OFFICIAL RESPONSE – Banking Royal Commission

Written by Andrew Pribil (Managing Director – A&C Finance Group)

Impact of the Royal Commission – We Remain Open for Business!

Firstly, I wish to preface this article by saying A&C Finance Group is still proudly open for business and we look forward to continuing our support of Australians as they build their futures. Any of the relevant changes recommended by Kenneth Hayne’s Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry are not due to commence for another 18 months and wouldn’t be fully implemented for another two-three years.  Thanks also to all of my loyal clients who have reached out to see what impact this will have on me and my family. As long as I have a job where I can still provide value to my clients through our focus on service, regardless of the outcome of the royal commission, we will still have a viable business model.

I look at this from a relatively unique perspective. Our mortgage broking business has been operating for more than four years now, and I have almost 10 years’ experience working in mortgage for major banks. Roles I have had cover frontline lending, leading/managing teams of mortgage writers and head office roles overseeing the national business. As a result, I have an entrenched understanding of banking culture & systems in the mortgage space, as well as the broader broking operation.

What has changed?

The key recommendations as part of Hayne’s royal commission affecting the ~17,000-20,000 brokers operating in Australia relate to trail and upfront being banned, which are currently paid by the banks at no cost to the consumer. Hayne has instead recommended we adopt the Dutch model, where borrowers pay a fee when speaking to either a bank or branch lender about their mortgage.

The surprising aspect of the ruling, which many industry commentators are struggling to understand, is that the outcome of the royal commission into the big banks will result in them being more profitable, their competition largely removed and consumers having to pay an extra fee.

At present, brokers receive an upfront commission of ~.65% for any settled loan and an ongoing trail of ~.15%, fully funded by the banks at no cost to the consumer. Removing these payments will save banks an estimated $2.6 billion per annum, with a substantial benefit also procured from the increased business flow they’ll receive from reduced competition.

There is little doubt these proposed changes would materially shift the economics of the broking industry whilst further strengthening the major banks. The majority of consumers when surveyed stated they would not be willing to pay a fee, meaning the entire income base for brokers would disappear. Similar studies have also estimated that up to 60% of Brokers would cease operation immediately.

One of the biggest issues with this scenario relates to the significant reduction in competition. Brokers provide a shopfront for smaller lenders who invariably offer discounted rates. Given that major banks have to compete for the same business, this puts downward pressure on rates. If these recommendations are adopted in full it would obviously channel more activity back to the branches, entrenching the oligopoly they already enjoy. Once they regain market dominance (control is probably a more apt term), we then have to trust the banks to manage interest rates responsibly; highly unlikely in the absence of serious competition. More so given their historical proclivity to raise rates outside of the RBA’s standard rate cycle.

An element of this decision that has largely slipped through unnoticed is that the Dutch model legislates banks also need to charge a fee for any mortgage discussion, so it wouldn’t be solely brokers charging this fee. Whilst there is some cynicism about banks being able to waive this given their sheer size, the proposed system is meant to work as a free market mechanism, where cost is negotiated depending on the value delivered. Not only will this be an extra cost to the consumer, it also nullifies the ability for clients to refinance. Given other costs involved to move banks of ~$500-$700, it is hardly worth it if there’s an extra $2k-$3k fee on top.  On average, we save our clients who refinance around $2,500 p.a. and review this every 2-3 years to ensure they remain at the bottom end of the market rate-wise. Ironic that this factor has been ignored considering legislation introduced in 2011 by Labor’s Wayne Swan had the stated intent of encouraging borrowers to refinance more regularly.

The vast majority of brokers are trained experts who spend their time researching deals to align bank products with their clients’ situation. They are constantly monitoring the market to secure the best deals possible for both new and existing clients as their circumstances evolve; a behaviour which the current model encourages. The average mum and dad do not have the time or inclination to visit several banks to ascertain the best deal for them. Any new model without brokers will result in prospective borrowers simply going to the closest branch and getting it done there to expedite the process, and who knows if that’s the best deal for them? Retail banking has long moved away from a relationship model where bankers regularly contact clients to ensure the structure implemented has kept up with any subsequent life events. Nor will a bank be proactive and ring a client to see if they can improve their interest rate. The outcome will be clients sitting on the bank’s back book longer than they should, paying interest rates that are far too high. It seems a bizarre system to actively promote.

In terms of the other issue that the broking industry is concerned about, I won’t address the worth or otherwise of trail in great detail. Whilst I don’t think it is ‘right’ that brokers would not get paid for ongoing maintenance work, its removal wouldn’t be industry destroying like removing upfront payments. In isolation, I also foresee further maintenance enquiries being sent to bank staff rather than the broker, which would again be a considerable impost for the majors who already struggle with the complex aspects of a home loan. More numbers, more dollars spent, more branches/sites and more training – what would that do to rates?

Why was the decision made?

I like to view myself as a logical thinker, so have spent some time considering all possible reasons that could have led to these recommendations. Obviously, having a vested interest clouds my perspective, but I’ve carefully analysed Hayne’s explanations in a bid to find some reasoning.

To give this some context, a recent DNB study noted Australia as having one of the lowest default rates on mortgages in the developed world, pointing to a system that is fundamentally strong. A good place to start is to understand what problem we’re trying to solve and Hayne stated we need to ensure individual lenders aren’t incentivised to provide loans that clients can’t afford.

Hayne was particularly concerned about a prevailing sales culture within financial institutions, where bankers and brokers were incentivised to lend beyond what a customer could afford. Certainly an understandable issue, but one which has been addressed recently by banks altering the minimum expenses figure they use as part of their serviceability calculations and brokers no longer being paid on funds sitting in an offset or redraw account. This reduces the incentive for brokers to lend right up to a client’s borrowing capacity to maximise commission and also ensures banks are actively policing the affordability element. Along with the royal commission’s recommendations around further resourcing for our regulators and greater penalties for misconduct, problem solved I would have thought. But Hayne clearly disagrees.

In his commentary, Hayne also noted a lack of transparency around what broker commissions mean for the final interest rate. Obviously, banks build-in commission payments when their Treasury departments calculate interest rates and Hayne saw this as an issue that needed to be immediately resolved. I’m struggling to believe that an obviously intelligent and successful professional would put his name to such a view, as it does nothing but highlight a stunning lack of commercial acumen on his behalf.

Not only are broker commissions factored into the final ‘price’, but so are banker wages, Superannuation payments, branch leases, electricity costs, sick leave, management costs, etc. In fact, senior management at certain major banks have discussed the need for branch lenders at all, given the costs are so great to pay all of the above; often for sub-standard results. The existing model is substantially cheaper for the banks, given the reduced fixed costs involved, meaning the potential for further downward pressure on rates. If brokers are removed, banks would need to employ more staff to meet the demand and will have a sizeable training impost ahead of them. On-boarding hundreds of new lenders would be a substantial task and customer satisfaction would be expected to plummet during this phase. Whilst more profitable in totality due to limiting competition, it is the cost base that affects the interest rate decision and this cost base will be neutralised at best. A pretty obvious outcome I would have thought, but one which escaped Hayne and is also a view embarrassingly repeated by the Sydney Morning Herald’s Jessica Irvine without even considering what the flow-on effects would look like. Did Hayne ever think of asking about the ‘complex web’ related to banker salaries/bonuses?

On a similar note, there is a belief that brokers channel business to certain lenders based on the size of their commission. Whilst this may have been a legacy issue, for someone such as myself who has been a broker for just over four years, the ‘spread’ of upfront commissions for any lender I have worked with is only .075% or $75 per $100k settled. If anyone is making a decision around bank selection based on $75, I dare say they wouldn’t be broking for long. Even if this was merely an issue of perception, then legislating for every bank to offer .65% (for example) would solve the problem. In fact, Bankwest experienced some of the strongest growth through the broker channel of all lenders over the past four years, and they would pay a broker the least over the first 12 months throughout this period. Brokers will always value the rate they can secure, fit for the client and overall efficiency of the process ahead of a negligible return. It is poor business to approach the transaction in any other way, and the market would certainly deem any such operator as unworthy.

The other thought process I’ve pursued is around why the Dutch model has been deemed superior to Australia’s existing structure. Again, there is minimal data to support this. The same DNB study referenced above shows the Netherlands has a mortgage default rate almost double that of Australia’s – .96% vs. .50%. The Netherlands’ system also allows borrowers to claim as tax deductible all interest and other charges on the home mortgage, meaning there is a lower cost base for the end customer.

Finally, I thought there must have been strong consumer sentiment demanding a change I was oblivious to. So I looked at the numbers. An FBAA study last year showed that around 96% of broker clients were satisfied with their interaction. As referenced above, almost 60% of consumers use a mortgage broker (up from around 40% just five years ago) as opposed to a bank lender; numbers that don’t exactly point to an immediate need to completely overhaul the current model.

Whilst I wouldn’t question that ‘predatory’ sales behaviours can exist when a financial return is possible, the commission’s recommendations for harsher penalties and further resourcing for our regulators goes a long way to removing this carrot. As do the changes to broker remuneration for funds in offset/redraw and banks ‘beefing up’ their servicing calculators to more accurately gauge what a client can afford. It seems like Hayne has erroneously coupled mortgages, a largely commoditised product, with financial advice, which is a specialised stream that would never sit in the retail sphere. The arguments made in support of all but decimating the broker industry seem very basic, with unintended consequences far greater than any problems that may exist. There is a very tenuous platform to close 17,000-20,000 businesses, charge consumers more fees, reduce competition and increase the major banks’ profits.

The cynical view

I’m the furthest thing from a conspiracy theorist and plan to keep my metaphorical tin-foil hat well and truly shelved.

However, the outcome of this seems too perfect for the banks to completely ignore some of the industry whispers. More so after the ACTU revealed correspondence between the majors and Government prior to the commission commencing, which helped frame how this would play out. If you recall, the banks originally called for the royal commission after extended debates on the topic, led by the Federal Opposition and various pressure groups. Very interesting when you consider the final outcome.

Throughout the process, CBA’s CEO Matt Comyn even suggestion his bank was a week away from adopting a fee-for-service model but it was obvious that CBA as the largest bank had the most to gain from such a move. It was a clear vested interest that would be ignored. Comyn’s belief was that the Dutch model was superior and the approach we needed to take.

Astonishingly, the final recommendations were basically what Comyn suggested verbatim. Being the biggest branch network, CBA’s natural market share hovers around the 30% mark for all mortgages if you solely consider proprietary channels (home loans written by CBA branded mortgage writers). However, if you look solely at where brokers distribute business, CBA’s market share reduces to around 18%. Removing brokers would channel more business back to them and they would be the main beneficiary. It’s no surprise that both CBA and Westpac (with the second largest natural market share) have quickly endorsed these recommendations.

As mentioned above, the royal commission into misconduct that was largely initiated due to the poor behaviour of the major banks has resulted in them being more profitable and reducing their competition. Was the result pre-determined when they agreed to the royal commission? Were banks too uncomfortable with no longer having control over 60% (and rising) of all home loan clients? Just how powerful is their lobby group the Australian Bankers’ Association (ABA) vs. the MFAA & FBAA? Did their lobbying have any impact?

I can’t answer these questions, but the market certainly didn’t expect this result. For those who follow it, share prices factor in certain expected outcomes. If the outcomes aren’t as bad as expected, share prices increase. If the outcomes are worse, the share price falls. Following last Monday evening’s recommendations being released, we saw strong increases in bank share prices and a precipitous drop in aggregation companies (who represent brokers).

Again, very interesting.

Where to from here?

Whilst the current Treasurer, the Coalition’s Josh Frydenburg, has opposed the removal of upfront fees, the likely Treasurer post-May, Labor’s Chris Bowen, has stated his Government would implement all recommendations in full.

Regardless of who is in power, a bill still needs to be formed and voted on by both Houses of Parliament before it becomes legislation. It is very likely Independents will ask the same questions the current Government has, all of which will take some time.

Recent views broadcasted by 3AW’s Tom Elliott, financial commentator Peter Switzer and RBA Governor Phil Lowe have started driving sentiment against the key recommendation relating to upfront payments. NAB has also publicly stated broker upfront payments should increase as a result of trail income being removed. Along with the stance made by the current Government, there is certainly hope for a positive outcome and that complete market dominance won’t be handed to the big four. There is also a change.org petition with over 64,000 signatures collected in less than a week, whilst the MFAA and FBAA are initiating their own campaigns to challenge the outcome.

A&C Finance Group will continue operating, so all my loyal clients have no need to fear. However, new starters and those with a smaller client base will likely leave the industry; competition that the market sorely needs. Brokers are there to represent and work on behalf of the client. If they’re not doing that, the market will ensure they don’t get referrals and their business won’t succeed. Moving to a model where the consumer has to deal with the bank creates a flawed system – nobody knows where the competition sits and the client is forced to navigate their way through this time consuming process on their own.

The outcome of the royal commission simply can’t be that the major banks increase their control of the market, consumers pay more fees and competition is severely reduced. I have faith that common sense will (eventually) prevail, but it will take some work.

Andrew Pribil
Managing Director
A&C Finance Group Pty Ltd