Home | Blog

Friday, November 25th, 2011

Intermediation in Financial Services: What Should One Do?
posted by Ross Dawkins

In a previous post, I noted some of the issues around commissions and intermediation.  There are a number of choices that are possible if regulatory action is required.  To give some real-world context, I will look at the mortgage market.  (There are other regulatory concerns around intermediaries: for example, the UK's Office of Fair Trading - www.oft.gov.uk/OFTwork/credit/credit-brokers/ - has published guidance on credit brokers, having identified some pretty outrageous practices.  I will simply be considering those regulatory fixes directly aimed at third party commissions).

First there is straight-forward prohibition or at least placing a tight cap on commission levels (creating a forcing effect towards remuneration by fees).  This can lead to a loss in efficiency in the distribution of products — such that a principal-agent style problem is recreated for the mortgage providers.  For the consumers there may be a gain if in the previous situation they were being over-sold to.   This is a function of the ability of consumers to understand the product and the situation they are in (i.e. are they dealing with someone largely incentivised by the biggest commission payment?)   One would also need to look at soft commissions (e.g. the provision of training, IT systems, and so on). 

Altogether then prohibition would be a revolutionary change — it needs to be demonstrated market by market that such change is necessary to restore proper functionality to that market.  And I mean demonstrated by evidence, not by a theoretical model (no matter how apparently neat it is).

A second tool is building transparency as to the nature of the relationship and on commission levels are tools.  This is important but reliance on disclosure by itself is not without issues.  Consumers can be overloaded with information and, even when great care is taken, can display a marked inability to identify the better deal. 

In an experimental study carried out by the Federal Trade Commission in 2004, a group of then recent mortgage borrowers were asked to compare two loans and state which was cheaper and which they would choose.  One had broker commission, the other did not.  The question was posed twice — once with the brokered loan less expensive than the other and again when the costs were equivalent.

In the control group, where there was no disclosure about broker commission about 90 per cent of consumers could identify the less expensive loan from a choice of two (up to 99 per cent could identify two loans as being comparable — implying low confidence in at least a minority).  If the choice of loans was increased from two to a number comparable to that of the whole market then that percentage would, no doubt, have been lower still.  In part this justifies and explains the opportunity for comparison websites (and the importance of their accuracy and impartiality) and perhaps also he role of good financial journalists.

When disclosure of the value of commission due to the intermediary (payable by the lender) was introduced it had effects as follows.  With the brokered loan less expensive, 63-72 per cent selected that loan as the cheaper (different groups were presented with the disclosure in different designs, hence the range).  This would manifestly lead to consumer detriment.  When the two loans had equivalent costs then 45-54 per cent of the potential borrowers would choose the loan without the commission element within cost disclosure (i.e. bias against intermediaries).

Naturally, there could be some interplay between the physical presence of an adviser and the partial alleviation of such consumer confusion - but this would hardly lead to a complete solution.  Transparency on its own is not enough.

A third, less well-used option, is to look at the payment structure.  Commission is a system of remuneration that can promote moral hazard in the absence of proper risk-sharing.  For many products this can be directly dealt with by re-designing the remuneration profile, such as staggered payments so that the remuneration structure is risk-based.  In the case of a mortgage, say, if the mortgage defaults, then the commission payments could stop.  This is a remedy against incentives to over-sell that we backed in an old study on credit intermediaries.  As a remedy it would not be without problems.  In transition there would be a cash flow shock for brokers used to paying paid up front.  There would also be an increase in complexity - a mortgagee defaulting on payment may not have been overs-old the mortgage at inception: circumstances change.  Any clawback in such a case would appear unfair to the intermediary. 

An option that has not figured very much but which I wish to consider here is as follows: to ensure the co-ordination of commission rates within a tighter range.  To minimise the level of regulatory interference this would be at the level of the individual intermediary: the commission rate at which it is willing to do business within a set product category would be set and posted to customers and suppliers alike.  (It would not involve the commission rate being set by the relevant regulator as a price control).

The supervisor’s interest would be to monitor and check whether sufficient depth of product was being offered in a particular category.  (To ensure that a proper job was being done and to avoid encouraging the choice of a particular product by framing it with unattractive comparisons, say, as a form of regulatory get-around).

The main problem (and not a trivial one) is that there is a risk that the rate of product innovation within a given category could reduce — there could be a disincentive to increasing product complexity.  Some might argue that this was in itself actually an advantage.

Source: “The Effect of Mortgage Broker Compensation Disclosures on Consumers and Competition: A Controlled Experiment”, Federal Trade Commission Bureau of Economics Staff Report, James M. Lacko and Janis K. Pappalardo, February 2004

 


Blog Archive

Blogroll

Latest Publications