The Morrison government, under heavy fire from politically influential mortgage brokers, has backed down on a key recommendation from the Hayne royal commission, and will no longer ban trailing commissions from 2020.

The flip was revealed by the treasurer, Josh Frydenberg, after a cabinet meeting on Tuesday. He told reporters the government had resolved not to prohibit trail commissions on new loans, but rather review their operation in three years.

The proposed review will be undertaken by the Council of Financial Regulators and the Australian Competition and Consumer Commission.

Frydenberg said the government changed its position because “we are concerned about the impact on competition in the mortgage-lending market”. He said brokers played a “critical role” in the home lending market, and declared the government “stands side by side with mortgage brokers”.

The banking royal commission recommended that commissions to mortgage brokers be axed and replaced by upfront fees. The commissioner, Kenneth Hayne, recommended new regulations requiring mortgage brokers to act in the best interests of borrowers or face civil penalties, and also the establishment of a user-pays system whereby the customer paid the broker for arranging the loan, rather than the lender.

On the day the findings were handed down, the government said it would prohibit the payment of trail commissions for new loans from July 2020 – which prompted an immediate warning from the sector that the changes would cripple their business model and decrease competition in the home loan market, hurting consumers.

Labor, in its response to the Hayne report, initially indicated it would implement all the recommendations, then under pressure from the industry, also backflipped, proposing a fixed-rate commission for mortgage brokers rather than accept the banking royal commission recommendation to apply user-pay fees to the service.

Brokers are well organised and politically influential, and have been lobbying intensively since the royal commission findings were handed down.

The sector was active concurrently with the Hayne proceedings. Reports before the final report of the banking royal commission was handed down suggest the assistant treasurer, Stuart Robert, gave a group of brokers a level of comfort that their practices would not need to change markedly.

A report from last December of a private meeting between brokers, Robert and fellow Queensland Liberal MP Andrew Wallace, quoted finance broker John McNamara saying the assistant treasurer had indicated “he didn’t see that broking needed to change or that trail needs to be dramatically changed for mortgage brokers”.

The reassurance was characterised as “very encouraging for all of us”.

Frydenberg said the government review would follow “the introduction of a number of new measures that the government has already announced”, including regulations imposing a legal obligation on mortgage brokers to act in the best interests of consumers; a new requirement that the value of upfront commissions be linked to the amount drawn down by borrowers; a ban on campaign and volume-based commissions; as well as a two-year limit on claw-back, starting from 1 July 2020.

“These changes will address conflicts of interest in the industry by better aligning the interests of consumers and mortgage brokers,” the treasurer said.

Frydenberg noted there were 16,000 mortgage brokers across Australia – “many of which are small businesses – employing more than 27,000 people”.

“The government wants to see more mortgage brokers – not less,” the treasurer said.