Financial services spring update

12 May 2021

As we face a second year living with the effects of COVID-19, how do financial services companies view the immediate future, and what plans do they have to move forward? We review the financial services outlook.

We recently surveyed 377 financial services business leaders on their outlook for 2021, what they perceive as the oncoming challenges and how they are preparing for the future.

Here are the five key trends that resonated with industry leaders around the world.

1 Going digital

Our research showed 56% of banking, 54% of insurance, and 52% of asset management firms expect to increase their investment in digital transformation over the coming year. While this trend isn't new, its acceleration will be a key trend to watch in 2021.

2 Skills shortage

To compete and thrive in an increasingly digital marketplace, skilled labour is an essential requirement. Yet, 65% of banking firms cited the availability of a skilled workforce as a major constraint to growth, equally concerning as the current economic uncertainty. This unease also surfaced in the industry's outlook on remuneration.

The vast majority of financial services firms plan to increase salaries in 2021, in line with inflation. 35% of banking firms are predicting above inflation increases, compared to 21% of other industries, indicating that a shortage of talent could hold many companies back.;

3 Collaboration and innovation

Another area where financial services companies plan to invest more than other industries is research and development.

With 52% of banking firms expected to increase spending in this area over the next year, it could indicate a need for new ways of working, new products, and new ways to grow. Across the board, our global team have all independently witnessed a growing tendency for business partnerships, collaboration and innovation, a positive takeaway from lockdown.

4 Customer behaviour

Another unifying trend across all three areas of financial services can be seen in their preparation for recovery. All the sectors indicated they're already planning for changes to customer behaviour or competitive dynamics in varying degrees (asset management 45%, banking 28% and insurance 36%).

Our panel have all observed a new urgency of response to recent changes in customer behaviour.

5 Optimism about the future

The research showed that over 40% of financial services businesses had grown their revenue by more than 5% in the last 12 months. This is far more than the businesses that have lost a similar percentage of revenue.

In addition, the majority are either 'optimistic' or 'very optimistic' about the economy in 2021 (in banking, this ranges from 63% in the EU to 73% across APAC, and 74% in the Americas). But where does the optimism spring from, and is it realistic?

My colleagues will look at each sector in more detail:

Capital markets
Banking
Insurance
Investment management

Capital markets

Change is the only constant

John Da Gama-Rose

The first quarter of 2021 proved eventful for financial services, with significant implications for capital markets firms in the UK and their focus for the year.

UK-EU regulatory cooperation

As expected, Brexit led to a rapid reduction in trading activity, particularly in European equities where EU and US financial centres experienced a boost.

The UK and EU's memorandum of understanding set out plans for a joint financial regulatory forum to support voluntary cooperation, with biannual meetings between the UK chancellor and EU commissioner for financial services.

This will reduce regulatory uncertainty and help prevent arbitrage, which are both important criteria to achieve regulatory equivalence in the future.

The Financial Services Act 2021

No doubt helping this cause, HM Treasury's Financial Services Bill has received royal assent and become law in the Financial Services Act 2021. This is to maintain an effective UK regulatory framework that continues to protect markets and consumers, ensuring the UK remains an open and dynamic financial centre.

The Act emphasises LIBOR transition and prudential reforms aligned to the implementation of Basel 3.1 standards, while also considering UK competitiveness and market access. UK regulators will be granted new powers under benchmark regulation to support a smooth transition from LIBOR.

LIBOR cessation announcement

At the beginning of March, the Financial Conduct Authority (FCA) made the highly anticipated announcement on cessation and loss of representation of the LIBOR benchmarks. They also outlined plans for a future synthetic LIBOR publication, covering all 35 LIBOR settings in the five currencies currently published.

Publication on a representative basis will cease at the end of this year for all LIBOR settings, except five major USD tenors, for which panel banks' submissions will be sustained until the end of June 2023.

As an index cessation event under the International Swaps and Derivatives Association (ISDA) interbank offered rates (IBOR) fallbacks supplement and protocol, this triggered fixing of credit spread adjustments on the announcement date. The spread fixings also serve as references for many cash products.

UK regulators expect firms to adhere to the roadmap, progressing active transition where viable by the end of Q3 and phasing out new LIBOR contracts, with Q1 key milestones for most products.

Subject to legislation, the FCA intends to oversee publication of one, three and six-month tenors in GBP, JPY, and USD on a non-representative basis for some time, to support tough legacy contracts and will consult on relevant policies in Q2.

Meanwhile, New York state legislation to support the transition of tough legacy contracts has been enacted into law and will particularly facilitate floating rate debt and securitisations issued under state law.

LCH has announced a backstop conversion process for CHF, EUR, JPY, and GBP LIBOR-linked cleared derivatives outstanding close to the index-cessation effective date and will commence charging fees from the end of September due to increased risk management effort and to encourage proactive prior transition.

Preparing for a large-scale conversion event in December is a significant task, as is prior portfolio reduction in line with regulators' expectations.

Implementing Basel 3.1

The Prudential Regulation Authority (PRA) has completed a consultation, proposing capital requirements regulation (CRR) rules to support timely implementation in the UK of the remaining elements of Basel international standards, including previously on-shored EU legislation (CRR II).

The implementation target date is 1 January 2022, which provides additional time for firms to optimise solutions and embed supervisory reporting, such as market risk under the standardised approach of the Fundamental Review of the Trading Book (FRTB).

ESG

A wave of environmental, social and governance (ESG), and climate risk regulation was published in 2020. Investment decisions now regularly consider ESG and demand for green bonds has risen exponentially.

Capital markets firms undertake a range of activities that need to consider ESG for bond issuance, securitisations, participating in the underwriting of corporate bond issuances as part of a syndicate, as well as entering into derivatives contracts with corporates or providing credit facilities to commercial clients.

Due diligence must include ESG assessments, which extend beyond climate risk to cover governance structures, board oversight, diversity and inclusion, non-discrimination, forced labour practices, gender pay-gap, energy, emissions, and waste management.

In 2021, capital markets firms face greater regulatory demand for ESG disclosures, and increased commercial demand for sustainable and socially responsible products. Patterns of lending rates for green labelled products need careful consideration.

Assessing operational resilience

The UK supervisory authorities have published their final policy and supervisory statements to strengthen the operational resilience of financial services firms and market infrastructures.

These rules come into force in March 2022, and firms must identify their important business services, set impact tolerance levels for disruption, map resources, and test relevant scenarios against tolerance levels.

The PRA also published a supervisory statement on outsourcing and third-party risk management. These policy and supervisory statements provide firmer guidance to assess the current state of resilience and rapidly embed a robust framework to address any gaps.

The Basel Committee on Banking Supervision has issued updated revisions to the Sound Management of Operational Risk and complemented this with Principles for Operational Resilience. This aims to promote a principles-based approach to improvements, as well as international and cross-sector collaboration.

Shadow banking in the spotlight

The first quarter ended with Greensill Capital and Archegos Capital Management in the headlines.

Both collapse incidents resulted in significant losses for major global banks and prime brokers, ongoing criminal investigations, parliamentary debate and probing by European and US regulators into their operations.

With the Wirecard scandal still fresh in mind, shadow banking will come under increased scrutiny with a focus on risk management and obscurity in implicated financial instruments. A greater emphasis on risk culture, internal risk controls frameworks and effective challenge across all lines of defence will benefit all financial institutions, supported by the Senior Managers and Certification Regime (SM&CR).

Even if financial stability wasn't compromised by these incidents, systemic shocks may be lurking, and shadow banking needs greater regulatory consideration. The UK has another opportunity to make an impact when designing its future regulatory framework.

If you would like to discuss these challenges and opportunities in the capital markets sector, contact John Da Gama-Rose.

Top 10 themes for capital markets in 2021

Banking

ESG is a key theme

Paul Garbutt

Despite national lockdowns, the banking sector has been under pressure in Q1, with high demand for services and branches remaining open throughout. Short-term measures such as forbearance for retail customers and government-backed lending schemes have continued into 2021.

As these measures lift, the focus will shift to easing customers away from support, with an expected rise in collections and recoveries activities. The most important challenge for banks is making sure all business and retail customers are treated fairly and with good conduct, while maintaining regulatory compliance.

Recognising the expected surge in collections and recoveries, many banks are planning ahead to make sure the right specialist resources are in place to achieve the best customer outcomes. This includes extensive operational planning and significant outcome testing across the sector.

ESG is ramping up

While macroeconomic recovery is the most widely publicised challenge for banks, climate risk and ESG are also ramping up. The UK is hosting the United Nations Climate Change Conference (COP 26) in November, which has prompted a wide range of publications and activity from all sectors.

In preparation, banks are gathering data and advancing their policy decisions, some of which are moving into the mainstream media. Common debates cover how to address transition plans. For example, how to reward fossil fuel companies that pivot to sustainable sources of energy but without falling for “greenwashing” statements.

Previously simple lending decisions have become more nuanced, based on an organisation's long-term objectives, rather than their current activities. In turn, this poses questions over how to monitor that progress, who has the data and who can validate it? These are quickly becoming mission-critical factors for banks, and best practice is still unclear.

Fraud

Fraudulent activity has increased since the start of lockdown, compounded by fewer customers talking face-to-face with their bank.

Government lending initiatives also increase opportunities for fraud, but resources are stretched to keep up with demand. This has led to an increase in anti-fraud measures across the board, in addition to managing historical issues and implementing the new anti-financial crime agenda.

The need for remote access during lockdown, both for customers and employees, has created new efficiencies and opportunities. Moving forward, banks will need to consider how to maximise these benefits and factor them into their long-term business models.

Changes include better use of technology, data, reporting and digital channels, which can all support know your customer processes. As banks adopt the lessons learned from lockdown, this will naturally lead to a wave of change programmes. For incumbents, this has its own problems as it's always tricky to introduce change on top of legacy systems.

On the other hand, challenger brands are well placed to make rapid changes as they don't have the same degree of legacy infrastructure, making them inherently more agile. They're already making a real impact on the market with increasing balance sheets and a good market share, and they're leading the way when it comes to new client trends.

Overall, the pace of change is building. There are real commercial opportunities as the global economy goes into this next phase. While the challenges may be different, the fundamentals of effective leadership, strategy, risk management and agile implementation will continue to drive success.

If you would like to discuss these challenges and opportunities in the banking sector, contact Paul Garbutt.

UK banking sector: top ten themes for 2021 and beyond

UK regulatory handbook 2021

An indispensable guide to the regulatory landscape for financial services

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Insurance

A difficult market ahead

Rob Benson

The insurance market is set to thrive in 2021, moving on from a challenging 12 months. While the impact of recent events will be felt for months to come, there are green shoots of a hardening market, improved investment returns and a focus on evolution and growth rather than resilience.

General insurers and intermediaries

The impact of business interruption claims is still to be quantified, but those with large exposures are starting to feel the volume of transactional activity. Much will depend on the awareness of policyholders that they have a right to claim, given the multiple policy wordings that exist and the varying degrees of cover.

Intermediaries are preparing for the impact of the GI pricing practices consultation that is anticipated soon. The FCA has already advised the market of the deadlines expected to be achieved with systems, controls and product governance rules coming into effect in September. Pricing remediation, auto-renewal rules and reporting requirements are set to go live in December.

London market brokers

Having successfully navigated the January renewal period, brokers are now looking at the challenges of the hard market and the availability of market capacity for April and June renewals. The market continues to experience M&A activity along with significant moves for individuals and teams, which will create opportunities for accounts to carefully consider their options.

Lloyd's and London Market

Lloyd's results issued at the end of March reported a mixed bag, with greater losses in property and casualty insurance than the gains made in marine, aviation, transport, and energy. The return to profit of key classes has bred optimism for 2021, and is testament to the activities of the last few years in terms of identifying the root cause of historical underperformance.

These results, alongside the anticipation of lockdown easing over 2021, are being seen positively, albeit with an unnerving backdrop of an unpredictable year of catastrophe expectations and the already-known disruption caused in the Suez Canal in March.

The 'Future at Lloyd's' initiative promises greater efficiency as a result of revised operating models. And the rest of 2021 will see more design-based activity leading into market adoption later in the year.

Life and pensions

The life market continues to see separation and acquisition activity across larger businesses. Along with this comes the need for integration and, gradually, transformation.

Many organisations are looking at major transformation programmes across operations and finance, with the need for efficiency and optimisation, along with the forthcoming requirements of IFRS 17 fundamentally changing existing practices.

If you would like to discuss these challenges and opportunities in the banking sector, contact Rob Benson.

Insurance: top 10 themes for 2021

Investment management

Firms to focus on M&A, ESG and IFPR

David Morrey

Mergers and acquisitions

The investment management sector is increasingly consolidated, with large scale mergers and acquisitions activity, which is likely to gain pace this year.

Key acquisitions include Columbia Threadneedle buying BMO Asset Management. And Morgan Stanley acquiring Eaton Vance. While this provides economies of scale for larger firms, and eases pressure on the profit margins, it will undoubtedly make competition more challenging for smaller players.

Looking ahead, the investment management sector may be dominated by a small number of large groups, each benefiting from their scale. In contrast, this will be balanced by a long tail of small, niche players who may struggle to compete unless they can deliver a distinctive benefit to clients.

Growth is also on the agenda for many smaller and mid-size firms, with ‘bolt on’ additions of similar firms, or those which add new capability. For many vertical integrations, teaming up with platforms and distributors is the model which seems to offer the greatest commercial opportunity.

Technology is one imperative in remaining competitive. Effective digital approaches can help streamline processes, simplify operations and improve the customer experience. They can also reduce cost, which in turn supports future growth and long-term profitability.

Investment firm prudential regime

The new prudential regime for investment firms is one of the first EU initiatives to be directly implemented in the UK, as opposed to being on-shored. It offers a fundamentally new approach to prudential regulation and supervision for the investment management sector, covering capital, liquidity, reporting, disclosure and remuneration requirements.

The UK's implementation has been delayed by six months due to COVID-19, while the EU's timeline has remained the same, creating a tricky six-month period of dual compliance for firms with an EU presence.

Key considerations include:

The K-factor requirement for own funds calculations has changed, which relies on updated data processes
The Internal Capital Adequacy Assessment Process (ICAAP) will be replaced by a more holistic Internal Capital and Risk Assessment (ICARA) to focus on specific business models and activities
Governance changes including ESG requirements, remuneration policies and new disclosure requirements

It's also important to consider interaction with HMT's New Funds Regime, which aims to make the UK an attractive location for domiciling funds. The recent consultation suggests the UK is aiming to position itself as a base for hedge funds and infrastructure funds after Brexit. Attracting retail funds may be more problematic due to the new regulatory restrictions.

ESG

ESG concerns are under increased scrutiny from the regulators in the UK and internationally, including the FCA, PRA, European Securities and Markets Authority (ESMA) and the International Organisation of Securities Commissions (IOSCO).

While ESG products are increasingly popular, both to reduce the impact of climate change and to diversify portfolios, greenwashing is a concern. There is a risk of mis-selling products that are not as environmentally friendly as they are marketed to be, with future liability risks.

As such, there are a number of initiatives underway to standardise terminology and improve investor confidence, including the EU taxonomy and the sustainable finance disclosure regulation, among others. While these are both European regulations, they will apply to asset managers with an EU presence.

New disclosure requirements for asset managers will take effect in 2022/2023, as part of HM Treasury's phased roll out for all UK firms by 2025. The new requirements align with Taskforce for Climate-related Financial Disclosure (TCFD) recommendations for consistent standards, greater comparability for investors and to reduce greenwashing.

Brexit

Post-Brexit financial services arrangements are still not confirmed, and regulatory equivalence remains a subject of debate. The memorandum of understanding with the EU doesn't improve the UK's market access position, and there are points where greater clarity is needed.

For example, certainty that portfolio management contracts delegated from EU to UK funds can continue in their current form. Similarly, further clarification over cloud service classifications would be beneficial, and there's a risk that some UK firms will not be able to undertake any activity for EU clients except in the very limited circumstances permitted by the own initiative rules.

If you would like to discuss these challenges and opportunities in the banking sector, contact David Morrey.

Ten themes for investment management in 2020