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
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.
I recently participated in a discussion on the impact of the ECJ decision to prohibit the use of gender as a pricing factor. (My slides are here). This is a topic that I have discussed here before so I will limit myself to my newer thoughts on this, specifically whether there are implications for other pricing factors currently in use — age, disability and such like.
An important caveat on the below is that it is based upon my reading of Attorney General Kokott’s opinion. The final judgement of the ECJ is notably more circumspect with respect to detail on the reasoning underlying their decision — I am assuming that this does not diverge significantly from that presented by Attorney General Kokott, but at present this remains uncertain.
Attorney General Kokott disliked the idea that there is information about insurance risk in someone’s gender. This is because gender is a characteristic of the customer that is inherent and immutable but, in Kokott’s view, lacks a direct causation to differences in risk. Even with longevity her argument would appear to be that this is due to lifestyle choices rather than someone’s sex per se. Statistical inferences are treated somewhat dismissively. This is of course rather worrisome in the context of an industry which is in large part built upon statistical inference.
Let’s now consider three cases: age, disability and credit rating. All are used as rating factors by at least some UK insurers in particular products. Starting with your credit rating, the use of this to price insurance does not seem to be affected by the ruling. It’s correlative rather than causative in its effects — but it is not an intrinsic personal feature although restoring it to good health is no doubt harder than impairing it.
Disability is clearly hard to change, subject to medical advances. However, it’s use in the UK is in a precise way (i.e. it’s not used as a blanket factor to affect pricing) — so that it has causative properties. However, some judgement may be used beyond statistical evidence: to this extent there seems to be an element of exposure to challenge as a direct consequence of the ECJ decision.
Age is perhaps the most commonly used variable of all. Mostly, there is causation too: a young driver is also an inexperienced driver so pricing effects in motor insurance do not appear unfair. Similarly, death is likely to be nearer as you age, so that life insurance pricing should still — surely — reflect that (let’s face, this product would disappear otherwise). Kokott’s reasoning can be applied with unsettling consequences: if one looks at health insurance then, yes, more ill-health is correlated with getting older — but how you choose (or chose) to live your life also impacts. However, the Attorney General herself draws the helpful distinction that your age changes such that over a lifetime it should all balance out.
Overall then it seems that gender should not be the thin end of the wedge that undermines the basis of all insurance delivery. That does not make the ECJ’s decision a good one (in my economic view) but is does mean that the further fallout should be limited.
The Junior ISA should provide a ready-made vehicle for saving by families and friends on behalf of children. There are a number of potential benefits that can be accessed by increasing family saving. First, it can increase the capacity of the family to withstand financial stresses and strains (by providing some resources to dip into in the event of an unexpected shock to income). This may even enhance the overall durability of a family (given that financial issues can be a major contributing factor in marital or family break-up). Second, it permits the build-up of an asset that can contribute towards broader opportunities for the child or children. As such, the Junior ISA is a “good thing”.
However, unlike with its predecessor (the Children’s Trust Fund) there is no seeding by the government. The JISA is an enabling product not a universal offering. As such it is likely to lower the cost of saving (say for a child’s grandparents) but will not offer added benefits such as assistance in wider financial education initiatives.
The loss of seeding, in particular, is regrettable. As I have previously argued with respect to CTFs even the minimum public seeding (i.e. without anyone any additional funds) on that product could have had sufficient value at maturity to fund learning to drive, a rental deposit and such like — potentially expanding the choice set significantly of children born in low-income families.
In consequence the "nudge" of the JISA will be gentle in the extreme. However, since this is — by design — a long-term policy in its outcome effects the opportunity cost of the lack of seeding in the JISA scheme will not be felt for some time.