The inevitability of conflicts: Managing and disclosing conflicts of interests
The Banking Royal Commission has exposed, to public scrutiny, the "misconduct, mismanagement and misaligned incentives" that seem endemic to the financial services industry. I don't intend to use this opportunity to warn about the threats and challenges posed by vertical integration, but I do want to practically explore how we identify and manage conflicts of interests as well as the challenge of prioritising clients' interests.
I appreciate that many people simply ignore conflicts. Others accept them as inevitable and inescapable. Some see them as (largely irrelevant) disclosure issues.
Conflicts are inevitable but, in my opinion, the way in which you deal with conflicts is one of the most telling indicators of your professionalism.
Context is everything
If you're aware, or reasonably should be aware, of a conflict between your client’s interests and the interests of another party, you must give priority to your client’s interests. This includes providers, licensee, authorised representatives of the licensee and any associates of the previously mentioned.
Although their appearance before the Banking Royal Commission suggests an inability to apply their own standards to their conduct, the FPA Code of Ethics requires advisers to "ensure the integrity of their work, manage conflicts and exercise sound professional judgment".
Financial advisers and Licensees are required to disclose these conflicts and relationships formally within their advice documents (947B and 947C) and financial services guides (942B and 942C). Consideration also needs to be given to these relationships throughout the advice process and where necessary, evidence provided to prove that the decision was in the client’s best interests.
The most recent discoveries of the Royal Commission have brought some information to light surrounding the potential conflicts in the mortgage broking and lending sector, and it may come as a surprise to some who are reading this that not all of these disclosure obligations are consistent through all sectors of the financial services industry.
Disclosure is not enough.
Part of giving priority to the client’s interests is considering as well as disclosing any information which has the potential to influence the advice. The most common form of these disclosures for advisers is remuneration, especially commissions.
Let's think about risk advice.
The recent changes to the financial advice industry in this area relate to the Life Insurance Framework which came into effect on 1 January 2018. The LIF Act placed a restriction on the amount of commissions able to be received from insurance product providers as well as changed the circumstances relating to when commissions can be received, in a bid to reduce conflicts of interest.
Prior to this, the percentage of the premium payable as a commission by the life insurance provider to the adviser varied in their amounts considerably depending on who you were dealing with. It was not uncommon to read a Financial Services Guide stating that they could receive anywhere up to 135% of the first year’s premium in the form of a commission payment.
Mortgage brokers, in particular, frequently repeat the statement that paying commissions “do not cost consumers anything” and they are “just a rebate of the profit margin.” This is a popular position but the fact remains that these payments can influence brokers' decisions, and rarely in the consumers favour if the recent report from ASIC is anything to go by.
In the end, whether, and to what extent, the conflict of interest influences the adviser's recommendation is largely irrelevant. The fact that it exists means that it must be addressed. ASIC have stated that they believe a conflict of interest arises in the current commission model for mortgage broking and lending in two main forms - Product Strategy Conflict and Lender Choice Conflict.
Product Strategy Conflict
ASIC's focus on this conflict is based on their view that Brokers routinely recommend larger loans than what the consumer needs. They conclude that the reason this is done is to maximise commission payment paid to the Broker.
The larger the loan = the bigger upfront commission.
The longer the loan = the longer the ongoing commission.
This has become evident in the recent reports from ASIC which highlights consumers on average, borrow more and pay down the loan slower when going through a broker.
It may be possible, particularly in a market with restricted supply, that consumers are using Brokers to obtain larger loans to maximise their purchasing options but, in ASIC's view, even if this were true the influence of the commission cannot be ignored.
Lender Choice Conflict
ASIC's concern is that higher commission arrangements may lead the Broker to recommend loans from a particular lender and these loans may not be the best fit for the consumer.
ASIC have suggested a number of changes which they think will help strengthen these areas, which include:
changing the standard commission model to reduce the risk of poor consumer outcomes;
moving away from bonus commissions and bonus payments, which increase the risk of poor consumer outcomes;
moving away from soft dollar benefits, which increase the risk of poor consumer outcomes and can undermine competition;
clearer disclosure of ownership structures within the home loan market to improve competition;
establishing a new public reporting regime of consumer outcomes and competition in the home loan market; and
improving the oversight of brokers by lenders and aggregators.
The future of broking
A 'fee for service' model has also been suggested as way to manage these conflicts and poor consumer outcomes that result from them, but both ASIC, and the Royal Commission, need to consider the impact this shift will on brokers, lenders and consumers.
ASIC believe that under a fee for service model, lenders might still compete on the size of their fees and as such, fee disclosure may provide an alternative solution.
However, I don't think you should anticipate any immediate changes.
No bank is going to move first because it would cost them business.
Consumers do need choice, but the selection protocol must be based on the right reasons.
Until then, I suggest that you place additional emphasis on documenting and verifying your processes for discussing, researching and structuring loans for clients. Documenting how your decisions are made will help you prepare for any changes on the horizon.
In the financial advice world, your decisions must be supported with research, file-notes and evidence. You must also document the basis for your advice including reasoning and alternate means. You need to demonstrate that the advice is in the client’s best interests.
There is a very high probability that the mortgage broking and lending sector may move in a direction much like that of financial advice as time goes on. Be prepared to see education and professionalism addressed as well as the remuneration structure and a higher level of disclosure and scrutiny overall.
Even in the absence of what James Shipton describes as "regulatory catalysts", you should accept that professional advisers don't rely on disclosure alone. In the wake of the Royal Commission, those businesses that rely on disclosing conflicts, rather than avoiding them, are going to suffer for their approach.