, 19 November 2018, 6560.
[30]FSRC, Interim Report, vol 1, 59–60.
[31]FSRC, Interim Report, vol 1, 60.
[32]ASIC, Report 516, 16 March 2017, 14 [51]–[52].
[33]Exhibit 7.10, November 2016, CBA Slide Pack of November 2016 Concerning Customer Outcomes; Exhibit 7.11, November 2016, CBA Slide Pack Customer Outcomes Update of November 2016; Exhibit 7.12, 31 October 2016, Memorandum of Commonwealth Executive Committee and Slide Pack of October 2016; Transcript, Matthew Comyn, 19 November 2018, 6563–5.
[34]Exhibit 7.10, November 2016, CBA Slide Pack of November 2016 Concerning Customer Outcomes; Exhibit 7.11, November 2016, CBA Slide Pack Customer Outcomes Update of November 2016; Exhibit 7.12, 31 October 2016, Memorandum of Commonwealth Executive Committee and Slide Pack of October 2016; Transcript, Matthew Comyn, 19 November 2018, 6563–5.
[35]Transcript, Matthew Comyn, 19 November 2018, 6585.
[36]Transcript, Matthew Comyn, 19 November 2018, 6585.
[37]CIF, Response to ASIC Report 516, December 2017.
[38]CIF, Response to ASIC Report 516, December 2017, 4–5.
[39]CIF, Working Towards a Better Mortgage Broking Industry for Customers, July 2018, 12, 18.
[40]Productivity Commission, Report 89, 29 June 2018, 331. The Commission recommended: banning trail commissions; requiring upfront commissions to be based on funds drawn; banning volume-based commissions and payments and campaign‑based commissions; and limiting the clawback period to two years.
[41]FSRC, Interim Report, vol 1, 62–3.
[42]FSRC, Interim Report, vol 1, 63.
[43]Productivity Commission, Report 89, 29 June 2018, 329.
[44]Productivity Commission, Report 89, 29June 2018, 330.
[45]ASIC, Interim Report Submission, 29 [129].
[46]See, eg, Finance Brokers Association of Australia, Interim Report Submission, 1–2, 11–12; Mortgage Choice, Interim Report Submission, 9–10; Aussie Home Loans, Module 1 Policy Submission, 6–7; Westpac, Interim Report Submission, 8–9; Regional Banks, Interim Report Submission, 15–17; NAB, Interim Report Submission, 49 [205].
[47]Exhibit 7.9, October 2016, Emails between Comyn and Narev, 4.