The value of adopting such an approach was an important lesson to come out of the Global Financial Crisis. In the early part of this century, mortgage lending boomed. Even though the term is frowned upon in official circles, there was a housing lending “bubble”, and nowhere more so than in the United States. And during 2007-08 that bubble burst, precipitating the GFC.
There were many causal factors that contributed to the GFC but, primary among these, was the runaway growth of broker-originated loans in the US which fed a rapacious asset-backed securities market. Fuelling this rapid growth in mortgage lending were incentive arrangements in which mortgage brokers were paid an upfront commission based on the volume of loans they originated. Any referral to bank lending standards was cursory and instances of predatory lending abounded. As a consequence, large volumes of poor quality assets entered global securities markets.
This was a market failure, plain and simple. While the investment banks that accepted these loans all had lending criteria in place to which the brokers were obliged to adhere, these were not checked and problems with the loans only became apparent some time down the track. By this time, the broker who has received an upfront commission for originating the loan, had moved on. The incentive for the broker ends at the point the loan is on the books of the bank.
Conversely, with a properly structured trailing commission (and I admit that not all trailing commissions are well-structured), brokers will remain in the frame and accountable for their lending decisions into the future.
One point seemingly overlooked by Hayne is that APRA’s prudential standards in relation to remuneration (including requirements relating to deferral and ex post adjustment) apply just as much to brokers used by banks as to a bank’s employees. So the idea of a trailing commission already sits well with the prudential framework applicable to Australian banks.
A well-structured trailing commission should fully incorporate the APRA requirements and thus enable the amount of commission paid to be varied in line with performance of the loan over time. Such an assessment could include not only on-going compliance with the bank’s lending standards, but also compliance with Household Expenditure Measures (HEMs) and demonstration that the loan as made was “fit-for-purpose” and suitable to the borrower’s needs.
In this way, mortgage brokers would be incentivised to act in the best interests of both banks and borrowers. Far from being “money for nothing”, trailing commissions could be “money well spent”.
David Lewis’ paper on the GFC and its causes – Risk-Based Supervision: How can we do better? – is available on APRA’s website under Speeches (June 19, 2013)
David Lewis has held numerous senior roles at the Reserve Bank and APRA. He is now an adviser on matters relating to governance, culture and accountability in the financial sector.