RC & Broking

28/11/2018

Plenty happening in the financial services industry, especially with CBA’s “honesty” in dealing with the Royal Commission (“RC”) during the final round of its inquiry.

The RC appears to be advocating a fundamental change of remuneration arrangements for the industry.

What is missing from the discussion to date, are some unaddressed pieces of the puzzle – Who is the Broker working for, Distribution and Trust.

Background

The finance broking industry is relatively young in Australia when benchmarked with other professional service categories such as accounting, insurance and financial planning.

There is greater data being collated on the industry which provides some insights into average earnings and performance of finance brokers. 

As a sweeping commentary, the industry participants are widely dispersed and are generally “micro businesses” that could not operate on a sustained basis without the active involvement of its owner. 

As a collective, they are certainly not earning “millions” as was emotively raised in the RC hearings.

Research, such as the July 2018 Deloitte Access Economics Report “The Value of Mortgage Broking” stated that on average 56% of residential mortgages were completed by brokers, and that the average mortgage broker has almost 14 years of relevant experience.

Supporting these finance brokers are aggregation groups which compete for the circa 14,000 active industry members.  

In short, the financial insights provided by all stakeholders (aggregators, industry groups, research groups etc) has been very professional and substantive, but regrettably appears to be falling on deaf ears or is otherwise being dismissed as self-serving.

Who does the Broker Work for?

Commissioner Hayne raised this relevant question at the outset of the RC. 

I would agree it is not clear. Though one consideration confirms why value based or commission-based remuneration is a better model than fee for service.

Why?  The answer is in the functional work that the broker now does as part of the mortgage process.  More of this work is work that would normally be done by a financier (think compliance, loan submission, loan document coordination etc.) as opposed to work that would be normally done by the applicant.

This is the challenge for a fee for service model in this industry. 

The lenders technically will prescribe that brokers are not agents or representatives, but a broker defrays so much of the work that would normally be done by them.

That component is all about opportunity cost for the lenders.

There is value to the customer too of course. Brokers have connection to their customers and would generally feel that they work for them.

However, the increasing processing / oversight is not something the customer would say is a value add or solves a separate problem for them, as it needs to be done by someone (the lender traditionally) in any event. 

So why would Customers pay materially for that?

The other challenge for a fee for service model is pre-work.  Brokers must spend a lot of time determining whether they can in fact provide a service at all.  The data gathering (think living expenses as an example) and Preliminary Assessment requirements are considerable.  Regulation now takes this to another level too.

Do customers want to pay for that if there is no outcome at the end of the process?

Distribution

There is a lot of talk of “product led” advice/sales etc. The real context is all about Distribution.

Distribution is a key plank in any business or industry.  It is all about how you make your services available, and who you make them available to.  For example, a travel agent is part of an airline’s distribution strategy.

This can only happen after you have established Positioning as a brand (e.g. are you Emirates or Jetstar?) – this is where organisations like CBA can face challenges.

The CBA are probably the best placed banking institution in Australia that could sustain their business without a third-party channel.

Why?  They have sunk costs (branches, mobile lenders etc. – established Distribution) and shifting away from paying broker introduced mortgages delivers more margin and utilises spare capacity.

Let’s consider Distribution for other financial institutions where the opportunity cost is not just soaking up fixed sunk costs.

Opening a bank branch might be say around $1.5M initially, and that is before it is staffed adequately.  Then there is the challenge of training staff in a more complex mortgage environment. It is a substantial fixed cost commitment which has to be funded somehow.

The Productivity Commission found that: “If mortgage broker services were not available, these [smaller] lenders would, on average, need to have an additional 118 branches each in order to maintain their current market shares in the home loan market.”

As an alternative, Mortgage Brokers are a variable cost distribution platform.  Whilst the research is not always explicit, the consensus is wide that the third-party channel is generally a more cost-effective form of distribution.

This was a point that Macquarie Bank CEO Nicholas Moore was talking to during his time in the witness box at the RC.

So, getting rid of commissions to brokers will certainly help CBA, but if other participants are to continue, they will need to replace a reduced variable cost base with an increased fixed cost.

Trust

The broader community may not be aware that the RC is not the start of a process, rather it follows an intensive period of time of regulation in banking.

The finance industry will continue to go up another level in terms of its professionalism; and with that Australian Credit Licence holders will be on notice that the depth of expectation from regulators and the like will continue to grow.  

Though there is a missing ingredient, trust.

We have financiers, regulators, aggregators all scrambling for more data about borrowers.  No-one is entirely sure what they are actually looking for or indeed the outcome they want, this is leading to enormous inefficiency and duplication.

This happens when there is fear, and an absence of trust for all the links in the chain.

Government must accept, just like the RBA Governor alluded to recently, that some borrowers will fail, and we cannot totally reduce risk in every market.

Trust ironically is not in short supply with consumers.  Research completed by Deloitte, the MFAA and others showing very high satisfaction ratings from their broker experience, and remember, people still have a choice whether they engage a broker or not.  

Ironic indeed.