The Retail Distribution Review and the impact on the mortgage industry
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Speech by Stephen Bland, Director, Small Firms Division, FSA
Mortgage Masters Conference,
30 November 2007.
I'm delighted to be here today. It's good to be among forward-thinking market leaders prepared to look at their industry, where it is heading, and what could be on the horizon. There are, as Donald Rumsfeld said, "known-knowns" and "known-unknowns" out there. For mortgage and protection-based businesses the Retail Distribution Review is clearly a "known-unknown".
I hope today will move us all more into the known-known territory. Although clearly the full implications of the review will not become apparent until next year, once all the feedback is in, and our research complete.
I've structured my remarks today under three headings: possible direct regulatory read-across of the RDR to the mortgage market; possible indirect consequences for the mortgage market; and whether the mortgage market may face similar issues to those covered by the RDR. I want to spend the majority of my time discussing the third heading, not because I have all the answers now, but because I hope this will provide a good basis for our panel discussion later on.
Possible direct regulatory read-across to the mortgage market
On the first heading – possible direct regulatory read-across to the mortgage market – I should start by putting your minds at rest and say that there will be no nasty surprises for you today; our position hasn't changed since we issued the RDR Discussion Paper in June so I'm not about to announce a read-across to the mortgage market! In the paper we said that, as the review aims to address the root causes of problems that persist in the distribution of retail investment products, there is no automatic transfer to the mortgage market. We have asked for views on this but it is too early to say where stakeholders will come out, other than in one respect which I will mention later. We also said that if we did have grounds to apply some or all of the ideas to other retail markets, then we would of course ensure that we went through an open process with the market, as we have done with the RDR.
Possible indirect consequences for the mortgage market
But, that is not to say the review is of no interest to you. My second heading – possible indirect consequences for the mortgage market – covers rather more material.
First, and most obviously, many firms are in the overall financial advice market, meaning they give advice on not just investments, but also on mortgages and protection, or some combination of the three. In the room today – and besides me on the platform – are people from businesses that offer financial advice on this full range of products and services.
Our latest figures show we have 6,406 directly authorised intermediary firms able to give advice on mortgages. Only 419 of these concentrate solely on mortgage business. 3,048 directly authorised firms can give investment and mortgage advice. So nearly half of the directly FSA-authorised mortgage brokers have the investment part of their firm affected by the review anyway, and thus their management will be getting to grips with it.
Secondly, as we acknowledged in the paper, firms from across the retail market – not just investment firms – may choose to apply the ideas put forward in the paper to other types of business, including the distribution of mortgage and protection products if they can see commercial and efficiency gains from doing so.
This applies particularly in the area of communications with customers, where we all want to minimise the risk of customer confusion by keeping the variety of disclosure documents and explanations about status to a minimum that delivers the desired effect, particularly if a firm is dealing with that same customer's varied needs for mortgages, savings and protection. It is in this area that we can already say that we have heard clear feedback on the RDR Discussion Paper: this is that the market believes there should be some convergence of approaches in the industry, whether or not these are mandated by the regulator.
Such convergence could also apply more widely than disclosure. For example, if a broker is operating on the basis of Customer Agreed Remuneration for its investment services and has agreed this with the customer, does the broker then want to have to explain a different remuneration system for mortgage services to the same customer? I ask this question – to which I don't yet know the answer – because even in the absence of regulatory intervention, some mortgage market practices may – for sensible commercial reasons – converge with future possible practices in the investment market.
And, thirdly, there may be consequences for the mortgage market in terms of its standing vis-a-vis the mortgage market. What I mean by this is that the RDR aims to achieve an investment market which gives consumers better outcomes in terms of the advice they receive and services available to them, with standards of professionalism that inspire confidence and clarity about the services being provided and what the customer is paying for. If we achieve this, and yet the mortgage market doesn't operate with these outcomes in mind, then the mortgage market could – relatively speaking – be seen as offering an easier ride for those individuals and firms not wishing to meet the professional and other standards involved. Or the mortgage market could be seen as a less attractive option than the investment market for individuals and firms who do wish to meet those standards. And both those effects could in principle lead to an absolute decline in the quality of advice and other services that the mortgage market offers its customers. So the mortgage market might need to up its game just to stay in the same relative position to the investment market.
Whether the mortgage market may face similar issues to those covered in the RDR
So to my third heading, whether the mortgage market may face similar issues to those covered in the RDR. Let me quickly summarise what our aims are for the retail market as a whole – which, of course, includes mortgages as an important component; after all buying a house is probably the biggest single financial transaction most people ever make – and then explain our aims for the retail distribution review.
For the retail market as a whole our aims are straightforward – to help consumers to achieve a fair deal from a sustainable financial services industry and for them to have confidence in the products they buy and the advice they take. We are tackling these issues in several ways, including our work to improve the public's understanding of financial matters; through our Treating Customers Fairly work; and through our principles-based regulation. And of course we are fully linked into other developments, such as Otto Thoreson's review of Generic Financial Advice.
However, there are particular features of the retail investment market and the way that products are designed and distributed that make our aims difficult to achieve there. It is the problems created by these features that we want to address through the RDR. The issues in the investment market, which I shall in a minute discuss in the context of the mortgage market, include:
- Poor consumer understanding and engagement, so they don’t act as a strong force
- Complex products
- Misalignment of advisers’ interests with those of consumers. We know that this does not necessarily always lead to inappropriate advice but we do see evidence of provider bias from the actions of providers to increase market share by raising commission rates
- Those providing advice can often do so with relatively little training and testing compared to other professions; and
- Low levels of profitability in some firms suggesting that some business models are unsustainable.
Given this, it was sensible for us to begin our review of retail distribution with a focus solely on the investment market. We questioned when we began whether to extend its scope, but the investment market is one that displays quite different characteristics from the mortgage or the protection advice market, which do not have the same recurrent problems.
Thus we began the retail distribution review looking at investment because we found – and others agreed – that the market wasn't working efficiently. Currently the mortgage market – the mainstream mortgage market, at least – appears a more complete market.
But there are serious issues for both individual brokers and the market as a whole to address, both in the current market and looking ahead to possible future developments.
As regards the current market, it was only earlier this week that we published the findings of a series of FSA reviews of mortgage brokers carried out during the summer. We found that while some have improved their advice processes, a number continue to operate well below our standards, with senior management failing to adequately monitor and control firm performance or ensure that they are treating their customers fairly
We did see a number of good brokers and others who had some way to go but who were willing to engage with us and be helped to improve their performance.
But it is clear there are still an unacceptable number of firms unwilling to change and who will damage the industry's image and reputation. For example, it is clearly not acceptable for some brokers to offer mortgages they know to be unaffordable and to accept self-certification business even if they have doubts about their client's income.
I acknowledge that some of the responsibility must fall to lenders – and we are currently in the process of carrying out a related project looking at the extent to which lenders are meeting the requirement to lend responsibly. We've also had issues about exit fees, and others, and I know Chris Cummings and AMI have their own suggestions on what lenders could do more of to make brokers' and customers' lives easier.
But the stark facts for brokers are that we've referred seven broker firms to our enforcement team and we are also taking a range of other regulatory action against another 65 brokers. And this follows extremely disappointing findings earlier this year after we looked at mortgage brokers' processes around the advice they give, in particular training and competence and senior management responsibility.
I appreciate that many of these findings are from small firms, and you represent the largest distributors, but we have to recognise that the majority of the mortgage broking market is made up of small firms, and if we are looking at the market as a whole we have to take these findings seriously.
We are dealing with some of these issues through our normal supervision work. Our enhanced strategy for small retail firms will see more help available for good brokers to make progress on treating their customers fairly from next year, and with additional enforcement resources attempt to deal with the bad apples.
That is the current market. There are also possible future developments which will affect the mortgage market, and may influence whether the problems we are trying to address and opportunities we are trying to identify in the investment market also apply to the mortgage market.
First on regulation, the findings from the project work I mentioned earlier will help inform our thinking about how we might further develop the mortgage regime, and apply a more principles-based approach. And we have our own review of the mortgage rules. We are close to concluding the second stage of our Mortgage Effectiveness Review. This has focused in particular on the experiences of lifetime mortgage and sub-prime customers, and those who have run into payment difficulties. Our findings will be published in the first quarter of next year. Our considerations will, of course, also be informed by the direction taken by the European Commission’s work on the case for intervening on mortgages to bring about a more integrated market – on which we expect to hear shortly.
Secondly, is the market becoming more complicated, in terms of the consumer needs it is trying to service, for example with ever more subtle distinctions between different forms of sub-prime and ever more complex equity release-related schemes?
Thirdly, and perhaps most obviously, will the economic climate continue to lead to a shake-up in the mortgage industry, with potential effects on some firms who become desperate for business, and are prepared to cut corners to get it.
So, with all this in the background, how does the mortgage market compare on the issues I highlighted earlier which lay behind the RDR for investment products? I will give a quick run through with some of my thoughts, but I'd really like to hear the panel's views and the views of the audience later.
The first driver for the RDR was poor consumer understanding and engagement so that consumers don’t act as a strong force.
In the mainstream mortgage market consumer understanding and engagement appear strong. Although general financial capability issues persist, people are engaging with the market, they know how to shop around, and they are interested and keen to take out a mortgage to purchase a house – they can see something tangible at the end of the process, unlike in the investment market where there is nothing to be seen for, often, many years.
But what about the self certification and sub-prime markets? Can we say the same things about them? And what about interest-only mortgages – are too many people with these not thinking about their savings vehicles?
We also recognised in the RDR Discussion Paper that investment products are often very complex and long term in nature. Mortgages, although long term, often appear much more straightforward – even though we now have many more types than years ago, people generally know what they are getting with them. And it is relatively simple to compare products or a particular deal and to see the effects at the time of purchase. It is not as easy to do that with a long-term investment product or a pension that won't mature until many years into the future.
Another issue with the investment market is the perception of the misalignment of advisers’ interests with those of consumers, largely due to the incentive structures that exist. An interesting aspect of the mortgage advice market is that it is almost all commission-based. Does this mean advisers have incentives that work against their clients' interests? Is there the potential for or perception that commission bias leads to poor outcomes for consumers in this market? Could this result in churning, of deliberately moving clients between providers to get new commission payments? These are very tricky questions which I think are worth exploring today so I'd certainly be interested to hear your views.
And equally, we have another interesting aspect to the market in this country, in that long-term fixed rate deals, of the type that we see overseas, are almost unheard of. The government has expressed concerns for the health of the mortgage market because of their absence. This is, of course, a question for the wider market and not just brokers. Is it healthy for customers to switch deals every two years in order not to fall to their lender's standard variable rate, and then get another short-term deal, paying the associated exit fees, application fees, solicitor's fees and so on. Are commission payments having an effect in this particular merry-go-round?
Another concern in the investment market is that those providing advice can often do so with relatively low qualifications and professional standards, certainly when compared to other professions and in spite of our emphasis on training and competence, this doesn't always seem to result in professional standards that inspire confidence and trust. Well, this is even more apparent in the mortgage market. It's interesting, if we look at, say, competence, that current minimum entry levels are even lower in the mortgage market than in the investment market. For example, the CII recommends that the basic qualification for a mortgage adviser should take 130 hours of study, less than half the time for a financial adviser's CfP. So if we think professional standards need to rise in the investment market, what does this tell us about the need for professional development in the mortgage market?
But then we have to ask, how much is this a problem? Do mortgage advisers need to be better qualified and adhere to higher professional standards? And are there valid reasons for the differences? Again, I don't know the answers to these tricky questions but I think they are worth some consideration. At least in the mainstream market products are simpler than in the investment market, consumers are more clued up and more engaged. It is a more straightforward advice process, more along the needs of the primary advice suggested for the investment market, maybe. However, there is evidence from our project work that training and competence do need to improve, especially in the non-mainstream market.
A final issue from my earlier list of RDR drivers was low levels of profitability in some firms suggesting that some business models are not that sustainable. There are clearly issues among provider firms in the current business climate, and a likely contraction in the housing market as well. These will impact on brokers, but is this just part of the normal business cycle or is it a reflection of deep-seated problems in the mortgage market overall? I'd be interested to hear your views.
So, the overall picture is really quite complicated and it is not necessarily appropriate, let alone easy, to draw direct comparisons for either the causes or solutions in light of the differences in the markets. What we have to remember is that the Retail Distribution Review was a response to specific, recurrent problems in the investment market for and among not only intermediaries, but also providers, banks and consumers. And, to my mind, the jury is still out on whether there are aspects of the mortgage market that require an RDR-style review at some stage. What I do know is that, while many firms are treating their customers fairly, too many firms are currently operating in a way which is unacceptable – and risk bringing the industry into disrepute and damaging consumer confidence in it. And this risk gets more and more acute in times of a market downturn.
So, in conclusion, there are clearly issues in the mortgage market that need addressing. But are the issues limited to certain sectors or are they more widespread? And can we see solutions to them within the normal scope of our work, such as the existing review of our mortgage rules, or our emphasis on Treating Customers Fairly? Or do we need to do more?
What is clear is that at this stage we are not saying the review should automatically read across to mortgages. But we do have an open mind about where the review goes. It must meet our primary objective of a better, more efficient investment market, but if the feedback and our own analysis suggest a wider application then that is something we will of course consider.
I've tried to range across the direct effects of the RDR (which is pretty limited at present), the possible indirect effects (which will be more substantial) and the wider question of whether the mortgage market faces some problems similar to those which prompted the RDR – on which I see the jury as being out. If that is the case – and there are certainly some problems – then the FSA looks first to see if the market itself is coming up with solutions. So I see this as being in the hands of you, the industry, so that market failures are addressed by industry solutions in the first instances and regulatory intervention is reserved for those failures that cannot be addressed, or have not been by the market itself when it had sufficient opportunity to do so.
In summary, the RDR implications for the mortgage market are still uncertain, but I hope I have made the subject less of a known-unknown, while acknowledging the difficulties in drawing direct comparisons.
Now I'm really interested to hear the views of others on the panel and the audience. Based on your experience, what do you think the implications of the Retail Distribution Review could be, or should be for the mortgage market?