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GPO Box 144

Sydney NSW 2001

1300 554 817

enquiries@mfaa.com.au

26 October 2018

The Hon Kenneth Hayne AC QC

By email: FSRCSolicitor@royalcommission.gov.au

Dear Commissioner,

MFAA Response to the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry – Interim Report

On behalf of the Mortgage & Finance Association of Australia (MFAA), we welcome the opportunity to submit a written response to the Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (the Commission).

About the MFAA

With over 13,800 members, the MFAA is Australia’s leading professional association for the mortgage and finance broking industry. The stated purpose of the MFAA is to advance the interests of our members through leadership in advocacy, education and promotion. To achieve this aim, the MFAA promotes and advances the broker proposition to a range of external stakeholders including governments, regulators and consumers, and continues to demonstrate the commitment of MFAA professionals to the maintenance of the highest standards of conduct, education and development.

Outline of this Submission

This submission is divided into two parts. The first section will draw the Commission’s attention to different reform initiatives currently underway to improve customer outcomes, while preserving competition in the mortgage broking industry. We ask that the Commission considers these efforts when drafting its final report. The second section of this submission will directly address a number of questions posed in the Interim Report which are of particular relevance to the MFAA and its members.

Should the Commission require further information to supplement this response, please do not hesitate to contact me on (02) 8905 1300 or by emailing Mike.Felton@mfaa.com.au.

Yours sincerely

Mike Felton

Chief Executive Officer

Mortgage & Finance Association of Australia

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Table of Contents Executive Summary ................................................................................................................................. 3

PART 1: Background and Reform to the Industry ................................................................................... 5

1.1 Performance of the Mortgage Broking Industry ..................................................................... 5

1.1.1 The ASIC Report .............................................................................................................. 9

1.1.2 The Combined Industry Forum ..................................................................................... 10

1.1.3 The Productivity Commission Report ........................................................................... 11

1.2 Current and Future Reform Efforts in the Mortgage Broking Industry ................................ 12

1.2.1 Channel Differences ...................................................................................................... 12

1.2.2 Commissions Paid on Drawn Down Amount, Net of Offset ......................................... 13

1.2.3 Alternative Remuneration Models ............................................................................... 15

1.2.4 Additional Remuneration Reform ................................................................................. 20

1.2.5 Customer First Duty ...................................................................................................... 20

1.2.6 Reforms to Governance Practices and Improved Oversight ......................................... 22

1.2.7 Monitoring and Enforcement via Mortgage Broking Industry Code ............................ 24

PART 2: Questions Raised in the Interim Report .................................................................................. 26

Who Does a Broker Act For? – Duties and Obligations .................................................................... 26

Conflicts of Interest ........................................................................................................................... 32

Remuneration and Disclosure Requirements ................................................................................... 33

Responsible Lending ......................................................................................................................... 34

Borrower Expenses and HEM ........................................................................................................... 35

Disclosure of Fraud and Misconduct ................................................................................................ 35

Intermediary Defaults ....................................................................................................................... 36

FOFA Reforms ................................................................................................................................... 36

External Dispute Resolution .............................................................................................................. 38

Other ................................................................................................................................................. 38

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Executive Summary The Commission’s work has uncovered significant instances of misconduct across the Australian financial services industry, ranging from potentially criminal conduct to dishonest behaviour. With a focus on consumer lending practices, the first round of hearings featured case studies concerning residential mortgages, credit cards, car loans, add-on insurance, credit offers and account administration. Key issues identified during these hearings and later addressed in the Interim Report include the role of intermediaries, communication with customers, and responsible lending practices.

This inquiry has continued to provide a timely and insightful investigation into financial services industry practices, and has exposed the need for meaningful review of a number of areas. The Commission was given a wide remit to consider “whether any conduct by financial services entities … might have amounted to misconduct” or conduct falling “below community standards and expectations”.1 While the Commission was also invited to consider the implications of any proposed legislative amendments “for the economy generally, for access to and the cost of financial services for consumers, for competition in the financial sector and for financial system stability”, it is our view that misconduct and related behaviour has formed the central focus of the Commission to date.

Based on our analysis of the Interim Report and Commission hearings (with respect to consumer lending), we do not believe the Commission has prioritised issues such as competition, consumer choice, or access to financial and credit services for marginalised groups. We acknowledge that these factors will likely be considered during the Round 7 hearings, and as such, this submission seeks to address certain considerations which we believe the Commission should examine prior to the delivery of its final report in February 2019. In tackling misconduct, the impact of proposed policy on competition, consumer choice, or access to financial and credit services is a key consideration.

Whilst the MFAA submission seeks to directly answer the specific questions relevant to mortgage broking asked by the Commissioner in his Interim Report, it also seeks to outline the findings from other relevant government and industry reviews. These reviews covered wider policy questions than misconduct alone, but in doing so addressed some of the drivers of misconduct identified by the Interim Report. This submission also seeks to explain in a fulsome way the major reforms currently being undertaken by the industry to address these drivers of misconduct. We believe that these reforms should always be viewed as an entire package to assess their full effect, as they are entirely interdependent. In short, the whole is much greater than the sum of its parts.

The submission also seeks to frankly examine suggested alternatives to the reforms being undertaken by the industry, assessing them against the following important criteria:

1. ability to mitigate conflicted remuneration (the ‘product strategy’ and ‘lender choice’ conflicts identified in the ASIC Report);

2. impact on consumer outcomes; 3. transparency of remuneration for consumers; 4. impact on competition at all levels of the industry; 5. impact on the structure of the industry or individual parts of the value chain; 6. simplicity and achievability; and 7. applicability to all jurisdictions, and impact on the specific needs of metropolitan, regional and

country areas.

An assessment is also made of the applicability of regulatory regime for the financial advice industry if it were to be directly applied to mortgage brokers. The MFAA generally supports the objectives2 of the Future of Financial Advice (FOFA) reforms being applied to the mortgage and finance industry,

1 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Letters Patent, p. 2. 2 Dealing more effectively with conflicts of interest; improving competency and the quality of advice; encouraging greater ethics, standards and professionalism.

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however, we argue that the mortgage and finance industry requires its own relevant reform measures – not simply a ‘cut and paste’. There are many significant differences between the financial advice and mortgage broking industries, both in a structural and customer sense, and we believe that many of the specific FOFA measures, if directly applied to the mortgage broking industry, could lead to a serious erosion in customer outcomes.

This submission seeks to clarify the question of ‘who the broker works for’. In doing so, we examine the current legal and contractual obligations on brokers, and discuss the need for greater disclosure and the adoption of a higher customer duty.

The MFAA also seeks to accurately assess the health of the mortgage broking industry through: an examination of the actual level of misconduct detected in the industry; an overview of the level of customer satisfaction with brokers; and an analysis of independent complaints data. We also draw on the work of previous government and industry reviews, which identified no systemic harm in the mortgage broking industry.

Whilst we believe there is no evidence of systemic misconduct or harm in the mortgage broking industry, the MFAA is still committed to pursuing the necessary self-regulatory reforms to address conflicted remuneration and improve governance in order to ensure strong customer outcomes into the future. We believe that it is important that when addressing issues such as conflicted remuneration, regard is also given to:

1. the brokers ability to genuinely act on the financial incentives provided through the conflict; 2. other controls on, and drivers of, broker behaviour which mitigate against this conflict; and 3. the unintended consequences of reform measures and their impact on competition, customer

choice and access to financial services.

Above all, we do not wish to see reform which inadvertently strengthens the power of the major lenders, at the expense of good outcomes for customers.

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PART 1: Background and Reform to the Industry

1.1 Performance of the Mortgage Broking Industry Initiating more than half of all residential loans in Australia, mortgage brokers play a significant role in assisting home buyers to secure appropriate finance and thereby contribute to competition in the consumer lending sector. The c.17,0003 brokers currently in the market provide customers with access to lenders (via their aggregator’s panel), which include most Authorised Deposit-taking Institutions (ADIs), as well as finance companies servicing consumers and small business. The mortgage broking industry is supported by franchise and aggregator businesses which employ thousands more staff and bring scale and efficiency benefits to the industry. Mortgage brokers provide comprehensive, convenient, and personalised advice to clients, offering a wide distribution network across Australia and often in regions devoid of bank branches. The industry contributes to competition in the mortgage lending market by providing smaller lenders and originators with a ‘shop front’ to compete against the larger bank branch networks.

The structure, remuneration practices, and governance of the mortgage broking industry have been reviewed twice in the past 24 months in a data driven manner: through Report 516 - Review of Mortgage Broker Remuneration, by the Australian Securities & Investments Commission (ASIC) (ASIC Report)4 and the Retail Banking Remuneration Review, conducted by Mr Stephen Sedgwick AO (Sedgwick Review).5 Neither investigation found any evidence of systemic harm. The Productivity Commission subsequently also looked at the remuneration practices for mortgage brokers in its 3 August 2018 Report: Competition in the Australian Financial System (PC Report).6

Publicly available data on the mortgage broking industry continues to strongly support the above ASIC Report and Sedgwick Review findings with strong satisfaction levels, consumer support and competition rising, net interest margins declining, complaint levels being low and falling, and arrears in the broker channel remaining modest relative to the proprietary channel.

The number of Australians securing a home loan via a mortgage broker is on the rise, as customers continue to recognise the value offered by brokers. Consumers’ Net Promoter Score (NPS) of brokers is in excess of +70, with over 90% of customers reporting satisfaction with their broker’s performance.7 This compares to an average NPS for the four major banks that is normally negative and as at May 2018 was -15.7.8 As reported recently by Deloitte Access Economics, “mortgage brokers make mortgage markets work better… [brokers] increase choice and competition between lenders, leading to better service levels and competitive mortgage pricing.”9 The market share of new residential home loans originated by brokers has continued to grow, as customers vote with their feet in support of the greater choice, experience, convenience and personalised service offered by brokers. The most recent quarter to June 2018 (despite being the traditional seasonal low point for broker originated loans) saw the largest single year on year increase for any quarter in more than three years (51.5% to 53.9%) with a growing share of that going to smaller lenders. Notably, this gain occurred during the height of the Royal Commission hearings (see Figure 1 below).

3 Mortgage & Finance Association of Australia, Quarterly Survey of leading mortgage brokers and aggregators (produced by Comparator, a CoreLogic company) for July, August and September 2017. 4 Australian Securities & Investments Commission, Report 516 - Review of mortgage broker remuneration, 16 March 2017. 5 Stephen Sedgwick AO, Retail Banking Remuneration Review - Report, 19 April 2017. 6 Productivity Commission, Competition in the Australian Financial System, 29 June 2018. 7 Deloitte Access Economics, The Value of Mortgage Broking, July 2018, p vi. 8 DBM Consultants, Big 4 Reputation at “lowest level recorded”, 5 July 2018 https://www.dbmconsultants.com.au/big-4-reputation-damaged-by-royal-commission/. 9 Deloitte Access Economics, The Value of Mortgage Broking, July 2018, p vi.

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Over the past 12 months, the broker channel has delivered between 53.6% and 55.7% of all residential mortgage lending in Australia (depending on seasonality of the quarter), and the share of broker-originated loans concluded through lenders not affiliated with the four major banks has increased from 21.4% to 32.7% in just five years between 2013 and 2018 as mortgage brokers continue to drive competition in the industry (see Figures 2 & 3 below).

This ongoing effect on competition has contributed to a three percentage point decline in net interest margin paid by consumers over 30 years (see Figure 4 below).10

The available data on complaints shows that over the past 10 years, complaints made to the MFAA, the Credit and Investments Ombudsman (CIO) and the Financial Ombudsman Service (FOS) about brokers have dropped significantly relative to broker numbers and market share and in the case of complaints to the MFAA, in absolute terms as well.

While broker-originated loans written annually have doubled between 2008 and 2017, complaints to the MFAA have fallen by 78% over the same period. Additionally, in 2017 mortgage brokers represented 91% of the CIO membership, however complaints about brokers represent just 6.1% of all complaints to the CIO, with the proportion of complaints relative to CIO broker member numbers halving in the period between 2008 and 2017. Mortgage brokers also account for just 1 per cent of complaints to FOS.

When reviewing arrears, ASIC data showed there is no significant difference between the broker channel and the proprietary channel.

The overall picture painted by the data and the recent reviews is one of an industry which is strongly pro-competitive, without systemic harm or customer dissatisfaction. This does not mean that the industry does not need to continuously improve, nor does it mean that remuneration and governance practices do not need to be reformed or enhanced. It does, however, demonstrate the importance in having a targeted, proportional response to these practices, and ensuring that any proposed reforms have full regard to their impact on competition and consumer.

10 Deloitte Access Economics, The Value of Mortgage Broking, July 2018.

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Figure 1: MFAA’s Quarterly survey of brokers and aggregators11

Figure 2: Value of new broker originated lending for each segment of lender12

11 Mortgage & Finance Association of Australia, Quarterly Survey of Brokers and Aggregators, (produced by comparator, a CoreLogic business), 10 October 2018. 12 Mortgage & Finance Association of Australia, Value of new broker originated lending for each segment of lender, Industry Intelligence Survey, 6th edn, (produced by comparator, a CoreLogic business), for the quarters Jul-Sep 2013 to Apr-Jun 2018.

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Figure 3: $ value and market share of broker originated lending for lenders other than the Major banks and their affiliates13

Figure 4: KPMG Major Banks – Full year 2017 Results Analysis14

13 Mortgage & Finance Association of Australia, $ value and market share of broker originated lending for lenders other than the Major banks and their affiliates, Industry Intelligence Survey, 6th edn, (produced by comparator, a CoreLogic business), for the quarters Jul-Sep 2013 to Apr-Jun 2018. 14 KPMG, Major Australian Banks: Full Year 2017 Results Analysis, p. 12.

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1.1.1 The ASIC Report The ASIC Report made 13 key findings and six specific recommendations. The six recommendations focused on: commission structures; soft-dollar benefits; key characteristics of the broker channel; value chain ownership structures; governance and oversight; and data quality and public reporting. ASIC’s recommendations painted a picture of potential conflicts of interest in current remuneration practices, and assessed the relative ‘health’ of the mortgage and finance broking industry.

Overall, the ASIC Report endorsed the role that brokers play in the provision of strong consumer outcomes and enhancing competition in the home loan market. The report found that brokers: are able to assist in matching consumers with the right home loan product and lender; assist customers navigate the loan application process; improve customer understanding and financial literacy; provide a distribution channel for lenders lacking a distribution network (especially smaller lenders); and apply downward pressure on loan pricing by increasing competition between lenders.15

The MFAA has dedicated considerable resources, both directly and through the Combined Industry Forum (CIF), towards engagement with industry, government, regulators and consumer advocates with a view to improving industry standards of conduct, culture and consumer outcomes, while protecting competition. These efforts have been noted by Treasury in Background Paper 24 (Background Paper 24):

161. As a key distribution channel for mortgages, and by assisting consumers’ search for a better deal, mortgage broking also has a vital role in facilitating effective competition and better outcomes for consumers that needs to be taken into account in assessing reform options.

162. Following a comprehensive report by ASIC in 2017 on mortgage broker remuneration, the industry is progressing reforms that could address the most significant misconduct with the current remuneration model, and ASIC is to obtain powers to intervene when satisfied that there has been, or is likely to be, significant consumer detriment. The adoption of a positive duty on brokers to act in consumers’ interests may also merit consideration if it can be achieved without adding undue compliance costs.16

The ASIC Report recommended the following changes to improve the industry:

1. Changing the standard commission model to reduce the risk of poor customer outcomes. 2. Moving away from bonus commissions & bonus payments which increase the risk of poor

customer outcomes. 3. Moving away from soft dollar benefits which increase the risk of poor customer outcomes and

can undermine competition. 4. Clearer disclosure of ownership structures within the home loan market to improve

competition. 5. Establishing a new public reporting regime of customer outcomes and competition in the

home loan market. 6. The industry needs to improve the oversight of brokers by lenders and aggregators.17

15 Australian Securities & Investments Commission, Report 516 - Review of mortgage broker remuneration, 16 March 2017, p. 9. 16 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Submission on Key Policy Issues, Background Paper 24, prepared by the Australian Treasury, 13 July 2018, pp. 40-41. 17 Australian Securities & Investments Commission, Report 516 - Review of mortgage broker remuneration, 16 March 2017, p. 23.

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1.1.2 The Combined Industry Forum In mid-2017, the mortgage broking industry combined in an unprecedented manner establishing the Combined Industry Forum (CIF), to drive better customer outcomes in response to the above recommendations of the ASIC Report, and to third-party channel recommendations in the Sedgwick Review. The above six proposals therefore formed the basis of the CIF reform package.

The CIF is comprised of the Australian Banking Association (ABA); the MFAA; the Finance Brokers Association of Australia Limited (FBAA); the Customer Owned Banking Association (COBA); the Australian Finance Industry Association (AFIA); as well as bank and non-bank lenders, aggregators, referrer groups, brokers, and consumer interest groups such as Choice Consumer Group, which represents the Consumer Action Law Centre, Financial Counselling Australia and the Financial Rights Legal Centre.

The reform package involves changes to address both the ‘product strategy’18 and ‘lender choice’19 conflicts outlined in the ASIC Report, and the introduction of a system of governance, monitoring and reporting to ensure that customer outcomes can be continuously assessed. In an industry first, the reform package defines a ‘Good Customer Outcome’ (discussed further below at 1.2.5) and sets new standards to assess whether a loan is appropriate and meets a customer’s requirements and objectives.

Through the CIF, the mortgage broking industry is committed to taking action to further improve customer outcomes and standards of conduct and culture, while preserving and promoting a vibrant and competitive mortgage broking industry that encourages consumer choice. The work of the CIF has been led by seven guiding principles:

In responding to proposed changes to remuneration and governance practices in the mortgage industry, the CIF, including industry associations, brokers, aggregators and lenders will:

1. support a co-regulatory approach and, to the extent possible, support industry self-regulation; 2. have better consumer outcomes at the centre of its approach; 3. ensure appropriate transparency of process for industry participants, government and

consumers; 4. promote competition at all levels of the industry; 5. not aim to change the structure of the industry or unfairly disadvantage any part of the value

chain; 6. promote simple and achievable solutions; and 7. seek solutions that can be applied in all jurisdictions and that take account of the needs of

metropolitan, regional and country areas.20

The Interim Report has described the CIF initiatives as “limited”.21 While we acknowledge the targeted nature of the CIF’s proposals, the MFAA must emphasise that the CIF is required to consider a wide range of issues in the industry, including the impact of reform on competition. The CIF reform package

18 Product strategy conflict is defined as “when a broker could recommend a product or strategy to maximise their commission payment, for example, by recommending a loan that is larger than a customer needs, or can afford.” Combined Industry Forum, Improving Customer Outcomes: The Combined Industry Forum response to ASIC Report 516: Review of mortgage broker remuneration, 28 November 2017, p. 10. 19 Lender choice conflict is defined as “when a broker is incentivised to recommend a loan from a particular lender over another.” Combined Industry Forum, Improving Customer Outcomes: The Combined Industry Forum response to ASIC Report 516: Review of mortgage broker remuneration, 28 November 2017, p. 10. 20 Combined Industry Forum, Improving Customer Outcomes: The Combined Industry Forum response to ASIC Report 516: Review of mortgage broker remuneration, 28 November 2017, p. 5 and see p. 23. 21 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Interim Report – Volume 1, p. 62.

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has been designed to ensure better consumer outcomes and improved standards of conduct and culture within existing industry structures, while promoting and maintaining competition at all levels of the industry. In contrast, the Commission has focused on examining instances of misconduct and similar unethical behaviour. The CIF’s work to date has removed key aspects of conflicted remuneration and has established clear foundations for future, continued industry improvement. We envisage the reform proposals will be delivered in full between 2018 and the end of 2020.

1.1.3 The Productivity Commission Report The recent Productivity Commission (PC) Report also made several recommendations relevant to questions raised by the Royal Commission. The PC Report ruled out either a consumer or lender-paid fee-for-service, and concluded that the current upfront commission structure should remain. This response echoed the CIF’s conclusions, recommending that remuneration structures should “require upfront commissions to aggregators and brokers to be paid based on the funds drawn down by customers, net of offset, instead of the limit of the loan facility.”22 When considering alternative remuneration models, the PC Report also stated that:

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.23

and

The Commission agrees that fees-for-service paid by consumers are unlikely to be pro-competitive, because a lack of willingness to pay is likely to result in a smaller mortgage broking industry, and the greater damage would be to the lenders without branch networks. Given that many mid-size and smaller lenders rely on brokers to compete … competition in the home loan market would likely be weaker as a result.24

To reduce the scope for damage from conflicted advice, the CIF is implementing a number of changes (discussed further below). We believe the CIF’s efforts in: reforming the broker remuneration model to pay upfront commissions on the amount of funds drawn down by a customer, net of offset (outlined at 1.2.2); the removal of volume-based bonus commissions, campaign-based commissions and volume-based bonus payments; the delinking of volume from soft-dollar incentives (outlined at 1.2.4); introducing a ‘Customer First Duty’ (outlined at 1.2.5); consumer tested changes to disclosure and public reporting; reforming governance practices (outlined at 1.2.6); and the introduction of a mandatory Mortgage Broking Industry Code (outlined at 1.2.7); will significantly assist in resolving the Productivity Commission’s concerns.

The PC Report additionally acknowledged that broker businesses need to remain commercially viable, recognising the critical role played by the broking channel in our economy.25

However, the PC Report also made recommendations with which the MFAA either does not, or only partly, agrees. These include the abolition of trail commissions26 and the establishment of a ‘best

22 Productivity Commission, Competition in the Australian Financial System, 29 June 2018, p. 331. 23 Ibid, p. 22. 24 Ibid, p. 333. 25 Ibid, p. 23. 26 Ibid, p. 22.

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interest duty’27 as a higher duty to customers. Our reasoning is explained below at 1.2.3 (Alternative Remuneration Models – Model C) and 1.2.5 (Customer First Duty), respectively.

The following section will draw the Commission’s attention to more detailed information on different aspects of reform currently underway, which we believe should be given further consideration prior to the release of the Commission’s final report in February 2019.

1.2 Current and Future Reform Efforts in the Mortgage Broking Industry The MFAA is of the view that certain issues addressed in the Interim Report concerning remuneration, conduct and culture can be effectively managed via the different reforms being implemented by the CIF, including: changes to remuneration structures; consumer tested changes to disclosure and public reporting; the introduction of a Customer First Duty; the introduction of a mandatory Mortgage Broking Industry Code; and an improved governance framework. We believe that these reforms should always be viewed as an entire package to assess their full effect, as they are entirely interdependent. In short, the whole is much greater than the sum of its parts.

The CIF reforms also need to be viewed as a response to the ASIC Report and Sedgwick Review. The CIF terms of reference were amended following the release of the Interim Report, to include other relevant reports and reviews. That said, it is our view that both the ASIC Report and the Sedgwick Review got to the heart of the conflicts in broker remuneration, and as such, the response of the CIF is entirely relevant to the Commission. In addition, both inquiries incorporated the retention of industry competition and access to financial services as key objectives, which we believe has not been a strong enough focus of the Royal Commission.

Further details concerning how these reforms will go some way towards addressing issues raised by the Commission are outlined below.

1.2.1 Channel Differences The Interim Report has cited the consequences of value-based remuneration of brokers to include:

• higher leverage;

• higher incidence of interest-only loans;

• higher total debt-to-income ratios;

• higher [loan-to-value ratios, or] LVRs;

• higher incurred interest costs; and,

• over time, an increased likelihood of borrowers falling into arrears, borrowers paying their loans more slowly and paying more interest than other borrowers.28

These findings are unsurprising, and have been examined closely by ASIC and as part of the Sedgwick Review. When considering the differences between the broker and proprietary channels, the Interim Report did not note the fact that greater complexity within different customer demographics has typically gravitated towards the broker channel. This is due to the fact that borrowers with more complex financial situations will more commonly turn to the broker for solutions.

The ASIC Report provided a comparison between loans obtained through brokers and those obtained through direct lending channels to identify differences in product features and outcomes between channels. Importantly, ASIC was required to account for differences across consumer profiles, as

27 Ibid, p. 2. 28 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Interim Report – Volume 1, p. 62.

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“outcomes were not necessarily caused by the channel and may instead reflect differences in the types of consumers”.29 The ASIC Report explained that:

825. Similarly, for loan performance, we needed to ensure that we compared similar consumers with similar loan products. In examining additional payments and arrears, we controlled for known borrower characteristics and basic features of the loan.

826. Even after applying these controls, there were still differences in loan features and performance between the two channels. Although these differences were observed, we cannot always explain the causes of these differences. Further work (e.g. a shadow shopping exercise or analysis of individual files) may be required to better understand the causes, and to determine whether any regulatory or policy response is required.30

After controlling the data on channel differences for borrower characteristics and loan features, the Report found significantly less pronounced differences between the broker and proprietary channels.

Treasury has also commented, in Background Paper 24, on the differences between channels:

243. These average differences are prima facie not so significant that they provide compelling evidence of major problems that require a wholesale change to the existing standard commission structure given the industry reforms currently underway…31

1.2.2 Commissions Paid on Drawn Down Amount, Net of Offset The MFAA, together with the CIF, has considered a number of adjustments to broker incentives to ensure a customer is not borrowing more than they require, and to avoid the creation of large initial offset balances. As noted by the Commission, the CIF reform package includes initiatives such as the payment of commissions on the amount of funds drawn down by a customer, as opposed to the size of the loan, which “removes an incentive for brokers procuring a loan larger than the borrower will use”.32 However, the Commission failed to mention that this reform also ensures that any funds held by a customer in an offset account are excluded for the purposes of calculating remuneration.

We stress the importance of this reform initiative as a useful means to confront product strategy conflict. The simplest way to remove the incentive to recommend an inappropriate use of offset balances is to implement up front commissions paid on the drawn amount of the loan, net of offset. As of October 2018, a number of major and non-major lenders, have announced to the market that they have adopted, or will imminently be adopting, CIF guidance with regards to this reform initiative which is scheduled to be delivered by 31 December 2018.

ASIC directly targeted the use of offset accounts in its 2017 report, as the largest enabler of the product strategy conflict:

440. As noted earlier, all lenders calculated the upfront and trail commission based on the loan amount. However, the amount of commission paid depended, among other things, on how the lender defined the ‘loan amount’.

441. This issue may be important in understanding whether a lender’s commission structures are more likely to increase the risk of inappropriate advice being given to a consumer by a

29 Australian Securities & Investments Commission, Report 516 - Review of mortgage broker remuneration, 16 March 2017, p. 155 [822]. 30 Australian Securities & Investments Commission, Report 516 - Review of mortgage broker remuneration, 16 March 2017, p. 155. 31 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Background Paper 24, prepared by the Australian Treasury, 13 July 2018, p. 59. 32 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Interim Report – Volume 1, p. 62.

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broker. In particular, some stakeholders have expressed concerns that brokers may recommend to consumers that they take out a loan that is larger than originally desired to maximise the commission.

442. A consumer is less likely to accept this advice if they will be charged interest on the additional funds. As a result, the consumer would be more likely to accept the broker’s advice (i.e. to borrow a higher amount) if they could leave the additional funds in the loan account (i.e. as a redraw amount) or in an offset account.33

While acknowledging some of the CIF reform efforts, the Interim Report states that “the change does not deal with the more basic problem of borrowers being encouraged to borrow more than they need.”34 The MFAA disputes this finding. The CIF has taken the initiative to mitigate product strategy conflict, and has produced a solution which remunerates brokers on total drawn funds (reflecting total economic value) over time, whilst removing the financial incentive to recommend loans with initially large, unutilised offset balances (in line with ASIC’s recommendation). This solution reduces total broker income, but protects the viability of broker businesses and, as such, the strong pro-competitive impact brokers have on the home loan market. We see this as the most effective method (and likely the only effective way) to address this issue whilst minimising unintended consequences.

We again strongly advise that when assessing the effectiveness of this measure in tackling product strategy conflict, it should be considered alongside the changes to volume-based bonus commissions, campaign-based commissions, volume-based bonus payments and soft dollar remuneration, improvements to disclosures that have been consumer tested, as well as the introduction of the new customer duty; the introduction of a mandatory Mortgage Broking Industry Code; and the significant enhancement of the governance and reporting framework. We would also recommend that the impact of this measure should only be assessed once fully implemented by lenders on 31 December 2018, and once the results have been monitored, analysed and considered.

Additionally, these reforms will be supplemented by the Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Powers) Bill 2018. The Bill will amend the Corporations Act 2001 (Cth) and the National Consumer Credit Protection Act 2010 (Cth) (NCCP Act) to introduce a Product Intervention Power, via which ASIC will have greater power to prevent or respond to significant consumer detriment. As Treasury has commented in Background Paper 24:

138. More recent reforms have sought to provide ASIC with greater flexibility in its ability to make rules. For example, in the reforms to life insurance remuneration, the Corporations Amendment (Life Insurance Remuneration Arrangements) Act 2017 provides ASIC with the ability to set the cap that applies through determining a legislative instrument. Similarly, the Product Intervention Power, currently being developed, seeks to provide ASIC with a degree of flexibility in setting its regulatory approach.35

264. … the standard commission structure represents a balancing of commercial interests and responsibilities between lenders, aggregators and brokers, as well as the interests of consumers. Too prescriptive and fixed a model risks being commercially inefficient, particularly as the market develops over time and technological and other innovations arise, and negatively affecting competition. While the online and technology based mortgage broker start-ups remain nascent, they are also innovating with remuneration structures (such as rebating commissions to customers) as a point of competitive advantage.

33 Australian Securities & Investments Commission, Report 516 - Review of mortgage broker remuneration, 16 March 2017, pp. 85-86. 34 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Interim Report – Volume 1, pp. 62-63. 35 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Background Paper 24, prepared by the Australian Treasury, 13 July 2018, p. 36.

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265. It would therefore, be worth considering flexible and less prescriptive approaches. The Product Intervention Power, once implemented, will enable ASIC to intervene in this area to target aspects of remuneration structures where ASIC is satisfied that there has been or is likely to be significant consumer detriment.36

1.2.3 Alternative Remuneration Models The MFAA and CIF have thoroughly assessed other remuneration models and their variants, and evaluated the potential unintended consequences arising from each option. Three key alternative remuneration models are discussed below. However, for a full breakdown of positive and negative features attached to all alternative remuneration models considered by the MFAA, please see the MFAA Response to the ASIC review of mortgage broker remuneration.

Specifically, alternative models have been assessed against the following criteria:

1. ability to mitigate the ‘product strategy’ and ‘lender choice’ conflicts identified in the ASIC Report;

2. impact on consumer outcomes; 3. transparency of remuneration for consumers; 4. impact on competition at all levels of the industry; 5. impact on the structure of the industry or individual parts of the value chain; 6. simplicity and achievability; and 7. applicability to all jurisdictions, and impact on the specific needs of metropolitan, regional

and country areas.

The latest MFAA analysis of three key alternative remuneration models and their variants, as well as the unintended consequences of each, is as follows:

Alternative Model A: Consumer-paid fee-for-service in lieu of commissions

Under current remuneration arrangements, brokers are paid differing levels of commission by each lender. It has been suggested that the elimination of this commission would remove any potential product strategy and lender choice conflicts of interest arising from this arrangement. Should commission be removed, brokers would be required to set a fee for their customers.

Alternative Model A would produce a number of significant consequences that could negatively impact consumers and the industry:

1. Will increase direct costs for the consumer – The Productivity Commission estimated that in 2015 the total commission paid by lenders to aggregators on an average home loan of $369,000 was an upfront commission of $2,289 and a trail commission of $665 per year.37 This translates to an average total commission of $2,954 paid in the first year of the loan, excluding trail commissions received over the life of an average four-year loan. This would likely be the minimum amount a customer would be charged under a direct charging model in the first year. Brokers are a distribution channel for lenders, and as such, consumers would in effect be paying the lenders’ acquisition costs.

2. Customers unlikely to see indirect cost savings – The MFAA believes that customers will not benefit from the savings which will accrue to lenders from no longer paying commissions, as it is most likely that such savings will be returned to shareholders in the form of higher profits rather than customers in the form of slimmer interest margins.

3. Reduces the broker value proposition – The MFAA believes that a direct average cost to consumers of close to $3,000 in the first year alone (based on the above figures) would significantly reduce the customer appeal of the mortgage broking channel. This position is

36 Ibid, p. 63. 37 Productivity Commission, Competition in the Australian Financial System, 29 June 2018, p. 306.

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supported by the Productivity Commission, which said: “Evidence supports that proposition that many consumers would not pay to use a mortgage broker … despite the fact that brokers provide access to a wider range of loans and are arguably better able to recommend a better loan compared to a lender’s employee”38. This will particularly be the case for first home buyers, and those of a lower socio-economic status. The Productivity Commission also stated that:

Consumers — again unsurprisingly — are also not attracted to paying for a service that they currently receive for ‘free’. Deloitte (2016a) found that 37% of surveyed broker customers were not willing to pay mortgage brokers a fee. Of the 63% that were, 22% were only willing to pay up to $500, and a further 18% were only willing to pay up to $1000. Focus groups revealed that most consumers would not pay, and would instead approach lenders directly.39

4. Creates a disadvantage between brokers and the lender branch channel – The big winners from such a reform will be the major banks with significant branch infrastructure, as customers will have a financial incentive to utilise a proprietary lending channel rather than a broker. The support for a consumer-paid fee-for-service by any lender with significant investment in branch infrastructure would as a result appear to be entirely self-serving.

5. Will rationalise broker numbers – The reduction in customer demand for brokers will force many brokers out of the industry. This will reduce access to credit and particularly in regional and rural Australia.

6. Will disadvantage non-major lenders without a branch footprint thereby reducing competition, choice, and access to credit – The reduction in broker numbers will mean that non-major lenders will have a smaller distribution network, impacting their ability to compete effectively with the major lenders and directly impacting competition.

7. Will increase barriers to entry for new market participants – New entrant lenders, without a branch network, will find it more difficult to enter the market as their cost of customer acquisition will be significantly higher than the major lenders.

8. Could lead to brokers servicing a narrower band of customers – Brokers will be incentivised to seek out the customers with the simplest needs, forcing those with more complex arrangements back into the proprietary channel. This will impact customer outcomes as the branch network currently is less effective in dealing with complex loan scenarios, which currently gravitate to the broker channel. It is worth noting that a recent Deloitte Access Economics report found that brokers on average have 13.8 years’ relevant industry experience.40

9. Could encourage brokers to cross-sell – Brokers will be encouraged to seek out alternate revenue sources as a result of decreased income.

10. Could reduce innovation – Mortgage brokers have contributed significantly to innovation in the home lending sector. For example, non-major lenders (acting through brokers) have delivered new products such as no establishment fee loans, offset accounts and reverse mortgages. Major lenders have been forced to adopt similar innovative products in order to compete, in turn driving competition and further innovation.

11. Could encourage brokers to charge additional fees to vulnerable borrowers – Borrowers with a more complex financial situation may be charged more by brokers because of the additional work in arranging their loan. This could disadvantage those borrowers who are most in need.

38 Ibid, p. 333. 39 Ibid, pp. 308-309. 40 Deloitte Access Economics, The Value of Mortgage Broking, July 2018, p. 8.

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The Productivity Commission has also acknowledged that:

… fees-for-service paid by consumers are unlikely to be pro-competitive, because a lack of willingness to pay is likely to result in a smaller mortgage broking industry, and the greater damage would be to the lenders without branch networks. Given that many mid-size and smaller lenders rely on brokers to compete … competition in the home loan market would likely be weaker as a result.41

Consumer-paid Fee-for-service: International Comparisons

In Background Paper 24, Treasury considered the use of upfront, flat fees and compared this model with remuneration arrangements in other jurisdictions. Looking at the Netherlands, while a fee-for-service model has been implemented, policymakers also mandated that lenders must charge a mortgage arrangement fee (without cross-subsidisation) if using a non-broker distribution channel. This mitigated the impact on competition. Background Paper 24 concluded that:

261. The risk with this option is if customers switch to obtain home loans from lenders directly rather than paying brokers an upfront fee, threatening the viability of the mortgage broker distribution channel. Estimates of what most consumers may be willing to pay a broker, of no more than $1000, are well below the average value of commissions currently paid by lenders. If mortgage broking activity contracted, this could have a significant detrimental impact on competition in the mortgage market.

262. A fee-for-service model has been introduced in the Netherlands. However, to maintain competitive neutrality between brokers and direct lending, and hence limit any negative effect on competition, policymakers also had to take the further step of mandating that lenders must charge an appropriately priced mortgage arrangement fee (without cross-subsidisation) when using non-broker distribution channels.

263. If a further change in the standard commission structure was supported by the Commission, consideration would also need to be given as to how best to achieve it. These changes, alone or in combination, have the potential to be disruptive to an industry already facing significant change in light of the CIF proposals and tighter lending standards, and involve significant costs in transitioning to and bedding down any changes.42

Alternative Model B: Flat lender-paid fee

While this option would assist in reducing product strategy conflicts, it would also have a number of unintended consequences which could negatively impact outcomes for customers:

1. Would not address lender choice conflict – The Productivity Commission has found that: A ban on commission-based payments in favour of fees would not eliminate the conflicts of interest that brokers face. While such a ban may address the product-strategy conflicts (that is, the incentive to prefer larger loans), it would not address lender-choice conflict (the incentive to prefer lenders that offer higher payments). This is because a lender could still offer higher fee-for-service payments than its competitors, in order to win referrals from brokers. In fact, mandating remuneration via fees strengthens the incentive for lenders to prefer borrowers taking out larger loans …43

In effect, this model would entrench power with the major lenders, as lenders could more easily move broker fees to suit their own business objectives, regardless of the impact on customer outcomes or competition. Fees are inherently easier to manipulate than percentage

41 Productivity Commission, Competition in the Australian Financial System, 29 June 2018, pp. 308-309. 42 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Background Paper 24, prepared by the Australian Treasury, 13 July 2018, pp. 61-62. 43 Productivity Commission, Competition in the Australian Financial System, 29 June 2018, p. 332.

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based commissions, and are much more flexible in application. Therefore, banks would also be able to deploy add on fees, remunerating brokers based on the product features they wish to sell. Such additional fees could increase the lender choice conflict as brokers seek to maximise their fee revenue.

2. Will turn brokers into ‘hunters’ and risks increasing churn – A single lender-based fee-for-service for loans, regardless of size, would incentivise brokers to write as many loans as possible. This would, in effect, turn brokers into “hunters” and would risk increasing churn which is not a costless exercise. As a result, brokers would be incentivised to write as many loans as possible, irrespective of loan quality or performance. They would also be incentivised to spend minimal time with any particular customer (risking quality and quantity of credit assistance provided) in favour of customer acquisition activities. Clawbacks would be less effective as the lender fee at risk would be simply replaced by achieving remuneration from another loan.

3. Will impact viability of broker channel – Broker income is automatically linked to the value of the housing market. A flat lender fee model would sever this link, leading to a reduction of broker income over time and particularly when taking inflation into account. Brokers servicing areas with higher property values will likely have an immediate reduction in average income earned. This model will therefore result in cross-subsidising between brokers, whereby brokers providing high value loans with a large economic value will in effect subsidise brokers with smaller value loans.

4. Will ‘commoditise’ broking – This model will reduce broker incentives to improve business practices through own-cost training or education.

5. Could lead to brokers servicing a narrower band of customers – Brokers will be incentivised to seek out the customers with the simplest needs, forcing those with more complex arrangements back into the proprietary channel (including first home buyers). This will impact customer outcomes as the branch network currently is less effective in dealing with complex residential financing, which currently gravitates to the broker channel where brokers have an average 13.8 years’ industry experience.44

6. Could increase pricing on smaller loans – As this model does not link lender costs to revenue, it would require a lender to use high value loans to cross-subsidise low value loans, and could result in a rise in the Annual Percentage Rate (APR) on lower value loans to compensate.

7. A tiered flat fee would increase product strategy conflict - A tiered flat fee model – where a higher fee is paid for loans of a higher value (say over $1 million) – would suffer from the same shortcomings but with a heightened conflict of interest as a customer’s intended borrowing approaches a tier threshold.

8. Could encourage brokers to cross-sell – Again, brokers would be encouraged to seek out alternate revenue sources as a result of decreased income.

Based on our assessment, the above consequences are likely to impact first home buyers to the greatest extent.

Alternative Model C: Removing Trail Commission

Trail commission, paid by the lender to the broker, is an important control mechanism. It was implemented as delayed upfront payment, intended to de-risk the system by spreading out a portion of the broker’s remuneration payment over time. It also reduced upfront funding requirements for smaller lenders, thereby increasing competition. It is therefore contingent income that is only paid if a loan is not in arrears, is not refinanced (remains appropriate), and does not involve misrepresentation or fraud. It discourages excessive churn, incentivises quality, aligns the interests of all stakeholders in the value chain with those of the customer by promoting responsible lending, and also encourages the broker to continue to provide service over the life of a loan. Trail also encourages

44 Deloitte Access Economics, The Value of Mortgage Broking, July 2018, p. 8.

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the broker to be relationship-focussed, taking into account the customer’s long-term needs and objectives rather than being transactionally (‘one-off sale’) focussed. Importantly, ASIC “did not identify trail commissions directly leading to poor consumer outcomes.”45

If trail was removed, it would have a number of unintended consequences, including:

1. Forcing brokers to become ‘hunters’ – The removal of trail commission will move brokers away from a service footing to a sales footing. With no contingent income attached to performance of a loan over its life, brokers will be financially incentivised to prioritise the achievement of sales over suitability.

2. Removing a control mechanism that aligns interests and incentivises strong customer outcomes – Trail is contingent income paid by the lender to the broker that is only paid if the loan is not in arrears, remains appropriate (i.e. not refinanced) or has not been found to involve misrepresentation or fraud. Even if trail was fully replaced with additional upfront remuneration, the contingent nature of the income and control mechanism will have been removed.

3. Will result in increased churn and shorter average life of loans – With no trail available brokers will have a strong incentive to be transactionally rather than relationship focussed, which will increase churn and likely reduce the average life of broker originated loans. This effect was observed in New Zealand, following the abolition of trail a number of years ago. The change has resulted in many lenders reintroducing trail, more recently.

4. Quality likely to deteriorate – The incentive to put forward higher quality loans (or guard against non-performing loans) will have been removed. The ASIC Report found that:

432. The payment of ongoing trail commissions usually provides an incentive to aggregators and brokers to put forward higher quality loans where consumers are less likely to default on their obligations. However, the option to waive trail commissions in favour of an upfront payment removes this incentive and is likely to increase the risk that aggregators and brokers will be less selective about which loans they put through to the lender. We would expect this lender to assess whether there is a difference in performance of the loans where this right has been exercised.46

Treasury has arrived at the same conclusion:

259. The removal of trails would, however, 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.47

5. Could impact viability of broker channel and distribution for smaller lenders – If trail paid by lenders to brokers is removed and not replaced by upfront commission or insufficiently replaced by upfront to fully compensate its loss, the change will be detrimental to the viability of the broker channel. Brokers, on average, earn an annual income of $86,400 before tax, making the channel vulnerable to a reduction in income which would also pose a risk to smaller lenders, competition and choice. It also removes a future income stream, restricting a broker’s ability to build value in their business or to deal with economic peaks and troughs and associated business flows (as experienced by brokers in Western Australia in recent years).

45 Australian Securities & Investments Commission, Report 516 - Review of mortgage broker remuneration, 16 March 2017, p. 85 [439]. 46 Australian Securities & Investments Commission, Report 516 - Review of mortgage broker remuneration, 16 March 2017, p. 84. 47 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Background Paper 24, prepared by the Australian Treasury, 13 July 2018, p. 62.

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6. Will affect post-origination service – Not having an income to support post-origination service is likely to reduce the frequency and quality of future credit assistance and advice provided.

7. Anti-competitive effects – An increase in upfront commissions will have an anti-competitive effect on the market, because lenders will be required to fund this payment. This would disadvantage lenders other than the major banks, due to their greater difficulty in funding large up-front payments.

8. Increased fees – A prohibition on trail commission will likely lead to increased lender fees to offset the increased upfront commission and increased broker fees (paid by the customer), in the event that upfront commission is not sufficiently increased by lenders to wholly compensate for the present value that trail provides.

1.2.4 Additional Remuneration Reform The MFAA also takes this opportunity to highlight other industry reforms currently in progress, through the CIF, with regards to volume-based and campaign-based commissions, and soft-dollar remuneration.

As part of the ASIC Report and the Sedgwick Review, it was noted that volume-based and campaign-based commissions which supplement the standard commission model can create potential conflicts of interest and “higher risk that brokers will place customers with lenders for the wrong reasons.”48 In response, the CIF has implemented a reform which has resulted in volume-based and campaign-based commissions and volume-based payments ceasing to be paid to reduce this risk of lender choice conflict. This is supported through the CIF’s governance framework.

In addition, the CIF reforms minimise the potential for both lender choice conflict and product strategy conflict through reforms to soft-dollar benefits including: tiered servicing models; conferences and professional development events; and entertainment and hospitality. These reforms have included the de-emphasising or de-linking of volume, better record keeping and disclosure, caps on the value of soft dollar benefits from lenders, and a strong focus on education at industry events.

As noted above, the volume-based bonus commissions, campaign-based commissions, and volume-based bonus payments reforms have been implemented and the soft-dollar remuneration reforms are expected to be implemented by the end of 2018.

A number of other remuneration structures and their variants have previously been considered. For a full breakdown of positive and negative features attached to all alternative remuneration models considered by the MFAA, please see the MFAA Response to the ASIC review of mortgage broker remuneration.

1.2.5 Customer First Duty The Interim Report has acknowledged the CIF proposal to introduce a Customer First Duty, but has suggested that:

It is not immediately clear what would be the content of a ‘customer first’ duty. In particular, it is not clear how this form of duty is intended to differ from the duty to act in the best interests of the client that the Corporations Act imposes on financial advisers. Nor is it clear, 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. 49

48 Australian Securities & Investments Commission, Report 516 - Review of mortgage broker remuneration, 16 March 2017, p. 24. 49 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Interim Report – Volume 1, p. 63.

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The MFAA firmly believes that the current obligation for a broker to recommend a loan which is “not unsuitable” contained in the responsible lending requirements outlined in the NCCP Act is inappropriate and that a higher duty of care should be imposed on mortgage brokers. We believe this duty should be designed with the customer’s interests positioned as the central factor, accompanied by a clear articulation of what a good customer outcome represents in practical terms. To this end, the CIF has developed the following definition of a ‘Good Customer Outcome’, to be implemented via an enforceable Mortgage Broking Industry Code:

The customer has obtained a loan which is appropriate (in terms of size and structure), is affordable, applied for in a compliant manner and meets the customer’s set of objectives at the time of seeking the loan.50

The above definition sets out four key measures that must be satisfied in order to reach this benchmark. These measures, and associated key risk indicators, will form the basis of a Customer First Duty:

1. appropriate size and structure of the loan; 2. meeting the customer’s stated requirements and objectives; 3. affordable for the customer; and 4. applied for in a compliant manner (meeting all responsible lending requirements).

This definition goes to the heart of the CIF reform package, and sets the benchmark which the industry will use to assess behaviour in the future. It holds the industry to a new standard beyond current responsible lending requirements, taking into account whether a loan is appropriate and whether it meets a customer’s requirements and objectives. The Key Risk Indicators (KRIs) monitored within the compliance framework will assist in assessing whether a broker has fulfilled their Customer First Duty are discussed below at 1.2.6.

The MFAA does not agree that a FOFA Best Interest Duty is the most appropriate duty, as this was designed specifically for the financial planning industry – not the mortgage and finance industry. ASIC Commissioner Peter Kell originally outlined the objectives of FOFA in May 2012 as follows:

ASIC wants to work with your industry to improve consumer trust and confidence. This can be achieved through:

• dealing more effectively with conflicts of interest;

• improving competency and the quality of advice;

• encouraging greater ethics, standards and professionalism.51

The MFAA supports the above objectives of FOFA being applied to the mortgage and finance industry, however, we argue that the mortgage and finance industry requires its own relevant reform measures – not simply a ‘cut and paste’. We would consider any duty which reflects and achieves the Good Customer Outcomes as defined by the CIF, and one that is more appropriately suited to the mortgage and finance industry.

In our view, the FOFA Best Interest Test is not a higher standard than the Customer First Duty recommended by the CIF, rather, it is an inappropriate duty for our sector and would likely lead to a number of unintended consequences. For example, the MFAA is concerned that a requirement to act in the ‘best interests’ of customers has the potential to translate into a requirement that brokers provide the ‘best’ or ‘most appropriate’ product or advice or to ensure the ‘best outcome’. Given that a broker may have access to more than 2,500 products available at any one time, in practice it becomes near impossible for a broker to assess all options to determine if a product is the ‘best

50 Combined Industry Forum, Improving Customer Outcomes: The Combined Industry Forum response to ASIC Report 516: Review of mortgage broker remuneration, 28 November 2017, p. 9. 51 Speech by ASIC Commissioner Peter Kell, to the Association of Financial Advisers’ Financial Services Council Leadership Forum, 1 May 2012.

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outcome’ for a customer, within an adequate timeframe. The MFAA therefore believes that a ‘best interest duty’ (or a ‘best outcome’ benchmark in practice) is not the correct goal for the mortgage broking industry – the aim to achieve a Good Customer Outcome, coupled with a Customer First Duty, should be the objective of all mortgage brokers.

As noted by Treasury in its Background Paper 24:

268. Applying a positive duty to brokers would not, however, necessarily be best achieved by attempting to replicate the financial advice best interests duty given differences between brokers and financial advisers, and the existence of responsible lending and other obligations. If it was to be introduced, careful consideration would again need to be given to an approach that mitigates conflicts of interest risks while avoiding unnecessary compliance costs, and to what extent it can rely on industry efforts or providing ASIC with some discretion or rule-making power.52

Coupled with the CIF reforms, we also note that brokers have an existing strong business incentive to act in the interests of customers, not only because of responsible lending legislation but also given that a broker’s business is based on the relationship model and is contingent on customer referrals, established by a history of good customer outcomes.

The Interim Report has noted that FOFA provisions impose a best interests duty on financial advisers which “emphasise process rather than outcome”, and that the obligation “will be met if an adviser follows the steps described in Section 961B(2)” of the Corporations Act 2001 (Cth).53 The Customer First Duty, coupled with a definition of a Good Customer Outcome, will deliver a principled, outcome-driven approach – in our view, superior to the FOFA prescriptive process-driven approach – and provide an appropriate benchmark for the mortgage broking industry that is not impractical to implement. The Customer First Duty also reflects the Interim Report’s focus on legislative simplicity.

When combined with other CIF initiatives around: changes to the standard commission model; improved governance and oversight; payment of up front commissions on the drawn amount of a loan, net of offset; movement away from volume-based bonus commissions, campaign based commissions and volume-based bonus payments; movement away from soft dollar benefits; improved disclosure requirements; and a new public reporting regime; we believe that the Customer First Duty will provide an appropriate and enhanced benchmark for mortgage broker conduct.

1.2.6 Reforms to Governance Practices and Improved Oversight The Interim Report was generally silent on the significant reforms proposed by the CIF in relation to the proposed mortgage broker governance framework. Whilst these changes were expected to be fully implemented by 31 December 2020, the CIF is keen to fast track as many reforms as possible, and components will be progressively implemented well in advance of that date. The governance framework is also based on proposals made in the ASIC Report.54 We strongly believe that improved governance and oversight, introduced via the Mortgage Broking Industry Code, will reduce the risk of poor consumer outcomes while maintaining competition in the lending sector.

The MFAA notes and agrees with the Interim Report’s statement that “Good culture and proper governance cannot be implemented by passing a law. Culture and governance are affected by rules, systems and practices but in the end they depend upon people applying the right standards and doing

52 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Background Paper 24, prepared by the Australian Treasury, 13 July 2018, p. 64. 53 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Interim Report – Volume 1, p. 140. 54 See Australian Securities & Investments Commission, Report 516 - Review of mortgage broker remuneration, 16 March 2017, pp. 26-27 [132]-[134].

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their jobs properly.”55 The centrepiece of the CIF reform package is a comprehensive governance framework for the mortgage broking industry intended to be self-assessing, self-correcting and continuously improving. The Customer First Duty (outlined above at 1.2.5) is intended to work in concert with the framework, and be a pervasive element.

The CIF and the MFAA is developing a holistic, consumer-centric governance framework that is based on self-assessment, is self-correcting and ensures continual improvement of consumer outcomes and the sustainability of the mortgage industry. Such a framework (outlined at Figure 5 below) will: match remuneration structures with behaviours and consumer outcomes; use data and risk-based monitoring and oversight to identify potential problems (both in systems and individuals); take remedial action; and adjust remuneration as required. These changes have been designed to underpin the entire CIF reform package, and will improve conduct and culture across the industry (and hence improve customer outcomes).

The governance framework is comprised of the following elements:

• KRIs, to act as triggers/flags for potential poor customer outcomes;

• portable unique identifiers, to allow for more complete reference checking and identification of poor performers;

• annual reviews of individual aggregator and broker governance frameworks;

• data-based broker monitoring;

• customer feedback and shadow shopping to ensure reforms are ensuring good customer outcomes;

• reporting and ongoing review of remuneration structures, including upfront, trail and clawbacks, to the extent they negatively impact customer outcomes; and

• remediation, such as training, education, and recognition.

This work is already underway and will be ongoing. Further details of the governance initiatives to be implemented are outlined below.

Key Risk Indicators

KRIs will be reported from lenders to aggregators/brokers to identify the potential for a poor customer outcome. These indicators will provide data-based direction to the allocation of oversight effort and resources, and will include the following, relative to the industry average:

• percentage of portfolio in Interest Only loans, whether for investment or owner occupier purposes;

• arrears (90+ days or average weighted arrears in the first 12 months); • “switching” in the first 12 months of settlement; • elevated level of customer complaints; • poor post settlement customer survey results of the broker experience; and • the quality of the loan, identified through any deficiencies found in Requirements and

Objectives (R&O) documentation.

Portable Unique Identifiers

The CIF will be working with ASIC to implement a proposed portable unique identifier for each broker and introducer/referrer to a lender. The identifier will be held on a register of brokers maintained as a reference checking protocol for credit professionals moving between aggregators or moving from working with a lender to an aggregator. It will be maintained throughout a person’s career across financial services industries, such as financial planning, mortgage broking, referring/introducing and as a lender-employed banker, and is proposed to be managed centrally by ASIC. Once fully

55 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Interim Report – Volume 1, pp. 320-321.

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implemented, this identifier will be used by aggregators, lenders, associations and ASIC, and be held against all loans lodged at the lender level to assist with data analytics.

Customer Feedback

The CIF is currently working to implement an industry standard customer survey to obtain customer feedback on an ongoing basis, to review whether the ‘Good Customer Outcome’ benchmark has been achieved consistently. This system will become integral to the aggregators’ monitoring of brokers, creating a ‘test and learn’ environment.

Remediation

In conjunction with ASIC proposal one (Changing the standard commission model to reduce the risk of poor customer outcomes), and along with training, education and recognition, the industry considers that good customer outcomes are promoted by withholding trail commission if a loan is:

• 60+ days in arrears; and/or

• found to have been calculated using inaccurate information allowing a customer to receive an inappropriately larger loan (trail not paid if any misrepresentation or fraud is found in the application); and/or

• refinanced or restructured, which may be potential evidence of not being fit for purpose.

It should be noted that upfront would also normally be clawed back by the lender if the above circumstances were to occur within the first 24 months of a loan.

1.2.7 Monitoring and Enforcement via Mortgage Broking Industry Code The CIF was originally developed as an oversight body for the mortgage broking industry, with strong emphasis on self-regulation. It is key that the industry develops appropriate mechanisms to properly enforce the reform package and assess industry conduct (and therefore ensure positive consumer outcomes).

On this basis, the MFAA (together with the CIF) is currently in the process of developing an enforceable Mortgage Broking Industry Code. The Code will apply to mortgage brokers, lenders, aggregators and, where appropriate, referral businesses, and will be subject to all applicable regulatory and competition law approvals. The CIF will work towards implementing an ASIC-approved Code for all industry participants. Owing to the protracted nature of the ASIC approval process, the CIF aims to implement an industry-based Code in the interim which will be backed by and enforced through the existing industry association compliance structures. If an ASIC-approved Code is unachievable, and an industry-based Code is deemed inadequate, the CIF will also consider a regulatory approach.

The Code will be outcome-driven rather than process-driven. It will be used to: implement changes to the standard commission model; implement the Customer First Duty and define a Good Customer Outcome; introduce new governance and oversight measures; manage the movement away from soft dollar benefits; enforce improved disclosure standards; and implement a new public reporting regime. Improved oversight measures, introduced via the new governance framework, will include KRIs to identify the potential for poor customer outcomes.

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Figure 5: MFAA illustration of CIF mortgage broking governance framework

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PART 2: Questions Raised in the Interim Report

The following questions have been selected from the Interim Report based on their relevance to the MFAA’s work and its membership. The Interim Report has posed a number of questions which we consider to be similar in content, and as such, various questions have been grouped under different theme headings below.

Who Does a Broker Act For? – Duties and Obligations 2.1 What should be disclosed to borrowers about an intermediary’s obligations to the lender

and to the borrower? (page 328)

The MFAA believes that there needs to be greater disclosure to the customer in regard to both the broker’s obligations to the lender, and the duty owed to the customer. As noted in question 2.3 below, brokers (through their aggregator) have a number of legal obligations to lenders. These primarily relate to compliance with the law and the collection of loan application information and documents. These legal obligations have no conflicting impact on the duty owed to borrowers.

We believe that clarification of the role of a broker will help to reassure customers, and will better educate them as to the importance of providing accurate and up-to-date information for use in documenting their applications. It will also serve to warn customers that any fraudulent or misleading information provided by customers which is used in a lenders’ assessment of their loan application may result in action against borrowers.

Besides contractual obligations under broker agreements, there may be a perceived or actual commercial obligation to a lender resulting from ownership or restriction in the number of panel lenders available. Any such material restriction should be disclosed.

The MFAA supports the full disclosure to borrowers of the obligations owed by brokers to both lenders and borrowers, and the disclosure of the Customer First Duty and the Good Customer Outcomes benchmark. The interaction and wording of both the Customer First Duty and the Good Customer Outcomes benchmark are discussed in section 1.2.5 of this submission.

The MFAA has also proposed that industry participants introduce greater transparency around ownership structures and related circumstances in which they may have the ability to exert influence. Specifically, we have proposed the disclosure of ownership structures if ‘significant influence’ can be exerted over an industry participant in a given structure.56 For example, if ownership is 20% or greater, or if ownership is less than 20% but a board seat is held, or a white label product is offered by a substantial shareholder (as defined). We consider that disclosure should extend beyond brokers to apply to all participants in the home loan distribution chain, including lenders and aggregators. Disclosure should be included in marketing material, digital formats and at all distribution points (for example, websites and at physical premises).

In order to assist in achieving this, we recommend that a licensee’s or credit representative’s Credit Guide be used to outline disclosure regarding the broker’s obligations to the lender and the borrower; relevant ownership structures and related circumstances in which they may have the ability to exert influence; and material restrictions relating to such ownership structures.

56 As guided by the definition of ‘significant influence’ in Australian Accounting Standard 128 (AASB 128).

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2.2 What duties does an intermediary owe to a borrower? (page 328)

Mortgage brokers owe a number of legal duties imposed by the NCCP Act and additional duties imposed by the MFAA Code of Practice.

Relevant duties under the NCCP Act are as follows:

1. to act efficiently, honestly and fairly; 2. to ensure borrowers are not disadvantaged by any conflict of interest; 3. to enter written Quotes when borrowers are charged a fee; 4. to provide written disclosure of commissions received (in the form of a Proposal Disclosure

Document); and 5. to adhere to all responsible lending obligations in order to ensure that proposed credit will

not be unsuitable for the borrower.

Additional obligations owed to borrowers may include obligations associated with limited agency,57 because brokers are often appointed the limited agent of borrowers to obtain a credit report under the access seeker regime.

Under the MFAA Code of Practice, members involved in credit activities must:

• comply with all applicable laws; • be a ‘fit and proper’ person; • maintain appropriate and relevant training standards; • hold adequate professional indemnity insurance; • arrange appropriate finance for customers; • act promptly and properly in relation to the management of finance applications; • disclose commissions and other benefits received (brokers only); • maintain IDR and membership of an EDR scheme; and • consider hardship applications submitted by customers in a timely and appropriately detailed

manner.58

2.3 For whom do the different kinds of intermediary act? (page 343)

• mortgage brokers

• mortgage aggregators

Mortgage Brokers

Mortgage brokers act for borrowers. Concurrently, brokers observe separate, non-conflicting duties owed to lenders. The legal obligations (under the NCCP Act) which brokers must observe when acting for a borrower, and the additional duties imposed by the MFAA Code of Practice, are outlined above at question 2.2.

Broker obligations owed to the lender are principally drawn from lender agreements. Lender agreements are typically executed between lenders and aggregators, and require that aggregators’ broker members must comply with terms outlined in the lender agreement. They ordinarily appoint brokers as the limited agents of lenders, to conduct anti-money laundering (AML) and verification of identity (VOI) checks. Lender agreements also typically prohibit brokers from making representations or decisions on behalf of lenders, expressly stating that brokers are not the representative of the lender. Under such agreements, the broker is therefore usually limited to submitting credit

57 The descriptor ‘limited agency’ is used in this submission to describe situations in which a broker’s appointed role (or legislation behind the appointment) uses the term ‘agent’. It does not indicate that a broker acts as a borrower’s agent in all situations. 58 Mortgage & Finance Association of Australia, Code of Practice, 4 September 2016.

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applications and has an obligation to take reasonable steps to ensure that borrower information provided in an application is accurate.

Mortgage Aggregators

Mortgage aggregators who appoint members as their credit representatives generally have the same duties to lenders and borrowers as brokers (because licensees are liable for the conduct of their members).

In other cases, aggregators are largely an organising body, having no direct liability to borrowers, but having significant obligations to their members and to lenders. These obligations are passed on to their member brokers. This is an appropriate relationship model given their function. There is no requirement for aggregators to have any direct obligation to borrowers.

Can the current system be improved?

The role of the broker should be better explained to borrowers, including the broker’s obligations to the lender and the broker’s duty to the borrower (with disclosure of the Customer First Duty and the Good Customer Outcomes benchmark). Added transparency regarding the broker’s role and duty will: reassure customers of the broker’s responsibilities; deliver clarity on the importance of providing accurate and up-to-date information in loan applications; and caution that fraudulent or misleading information provided by customers for use in a lenders’ assessment may result in action against borrowers.

2.4 What duties should an intermediary owe to a borrower? (page 328)

The MFAA believes that in addition to legal obligations, the broker’s duty to the customer should be elevated. To this end, the MFAA and CIF have proposed the introduction of a Customer First Duty (outlined above at 1.2.5) and a clear definition of a Good Customer Outcome which a broker must achieve. We strongly consider that this duty, produced following extensive consultation with members of the CIF, to be the most appropriate framework for the mortgage broking industry.

Brokers should also be subject to a robust and industry-specific, enforceable Mortgage Broking Industry Code, as proposed and being implemented by the CIF (discussed above at 1.2.7).

Customer First Duty and Good Customer Outcomes

A Customer First Duty will position the borrower at the centre of a broker’s decisions and actions, complemented by the broker’s understanding of a Good Customer Outcome. This definition (outlined above at 1.2.5) will impose a duty of care that takes into consideration: whether a broker has arranged an appropriate sized and structured loan; whether a loan meets a customer’s stated requirements and objectives; that the loan is affordable for the customer; and whether the broker has ensured the loan was applied for in an appropriate manner including meeting all responsible lending requirements.

Mortgage Broking Industry Code

The extent to which Good Customer Outcomes have been delivered (and therefore, whether a broker has fulfilled their duties to the borrower), will be assessed via key risk indicators, outlined in the proposed Mortgage Broking Industry Code as follows:

• percentage of portfolio in Interest Only loans, as an example of a product and whether for investment or owner occupier purposes;

• arrears (90+ days or average weighted arrears in the first 12 months);

• “switching” in the first 12 months of settlement;

• elevated level of customer complaints;

• poor post settlement customer survey results of the broker experience; and

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• the quality of the loan, identified through any deficiencies found in Requirements and Objectives (R&O) documentation.

The Code will apply to mortgage brokers, lenders and aggregators, and would be subject to all applicable regulatory and competition law approvals. This will inevitably be implemented as an ASIC-approved Code, but we acknowledge that ASIC approval will likely involve a delayed process and as a result, the proposed Code will initially likely be enforced through the relevant industry bodies including the ABA, the MFAA, the FBAA, COBA, AFIA and others, as applicable. Whilst the exact interim enforcement structure is yet to be finalised, all the aforementioned industry bodies, as members of the CIF, remain committed to proper enforcement of the Mortgage Broking Industry Code regardless of ASIC’s approval, as a priority. We expect that the Code will likely be applied to brokers by the MFAA and the FBAA; and applied to the broader stakeholder group by the ABA, MFAA, FBAA, COBA, AFIA and other relevant bodies. We note that at this early stage of development, this enforcement framework is a proposed measure only.

2.5 For whom should each kind of intermediary act? (page 344)

In relation to those whom a broker acts for, the MFAA considers it appropriate that mortgage brokers act for borrowers while also observing separate non-conflicting obligations towards lenders, as outlined at question 2.3 above. Importantly, these duties are non-conflicting.

The MFAA firmly believes that mortgage brokers should act for the borrower, but should be held to a new, higher standard in this regard. The Customer First Duty (discussed above at 1.2.5) will provide a higher duty, by positioning the borrower at the centre of a broker’s decisions and actions, and will be complemented by the broker’s understanding of a Good Customer Outcome.

A broker should act for a borrower in order to deliver added value in the context of an increasingly complex lending market, compared to traditional branch-based lending. For example, brokers should act for a borrower to: deliver guidance and education; deliver enhanced efficiency; provide accessibility and convenience; create reduced administrative burden and stress; and give access to a wider range of products than that available via a bank branch. Following approval of a loan, a broker should: continue to act for a borrower by providing assistance during settlement; provide any additional advice relating to the loan product; and subsequently review the borrower’s financial circumstances over the life of the loan.

A broker should act for a lender in order to: verify the customer’s identity and borrowing capacity; perform a preliminary credit assessment; collect relevant supporting documentation necessary for the loan process; and conduct AML and VOI checks on behalf of a lender if applicable under a lender agreement.

2.6 If intermediaries act for the consumer of a financial service (page 344)

• What duty do they now owe the consumer?

• What duty should they owe?

To the extent this question applies to mortgage brokers, we note that brokers currently observe duties including the obligation to secure a loan which is not unsuitable to the consumer’s financial circumstances, and related responsible lending provisions, under the NCCP Act. As outlined above at 1.2.5, the MFAA considers that additional requirements should be imposed on mortgage brokers, such as the Customer First Duty and the requirement to ensure a Good Customer Outcome.

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2.7 Is it desirable to prescribe that some or all of those who are not employees of banks, but deal with bank customers, must act in the interests, or the best interests, of the client? (page 325)

The MFAA is of the view that mortgage brokers should act in the interests of borrowers. In this regard, the MFAA considers that additional requirements should be imposed on mortgage brokers, such as the Customer First Duty and the requirement to ensure a Good Customer Outcome. For a full explanation of the CIF’s proposed Customer First Duty to deliver this measure, please see our comments above at 1.2.5.

2.8 In particular, what duty, if any, should a mortgage broker owe to the prospective borrower? (page 325)

Further to our response to question 2.4 above, the MFAA believes that in addition to legal obligations, the broker’s duty to the customer should be elevated. To this end, the MFAA and CIF have proposed the introduction of a Customer First Duty (outlined above at 1.2.5) and a clear definition of a Good Customer Outcome which a broker must achieve. We strongly consider that this duty, produced following extensive consultation with members of the CIF, to be the most appropriate framework for the mortgage broking industry and one that reflects a principled, outcome-driven approach rather than a prescriptive process-driven approach.

2.9 Is value based commission, paid to the broker by the lender, consonant with that duty? (page 325)

The MFAA is of the view that ‘best interests’ is not an appropriate standard, and that a Customer First Duty should be applied (as outlined at 1.2.5 above). When coupled with adjustments made to upfront commission on the amount of funds drawn down by a customer net of offset (detailed above at 1.2.2), value-based commission is consonant with the Customer First Duty. This is because the primary way in which product strategy conflicts could arise has been mitigated through this reform initiative, along with the additional CIF reform initiatives (discussed above at 1.2.4). These additional changes include the removal of volume-based and campaign-based commissions, and reform to soft dollar remuneration (including: changes to tiered servicing models; conferences and professional development events; and entertainment and hospitality). Together, these reforms ensure that value-based commission does not conflict with a broker’s duty to act in the interests of the borrower. It should be noted that trail commissions are also paid on outstanding balance net of offset.

2.10 Should a mortgage aggregator owe any duty to the borrower? (page 325)

Under the CIF reform package, mortgage aggregators will be subject to the enforceable Mortgage Broking Industry Code (outlined above at 1.2.7).

Currently, some aggregators appoint some of their members as their credit representative. Where this occurs, the aggregator will owe the same duty as the broker because licensees are liable for the conduct of their credit representatives.

Where brokers operate under a licence other than that of an aggregator, aggregators currently have no liability to borrowers. In these circumstances, it is not appropriate for aggregators to be liable for the conduct of brokers to borrowers because the liability should fall on the relevant licensee. An aggregator’s primary role is to organise the multitude of brokers for the benefit of lenders and customers alike. Some do provide additional services and support, but it is not appropriate that they become liable for the conduct of other licensees.

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2.11 Again, are the remuneration arrangements for aggregators consonant with that duty? (page 325)

The amount of remuneration is a matter of contract between the lender, the aggregator, and the aggregator’s members. Competitive pressure has driven down remuneration of aggregators in the same way as it has driven down the level of commission. We believe there is nothing inappropriate about the remuneration of aggregators.

However, under the CIF recommendations, aggregators will no longer be remunerated on volume.

2.12 What should be disclosed to borrowers about an intermediary’s remuneration? (page 329)

Currently, Division 5 of Part 3-1 of the NCCP Act requires significant information about brokers’ remuneration. These provisions require brokers to disclose:

• fees payable by borrower to the broker, including significant details about those fees – see regulation 28E(2);

• a reasonable estimate of the total commission to be received by the licensee, any employee, director, or credit representative, including significant details about those commissions – see regulations 28G and 28H(4);

• a reasonable estimate of the total fees and charges payable to the lender in relation to applying for the credit, including significant detail about those fees and charges – see regulation 28E(3);

• a reasonable estimate of total fees and charges payable to third parties in relation to applying for the credit, including significant detail about those fees and charges – see regulation 28E(3);

• if the credit is to be used to pay any of the above amounts, a reasonable estimate of the amount of credit left after paying for these amounts;

• if a payment is to be made for a referral (e.g. to a real estate agent, accountant, or lawyer), information about that payment – see regulation 28G(6); and

• if there is a volume bonus arrangement, a reasonable estimate of the maximum amount of commission likely to be received from the volume bonus arrangement.

The current financial disclosure outlined above, as required by the NCCP Act is both adequate and complete.

Building on this, the CIF has proposed to extend disclosure requirements to include: ownership structures (outlined above); a statement that broker fees are calculated net of offset (detailed above at 1.2.2); and a statement outlining which lenders a broker has used (and the percentage of business directed to the top six lenders used by the broker) in the last financial year.

MFAA members are subject to disclosure requirements under the MFAA Code of Practice. According to this framework:

If a commission or other benefit will or may be paid by or to a Member for, or in connection with, provision of Credit to a customer, the Member must always disclose to the Customer that fact and:

a. the name of the person by whom the commission or other benefit is payable; and

b. the name of the person to whom the commission or other benefit is payable; and

c. the amount of the commission or other benefit, if ascertainable; and

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d. if the amount of the commission or other benefit is not ascertainable, the basis of or formula for such commission or other benefit;

but this disclosure requirement does not apply to:

e. the amount payable in connection with a credit related insurance contract; or

f. the commission or other benefits paid to employees of the Member.59

Conflicts of Interest 2.13 Do broker contracts, as they stood at the time of the hearings, meet the statutory

requirement imposed by Section 912A of the Corporations Act 2001 (Cth) to have arrangements in place to manage conflicts of interests? Do broker contracts, as now made, meet those requirements? (page 328)

Section 912A applies only to financial services licensees and so does not apply to credit licensees. The relevant section in the NCCP Act is Section 47(1)(b).

The corresponding provision in the NCCP Act is different. Financial services licensees are required to ‘have in place adequate arrangements for the management of conflicts of interest [our bolding], whereas credit licensees are required to ‘have in place adequate arrangements to ensure that clients of the licensee are not disadvantaged by any conflict of interest’. For the purpose of responding to the question, this difference is not material.

Our response relates to the type of broker contracts generally used by industry.

There are usually contracts between:

• lenders and aggregators;

• aggregators and their broker members, which oblige broker members to comply with the lenders’ procedures and other obligations in the lender contracts; and

• brokers and customers to provide broking services. Often this is a verbal contract.

The first two contracts require brokers to deal with conflicts of interest by requiring brokers to comply with all laws, which includes the obligation to ensure that clients are not disadvantaged by any conflict of interest.

It is also important to consider whether the commercial arrangement covered by broker contracts could create a conflict interest. The contracts do not contain any provision which requires brokers to place the lender’s interest ahead of consumers. Indeed, it is strongly in the interest of all parties to ensure that responsible lending and other customer duties are properly performed failing which the lender’s loan could be at risk. We therefore conclude that broker contracts, as they stood at the time of the hearings, did meet the statutory requirements imposed by Section 47(1)(b) of the NCCP Act to have in place adequate arrangements for the management of conflicts of interest.

Brokers are often appointed lender’s limited agent to conduct identity verification and to collect other information. This limited agency does not create a conflict of interest.

Some lender commission schemes did provide for volume bonuses which could unintentionally create a conflict. Those incentives have now ceased in accordance with CIF guidance.

The mere fact that lenders pay commission has the potential to create conflict. However, that conflict is faced by all businesses – even those with the highest standard of care such as doctors and lawyers.

59 Mortgage & Finance Association of Australia, Code of Practice, 4 September 2016, s 10.

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All businesses must manage the conflict between earning more money and providing service at a fair cost.

Removal of lender paid commission would not remove that conflict, and may in fact increase the risk to consumers. This is because the most vulnerable in our community would likely continue to use brokers, and unscrupulous brokers could charge excessive fees. The current system ensures that the vast majority of commission is at an appropriate level and the law and CIF proposals ensure brokers must ensure that customers are not disadvantaged by that potential conflict. The use of aggregators, the compulsory disclosure of panel lenders, compulsory commission disclosure, and direct selling by lenders all mitigate the risk of harm to consumers from this potential conflict.

Remuneration and Disclosure Requirements 2.14 How should intermediaries be remunerated? (page 344)

Mortgage brokers must be remunerated in a sustainable way in order to prevent broker attrition and preserve competition in the lending market. To this end, the MFAA and CIF have developed recommendations as to how remuneration should be reformed, having considered the viability of a wide range of possible remuneration models and their variants potentially available to the industry.

As discussed above at 1.2.2, the MFAA and CIF have recommended the use of upfront commissions paid on the drawn amount of a loan, net of offset. We have recommended this model, as it will genuinely mitigate product strategy conflict by removing the financial incentive to recommend loans with initially large, unutilised offset balances (as recommended by ASIC). This solution reduces total broker income, but protects the viability of broker businesses and, as such, the strong pro-competitive impact brokers have on the home loan market. It should be noted that trail commissions are also paid on outstanding balance net of offset.

This is the most practical and effective method (and likely the only genuine way) to address conflicts of interest. This fact has been acknowledged by a number of major and non-major lenders which have announced their decision to adopt the CIF remuneration recommendation, as of October 2018.

Additionally, the industry has previously committed to the elimination of volume-based bonus commissions, campaign-based commissions and volume-based bonus payments, removing a considerable product strategy conflict risk. We note that there has been no grandfathering of bonus commissions as they relate to residential mortgages. The industry is also making adjustments to soft dollar benefits in accordance with CIF guidance, including changes to tiered servicing (broker clubs), conferences and professional development events, and entertainment and hospitality benefits. This change is due to be implemented by the end of 2018.

2.15 How is a value based commission consistent with acting in the interests, or best interests, of the client? (page 325)

We note that remuneration, regardless of how it is determined or by whom it is paid, has the capacity to lead to conflicts in some way. Recognising the criticisms of value-based commissions, the MFAA has thoroughly assessed the alternative remuneration models for mortgage brokers (outlined above at 1.2.3).

We believe that value-based commission is consistent in abiding by the CIF’s proposed Customer First Duty (and therefore acting in the interests of customers), due to the adjustments made to upfront commission on the amount of funds drawn down by a customer (detailed above at 1.2.2). This reform initiative genuinely mitigates the product strategy conflict through the removal of commissions from funds in offset and funding which has not been drawn down, and is the only practical and effective method (and likely the only genuine way) to address conflicts of interest. When coupled with the

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removal of volume-based and campaign-based commissions, and reform to soft dollar remuneration, value-based commission does not conflict with a broker’s duty to act in the interests of the borrower.

Responsible Lending 2.16 Are ‘Introducer’ programs compatible with responsible lending obligations? (page 71)

In our view ‘Introducer’ programs in this context denotes referrals by unlicensed persons directly to banks where a fee is paid for the referral. These introducers are exempt from the requirement to hold a credit licence, either because they are private individuals not conducting a business, or are exempt under the NCCP regulations because they make referrals incidental to business.

Both types of referrers also make referrals to brokers, although the MFAA understands that the majority of referrals to brokers are private referrals by customers who have had a good experience with the broker and for which no fee is paid.

It is important to distinguish between appropriate unlicensed introducer activity and introducers who make referrals as a business or as part of a business (as distinct from an exempt incidental activity). Concerns have been expressed by the Commission about the conduct of some introducers who have introduced customers to banks. It may be that these introducers have been doing so in breach of the requirement to hold an Australian Credit Licence to conduct the business of an ‘intermediary’ where that activity is not incidental to some other business (see Section 9 of the NCCP Act). Such licensing would ensure that these introducers are subject to appropriate training and oversight by ASIC.

A referral is akin to a recommendation, and therefore it is important that customers are aware that the referrer is being paid a fee for the referral. The law currently requires lenders and brokers to disclose in writing any fee paid for the introduction of credit business. In addition, under the exemption for business referrers, the referrer is also required by law to disclose that the referrer will receive a fee for the referral.

Paid referrals are a common commercial arrangement in many business types. These referrals are often the way consumers are directed to appropriate businesses. Referrals occur in many ways including product endorsement and increasingly via social media. The line between referrals and advertising is often blurred.

Provided that the licensee undertakes the referred business appropriately and in accordance with the law, and ensures that any referral program is conducted fairly and honestly, referrals are completely compatible with responsible lending obligations and are an important contributor to competition. Referrals are often particularly important for smaller lenders and broker groups.

The MFAA has not had any direct experience with poor conduct by introducers and so is unable to provide further insight. Our members regularly receive referrals and we have identified no problems with that activity.

2.17 How can entities’ systems be improved to detect and prevent breaches of responsible lending obligations by intermediaries? (page 328)

Various improvements to the mortgage broking governance framework will be used to detect and prevent breaches of responsible lending obligations. This framework will include:

• KRIs to act as triggers/flags for potential poor customer outcomes;

• portable unique identifiers to allow for more complete reference checking and identification of poor performers;

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• annual reviews of individual aggregator and broker governance systems;

• data-based broker monitoring; customer feedback and shadow shopping to ensure reforms are ensuring good customer outcomes;

• reporting and ongoing review of remuneration structures, including upfront, trail and clawbacks, to the extent they negatively impact customer outcomes; and

• remediation, such as training, education, and recognition.

Further details on how these improvements will operate in practice can be found above at 1.2.6.

Borrower Expenses and HEM The MFAA’s broad views on borrower expense verification and the use of HEM are provided below in

response to the following three questions.

2.18 What steps, consistent with responsible lending obligations, should a lender take to verify a borrower’s expenses? (page 329)

2.19 Do the processes used by lenders, at the time of the hearings, to verify borrowers’ expenses meet the requirements of the NCCP Act? Do the processes now used meet those requirements? (page 329)

2.20 Should the HEM continue to be used as a benchmark for borrowers’ living expenses? (page 329)

The MFAA believes that a more robust and consistent approach to the verification of a borrower’s expenses should be adopted by the mortgage and finance industry. A more robust and consistent approach will assist brokers in fulfilling their responsible lending obligations and the proposed Customer First Duty. We believe that any measures implemented to verify a borrower’s expenses should be lender-led, to ensure greater channel parity across the home loan distribution chain.

We believe that many lenders, including the major banks have already implemented these changes in response to ASIC recommendations. In addition, ASIC has indicated that reliance on HEM alone is not acceptable and we believe that the industry is largely responding to that guidance.

There however needs to be a greater degree of consistency in approach as currently the policy regarding assessment of expenses differs considerably amongst lenders making it difficult for brokers to apply.

Disclosure of Fraud and Misconduct 2.21 When an employee or intermediary is terminated for fraud or other misconduct, should a

licensee inform their clients of the reason for termination? (page 329)

In the case of mortgage brokers, in our view, it is certainly desirable that clients should be informed of the reasons for termination. The MFAA publishes records on its website of those members who have been expelled from the Association, or who have had membership suspended or cancelled, due to misconduct. The MFAA, aggregators and lenders have been endeavouring to improve methods for interchange of information about malpractice for more than 15 years. The objective is to have a method by which perpetrators of misconduct and fraud can be identified to avoid them reappearing in the industry without detection. Two key problems have frustrated this objective:

• determining beyond reasonable doubt that a particular individual was responsible for the conduct; and

• the risk of being sued for defamation.

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These challenges also apply to disclosure to clients, and no way to overcome these obstacles has been identified despite significant work.

The CIF’s proposal to introduce a portable unique identifier should provide some assistance in tracking individuals. The CIF is presently working with ASIC on this proposal. It is envisaged that an identifier will remain with a broker regardless of where they operate in the industry. This may assist in identifying individuals and matching against records of previous activities.

2.22 When an employee or intermediary is terminated for fraud or other misconduct, should a licensee review all the files or clients of that employee or intermediary for incidence of misconduct? (page 329)

We consider it highly appropriate for a licensee to review all files and clients connected to an employee or intermediary who has been terminated for fraud.

Intermediary Defaults 2.23 Who is responsible for each kind of intermediary’s defaults? (page 344)

The relevant intermediary and his/her licensee are currently responsible for default by the intermediary and that is an appropriate state of affairs

2.24 Who should be responsible? (page 344)

The relevant intermediary and his/her licensee are currently responsible for default by the intermediary and that is an appropriate state of affairs

FOFA Reforms 2.25 Should intermediaries be subject to rules generally similar to the conflicted remuneration

prohibitions applying to the provision of financial advice? (page 325)

The original objectives of the FOFA reforms were best outlined by ASIC Commissioner, Peter Kell, in his 1 May 2012 address to the Association of Financial Advisers’ Financial Services Council Leadership Forum:

ASIC wants to work with your industry to improve consumer trust and confidence. This can be achieved through:

• dealing more effectively with conflicts of interest;

• improving competency and the quality of advice;

• encouraging greater ethics, standards and professionalism.60

The MFAA supports these objectives however applied in a manner that is relevant to the mortgage and finance industry. The work of the CIF is focused on these outcomes, whether it is achieved through the recommendations to deal more effectively with conflicted remuneration, or through the implementation of a new Customer First Duty and customer-focused governance framework.

The MFAA argues, however, that the specific measures which were introduced through the FOFA legislation were designed specifically for the financial planning industry – not the mortgage and finance industry. Whilst we are generally supportive of the objectives of FOFA being applied to the

60 Speech by ASIC Commissioner Peter Kell, to the Association of Financial Advisers’ Financial Services Council Leadership Forum, 1 May 2012.

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mortgage and finance industry, we argue that we need our own relevant reform measures – not simply a ‘cut and paste’.

As outlined in section 1.1 of this submission, the current remuneration arrangement has driven competition, choice and access to credit which has provided many lenders with a shop front, successfully moderated the dominance of the major lenders and contributed to a decline in net interest margins. Recent data-driven reviews by ASIC and Sedgwick did not find evidence of systemic harm to consumers. This is supported by industry data showing high customers satisfaction, low and declining complaints, falling prices, modest arrears differences and strong increases in competition. Additionally, consumers continue to strongly support the broker channel with June 2018 loan introductions increasing to 53.9% in 2018 versus 51.5% in June 2017. This 2.4% increase is the largest year on year increase for any quarter in more than three years.

Whilst channel differences are noted, after controlling for borrower characteristics and loan features ASIC found these not to be significant (as outlined in section 1.2.1). Treasury also commented on this point in its Background Paper 24:

243. These average differences are prima facie not so significant that they provide compelling evidence of major problems that require a wholesale change to the existing standard commission structure given the industry reforms currently underway…61

It should also be noted that complexity gravitates towards the broker channel within each demographic which further explains channel differences.

The CIF is currently rolling out a package of reforms that will improve customer outcomes, standards of conduct and culture while preserving and promoting a vibrant and competitive mortgage broking industry that encourages consumer choice. This package of reforms includes:

• a Customer First Duty which, together with the definition of a Good Customer Outcome, provides an added layer to offset concerns related to conflicted remuneration provided for under responsible lending legislation and NCCP licensing obligations;

• direct changes to broker remuneration: o commissions to be paid on drawn down amount, net of offset (section 1.2.2); o the removal of the volume-based bonus commissions, campaign-based commissions,

and volume-based bonus payments, and the delinking of volume from soft-dollar incentives (section 1.2.4); and

• reforming governance practices (outlined at 1.2.6).

As outlined in section 1.2.3, the MFAA and the CIF have considered a large number of alternative remuneration structures and their variants as well the unintended consequences for each.

Our analysis revealed that fee-for-service type models (irrespective of whether the fee is paid by the lender or the borrower) would come at a heavy cost to competition and would ultimately not result in good customer outcomes.

In relation to a customer fee-for-service, this view was supported in the PC Report, which said:

The Commission agrees that fees-for-service paid by consumers are unlikely to be pro-competitive, because a lack of willingness to pay is likely to result in a smaller mortgage broking industry, and the greater damage would be to the lenders without branch networks. Given that many mid-size and smaller lenders rely on brokers to compete … competition in the home loan market would likely be weaker as a result.62

61 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Background Paper 24, prepared by the Australian Treasury, 13 July 2018, p. 59. 62Productivity Commission, Competition in the Australian Financial System, 29 June 2018, p. 333.

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The cost to competition was also outlined by Treasury in Background Paper 24:

261. The risk with this option is if customers switch to obtain home loans from lenders directly rather than paying brokers an upfront fee, threatening the viability of the mortgage broker distribution channel. Estimates of what most consumers may be willing to pay a broker, of no more than $1000, are well below the average value of commissions currently paid by lenders. If mortgage broking activity contracted, this could have a significant detrimental impact on competition in the mortgage market.63

We note the Interim Report has relied on the views of one major lender in support of a fixed fee for service. The primary winners from such a reform would be the major banks with significant branch infrastructure, as customers would have a financial incentive to utilise a proprietary lending channel rather than a broker. Therefore, support for a consumer-paid fee-for-service by any lender with significant investment in branch infrastructure would as a result appear to be entirely self-serving.

We do not consider it necessary to introduce further regulation into the mortgage broking industry regarding conflicted remuneration prohibitions, due to the changes to remuneration structure already underway via the CIF, in response to issues raised in the ASIC Report and the Sedgwick Review.

2.26 If some or all intermediaries should owe the customer a duty to act in that customer’s interests, or best interests, is it enough to prescribe the duty and direct ‘management’ of conflicts between interest and duty? (page 326)

The MFAA believes that a higher duty is required for mortgage brokers, and has proposed the introduction of a Customer First Duty as the most suitable standard, over the imposition of a ‘best interests’ duty.

The risk of conflicts is presently low in the broking industry and will be further reduced by the ongoing implementation of the CIF proposals. These include changes to remuneration structures (outlined above at 1.2.2); a Customer First Duty and a definition of Good Consumer Outcomes (outlined above at 1.2.5); a new governance framework and improved disclosure/public reporting (outlined above at 1.2.6); and a Mortgage Broking Industry Code (outlined above at 1.2.7). These reforms should be viewed as an entire package to assess their full effect.

To the extent that a residual conflict remains (which is principally the conflict arising from differing commission rates offered by lenders), the obligation to ensure borrowers obtain a suitable loan (under the existing law) as enhanced by the CIF proposals, in our view, manages that conflict appropriately.

External Dispute Resolution 2.27 Are external dispute resolution mechanisms satisfactory? (page 344)

The MFAA is of the view that the Australian Financial Complaints Authority (AFCA), a new external dispute resolution (EDR) scheme, is still in its infancy at present and should be evaluated in 12 months’ time. It is our hope that this new system will successfully streamline services for the benefit of both consumers and industry participants, and will have greater accountability.

Other 2.28 Should there be a mechanism for compensation of last resort? (page 344)

63 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Background Paper 24, prepared by the Australian Treasury, 13 July 2018, p. 62.

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While a compensation scheme of last resort may benefit consumers who engage with a provider of financial services whose business collapses or is wound up, mortgage brokers who provide credit services and credit assistance must hold a statutory professional indemnity insurance policy that covers any subsequent claim if their business fails or is wound up. These policies have a mandatory ‘run off’ period (that is, the period after the business ceases) of twelve months and, anecdotally, most policies viewed by the MFAA carry an 84 month ‘run off’ period.