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Friday, November 25th, 2011

Intermediation in Financial Services: Causes for Concern?
posted by Ross Dawkins

A common distribution model in financial services has always involved third-party intermediaries sitting between the customer and the “manufacturer” (such as a bank) and remunerated wholly by the latter.  This has attracted a lot of regulatory interest in the purchase of investments, with many supervisors around the world having affected or considering the ban of commissions in such cases. 

But the model of third party commissions extends well beyond investment products.  This is in large part because such payments are an efficient mechanism for rewarding product sales.  This works pretty well to the extent that you are only interested whether or not the intermediary’s incentives are aligned to those of the product’s manufacturer.  However if consumers expect advice from the intermediary to assist in product choice, then this can create apparent conflicts of interest.  What should be the level of regulatory interest be here?  I think that the key questions are these:

1.    To what extent are commissions driving product choice?  This is a fundamental question to pose but the answer can be hard to get at directly, and gets harder the more complex the product.  One can, however, look at the problem indirectly by assessing commission rates in the market to see how variable these are (little variation implies a limited role in any - possibly inappropriate - driving choice, as opposed to actual advice-giving).  Such a review should also include non-pecuniary, soft, commissions.

2.    Product complexity — specifically what is the likely ability of a consumer to understand products sufficiently well to make a good comparison and so monitor the transaction?  (There is a secondary issue here of which consumer — an “average” customer or one that is in some way considered “vulnerable”?)

3.    Consumer expectations of receiving any advice at all on which product to buy (or even whether to make a purchase or not)?  Or is the consumer simply seeking to make the process of searching for a specific product easier and cheaper? 

4.    Linked to this, another question relates to the consumer’s expectations about the “independence” of the intermediary, and hence the advice.  Notwithstanding the fact that the consumer may not be paying for any service received, it is often suggested that there is an expectation that the intermediary is considered to be working for the consumer, or at least impartial.  If you are dealing with a self-described saleswoman you should not anticipate any independence and really should be on your guard.  On the other hand, regulatory initiatives have meant that actual salesmen have sometimes acquired obligations to customers — such as advising on product suitability such that caveat emptor does not always operate as fully here as it might in non-financial situations.  It follows that expectations of “independence” may have been partly clouded from the underlying economic realities — consumers have been put off their guard, potentially becoming less wary.  If consumers are naïve about the relationship the risk of detriment arising from the interaction must surely increase.

I do not think that there is a simple algorithm to define how concerned anyone should be, i.e. no one should be a fundamentalist on this: rather it should be about the exercise of thoughtful judgement.  To illustrate these points I compare investment products with car loans as a form of worked example. 

Investment products are often highly complex, with even well-educated consumers struggling to compare products in a meaningful way.  Building a portfolio matched to your long-term goals is in fact rather hard (particularly in the current investment climate); judging the true quality of an investment before it reaches maturity can be difficult, even impossible.  The advantages of ensuring independent, high quality advice in such a setting are surely clear.

On the other hand, a car loan (perhaps intermediated at the motor dealership) has simpler attributes.  Part of the decision to buy a car is the calculation of how to pay for it.  For most people that will be before entering the showroom (i.e. it’s not a wholly ad hoc decision).  This provides an opportunity to research competing options and make a reasonable comparison, so that the result is a competitive loan even if not necessarily the cheapest available to find with no limit on search time.  The consumer should not expect to rely upon the independence or advice of such a point-of-sale intermediary — their ultimate interest is clear: to sell the car.  If you need finance for that, then an option will be available more or less off-the-shelf for you.  The convenience of this may well compensate for any disadvantageous price difference.  All in all, the theoretical grounds for concern are not great.  The empirical basis (i.e. evidence of actual detriment) for change would need to be extremely strong to justify any regulatory action.


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