Royal Commission: Key Recommendations, Winners & Losers

Ron Shamgar, Head of Australian Equities, takes a quick look at the key recommendations, winners and losers to come out of the Royal Commission report that was released early this week. ​We take a quick (we will keep it brief as we are sure you are being bombarded with similar articles) look at the outcome of the Royal Commission and impact on the different industries and businesses affected. ​

In summary, after 68 days of hearings, 130 witnesses and more than 10,000 public submissions, the Royal Commission final report includes 76 recommendations. We examined the report in detail and we outline below the key recommendations we think are important for investors to understand. We also detail the major winners and losers and the eventual impact on consumers.

Key Recommendations:

• That mortgage brokers must act in the best interests of the borrower and failing this duty would carry a civil penalty. Additionally, trail commissions should be abolished over a period of two to three years with upfront commissions to follow.
• That clients must approve in writing ongoing fee arrangements for the provision of financial advice every year.
• That grandfathered commissions should be repealed with the government announcing that they will cease from January 2021.
• That ASIC should consider banning commissions on life risk products. Also that the hawking of insurance products should be banned and the exemption for the sale of funeral insurance should be removed.
• Retail car dealers should be brought into the Credit Act and ASIC should impose a cap on the amount of commission that can be paid to car dealers for the sale of add-on insurance.

The Winners

Big Banks:
The report makes no changes to vertical integration or any expansion as to how banks assess the suitability of borrowers. Banks will also not be prohibited from the use of the "household expenditure measure" as the basis for making loans. The banks will ultimately win from the changing remuneration structure of mortgage brokers, when and if it happens. Watch out for the lobby groups because they are gearing up for a big fight!

Following the report the major bank share prices bounced strongly and we expect this may possibly continue in the short term. Over the medium term we still see banks facing headwinds with lower credit growth, higher cost of funding and falling housing prices. We favor non-bank lenders in this environment.

Consumers:
The government will establish a compensation scheme of last resort going back 10 years, providing $30 million in compensation for claims of past misconduct.

The Losers

Mortgage brokers:
These are clearly the biggest losers from the final report. We expect their basis of remuneration to change entirely and may fall significantly. Brokers also face a new best interests duty and possible regulation as financial advisers. The government has not adopted the suggestion to ban commissions for upfront commissions for mortgage brokers. It will remove trail commissions though, with Labor supporting these reforms. 

To put this into context, currently the single biggest cost a lender incurs on a home loan is the 0.6% upfront commission and 0.2% annual trailing commission they pay mortgage brokers. According to CBA this adds up to $6,600 in fees per loan. Based on the new reforms, these commissions will disappear completely, in the process, destroying the existing business models of 20,000 mortgage brokers nationally. These account for 60% of all mortgages written in Australia. 

Under the new reforms, these costs will now be charged to the borrower, who, on estimates, should be prepared to pay about $2300 for this service in future. Mortgage broking stocks fell as much as 30% on the day of the report.

Insurers:
Face the loss of commissions on life and general insurance products. This obviously creates the possibility of reduced revenues should the ban be implemented. 

Financial advisers:
Those who provide personal advice will have to be registered and the industry faces a central disciplinary body. We expect a mass exodus of advisers who are nearing their retirement in the next few years. Our expectations of industry wide disintermediation  has not occurred and it will be interesting to see how the future government deals with the issues of vertical integration and conflicted advice.

Car dealers:
Face a cap on commissions for add-on insurance sales. This means a dealer must wait anywhere between several days and up to the time the car is delivered before it is allowed to sell any insurance to their customers. If the latter time-frame is enforced, this could have meaningful impact on car dealership earnings. With new car sales down over 20% in the last three months, this is not a sector we currently favour. 

Conclusion:
This was not the report the public has been expecting. After the ferocity of the hearings and the ensuing public outrage, we think that Kenneth Hayne has delivered a weak report and that the best interests of the consumer have not been fully taken into account. The results are the potential destruction of the mortgage broking business, impacting a significant number of small business owners while strengthening the position of the banks. Consumers will ultimately bear the costs of this. The increased funding to the regulators will also need to be paid for. While we support a strong and tough regulator who does not take any flack from the banks, ultimately the cost of increased enforcement will have to be paid for and once again it will be the Australian tax payer who have to pay. 

Not happy Ken!!!​