11 November 2021
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In the past six months we've seen a step change in client activity. Regulatory pressures have come back 'on' as UK regulators shift from the short-term challenges of coronavirus and back to long term issues. Banks struggling to address pandemic-related demands have been denied any pause for breath as the familiar pre-coronavirus issues have come back harder than ever. ESG is moving fast, the drive to digitise is relentless, and there's a talent squeeze that demands the best leadership.
This is primarily a market-driven change. We're seeing signs of price differentiation coming through as larger borrowers' costs are linked to hitting climate or broader ESG targets. Increasingly, the focus is not only on net zero, but all aspects of ESG. Sometimes these priorities can conflict – putting the highest costs onto those least able to afford them or compounding financial exclusion. Leaders are being measured on achieving goals, but how do they set the goals and get the data to do the right thing and avoid greenwashing? Intricate matters require clear governance and a clear strategy for coming ahead of the pack.
The race to digitise successfully is still very much running. Customers are all digital natives now and expect business banking to be as user-friendly as personal banking. Challenger brands are showing what can be done with modern technology, and while traditional players continue to dominate the market no one can afford to get too far behind in this race. Making the institution “easy to do business with” is a common refrain and programmes to shift away from unconnected legacy processes are everywhere. We've seen a number of instances where banks are having to rethink their traditional segmentation into regulatory, product or customer types to take a more holistic and data-lead approach. The technology really is a game changer. Once you get past that, the difficult trick is getting it to work together with the people, processes and data.
The good news is that the interest rate hedging products (IRHP) and personal protection insurance (PPI) programmes of work are finally coming to a close. There are less visible - because they don’t involve direct customer outreach - but similar scale issues linked to the financial crime agenda and, increasingly, on regulatory (prudential) reporting. All our banking clients have or are engaged in change or assurance activities in these areas. Some in response to direct action from regulators and others to get ahead in anticipation of regulator or skilled person reviews. They're all keeping at least a watch on the FCA’s views on consumer duty and what that will mean both for the ways they engage their customers and evidencing compliance. Non-financial risks have gained prominence on the regulatory agenda in recent years and then the prudential reporting issues have come back to show how there's still often a sizeable gap between current regulatory expectations and historic common practices.
In a piece put out by a firm of auditors, this may seem like a self-interest point. The fact is we and our peers are increasingly being asked by banking clients to provide an independent and objective review of controls, processes, data and reporting relating to the points above. There are several 'big ticket' changes and themes in play just now. Banking leaders risk falling into a 'whac-a-mole' approach to resolving issues. We're increasingly working with clients to provide independent assurance and a critical sounding board on operational resilience, third party assurance – cyber, resilience, ESG, data, reporting assurance, ESG readiness, managing complexity and controlling costs. It's an unprecedented breadth of activity for us.
The challenge remains of making money in this environment of low interest rates, COVID and Brexit disruption. In 2020 results for many were propped up by trading businesses riding high volatility. 2021 seems to be lining up for results flattered by IFRS 9 provisioning coming off and back into the P&L. For 2022, the focus will be inflation. While rate rises will boost the inherent profitability of most banking balance sheets, the 2019 questions on achieving an adequate RoE are coming back. Cost control/optimisation, credit and other risk modelling updates, and relentless competition are all keeping leaders awake. These are challenging times for UK banks and their leaders. Expert advise is key for finding clear and actionable solutions to these issues.
If you would like to discuss these challenges and opportunities in the banking sector, contact Paul Garbutt
Helping you respond positively to long term and emerging issues in the banking sector
A stream of changes are set to impact firms in this space. The focus on ESG is accelerating competition, changes to regulations are bound to happen soon, and wealth consolidation continues to take shape. There's risk and opportunity at every corner.
In public investment, managers are racing to declare their green credentials and make grand claims for the positive impact their ESG investment ethos is having, above and beyond the competition. Behind the scenes managers are making a tremendous effort to try and develop both a coherent philosophy for ESG investing and operationalise it in their investment processes. Where should managers aspire to be on the ESG spectrum? And are their processes good enough to deliver on that aspiration? These are the two major questions managers are wrestling with. Very few are happy with the answers to those questions today, and all are concerned that the market could leave them behind if their competitors find better answers than they do. ESG investing has become a new frontier for competition and like any highly competitive environment, rapid change (and a fair number of mistakes and failures) is likely to follow.
During the implementation of MiFID II, much of the investment management industry saw their discretionary change budgets and bandwidth swallowed up by the scale of mandatory regulatory change. We're seeing a re-run of that experience now, although the regulatory change in question is a cascade of different initiatives rather than a single MiFID II scale development. The implementation effort for the new Investment Firm Prudential Regime (IFPR) is proving more significant than early predictions suggested, and new disclosures related to ESG, and heavy enhancements required in fund Assessments of Value are all absorbing significant time and effort.
2022 is unlikely to bring respite. A new Consumer Duty and FCA Consumer Investment Strategy indicate more changes ahead for those managers with a retail presence, while the expected rollback of some parts of the MiFID II regime will require work in the short term even if they produce longer term reductions in compliance effort.
One by-product of the regulatory change burden is the catalyst it provides to consolidate. In the wealth management sector that catalyst is meeting an unprecedented wave of consolidators looking to build a presence and established banks and asset managers looking to build a ‘vertical’ distribution model by bolting on advisors and wealth managers. The result is a stream of deals from the small to the very large, and multiples of these transactions reaching new highs.
Is it inevitable that many of these growth plays will fail to yield results? Perhaps. There's a widely held view (including by the FCA) that there's an ‘advice gap’ that needs filling, however much of that gap may be at the low end of the mass market – historically not where wealth managers make their profits. Time will tell, but it's safe to predict that this sector will see some very intense competition for market share in the coming years as businesses seek a return on their sizeable investments.
To discuss these challenges and opportunities in the investment management sector, please contact David Morrey.
Helping you to embrace innovation and shape your business models for long-term success
Global economies have been on remarkable recovery journeys. As much as COVID-19 challenges are still looming, the economic recovery is facing uncertainties, too. To thrive you need to understand the economic headwinds, the factors driving capital markets, and how firms and regulators are responding to these issues.
There are significant macro-economic impacts affecting the UK, ranging from the effects of Brexit to global supply chain issues, including the availability of semi-conductors and labour market imbalances. There are also concerning developments in energy markets, following the resurgence in economic activity, with unfavourable weather conditions compounding geopolitical factors, and stronger reliance on short term wholesale sourcing, especially by some gas suppliers.
UK banks have demonstrated resilience and retain strong capital and liquidity positions, offering sufficient capacity to continue supporting businesses and the economic recovery. However, there has been a recent economic slowdown, partly due to the global supply constraints, resulting in increased inflation, but also due to additional UK specific labour market challenges, which are more likely an effect of Brexit and the transition away from free movement. While labour supply may increase now that the furlough scheme has ended, it may not mitigate shortages in specific sectors in the near-term, such as HGV drivers or agriculture.
Uncertainty around servicing higher levels of post-pandemic debt among UK businesses, particularly SMEs, is likely to increase as government support is phased out. Central banks have nevertheless signalled interest rate increases amid concerns that rising inflation and while it's currently driven by supply constraints, it may prove to be longer-lasting than originally anticipated.
Peak pandemic times have brought operational risk and resilience into focus, and regulators have emphasised compliance with market abuse regulation and effective trade surveillance, as firms were embedding working from home practices while operating in volatile markets. Many firms are already starting to upgrade their arrangements in view of the FICC markets' evolution and increased electronic trading. In light of regulatory feedback and sanctions, these have broadened to review wider governance, risk, and compliance frameworks. Upgrading technology is aimed at enabling higher accuracy, as well as more integrated, preventative risk control. In particular, cloud adoption is seen as a major factor benefitting operational resilience, although critical reliance on outsourcing and third-party providers has associated risks of regulatory concern, which also make additional policy measures likely.
The implosions of Archegos Capital and Grensill Capital earlier this year have quickly brought financial risks to the top of the agenda, resulting in new lenses on counterparty credit risk, credit-contingent market risk, margining and inherent risks in shadow banking and supply chain finance. Here too, significant consideration is given to the effectiveness of governance and responsibilities across the three lines of defence model, which is underpinning effective risk management.
Increased global leverage and apparently greater risk-taking by some investment banking businesses in a low-interest environment are a concern in capital markets, as asset prices for riskier assets seem heightened. Evergrande Group’s challenged debt capacity, more recently, created volatility in international markets and the fallout of a potential collapse would be far reaching.
There has been a surge in M&A activity this year, and with Brexit impacts in the wake of the pandemic and weak Sterling rates, UK-listed companies have been attractive buyout targets, with 24 public companies being subject to take-overs in the first six months, and private equity firms paying record premiums over depressed share prices, with low interest rates making debt finance attractive. This has started to raise questions around constituent firms on the FTSE 100 and how to encourage listings from a broader range of firms.
LIBOR transition has entered its final quarter before most settings, as well as new transactions in continuing USD LIBOR, are due to cease, even if publication is extended to end of June 2023. Remaining legacy transition challenges include the late backstop conversion of cleared derivatives, but also concluding bilateral transition of client business, whereby the regulatory induced synthetic LIBOR for selected settings based on ARR term rates may end up supporting wind-down of tough legacy contracts. Readiness to offer new USD alternative reference rate products globally is critical, and product innovation has been boosted by the endorsement of SOFR term rates, while regulators continue to warn against credit-sensitive rates, which are seen to have many of the shortcomings of IBOR benchmarks.
Meanwhile, HM Treasury has consulted on reforms to the UK’s regulatory regime for wholesale capital markets to enhance openness and competitiveness, while maintaining the highest regulatory standards, in line with the government’s vision for the future of the financial services sector. Proposals address aspects of the Financial Services and Markets Act and the on-shored MiFID II regime, aiming to remove requirements that limit firms’ ability to access the most liquid pools of capital and deliver fair and proportionate regulation to support sustainable economic growth.
To discuss what's happening in the capital markets sector, please contact Alex Ellerton.
As the world cautiously reopens, risk continues to evolve in the insurance market. With developments coming in the form of regulations, rules, and reviews, there must be an emphasis on assessing the strength of internal structures for future changes while continuing to understand the impact these have on consumers and wider stakeholders.
The first part of the FCA’s new GI pricing rules set out in PS 21/5 came into effect on 1 October, with rules on systems and controls, product governance, and retail premium finance. The headline pricing remedy – equalising home and motor insurance premiums for new and existing customers – and associated reporting requirements come into force on 1 January 2022, as will requirements to provide increased information about automatic renewals.
Under this regime, retail premium finance is now an add-on product. As such firms must only sell this on an ‘opt-in’ basis – similarly to other add-ons, and provide additional information on the cost of purchasing insurance using retail premium finance. Product governance reviews must include specific consideration of whether products provide 'fair value.' Firms have 12 months to review any pre-existing products not yet subject to an IDD-compliant product approval process.
While the above measures should now have been implemented by firms, there is still considerable amounts of work left to complete by the end of the year. The most significant is the pricing remedy itself – a complex and multi-layered task: determining new pricing strategies, delivering this across both new and legacy products, and maintaining assurance that it achieves the intended outcomes and complies with the FCA’s new rules.
With only two months left, firms should have already made good progress towards the fundamental strategic decisions that these developments build on. However, this potentially leaves a significant volume of implementation and testing to be completed within a relatively short timeframe. With the FCA signalling that it has little appetite for a repeat of common errors from the 2017 renewal transparency requirements, robust project assurance will be vital.
In 2019 the PRA released Supervisory Statement 3/19 (SS3/19), which introduced new requirements for governance, risk management, scenario analysis and disclosures in respect to climate-related financial disclosures.
The regulator expects top-down engagement and wants firms and insurers to name a SMF(s) with specific responsibility for identifying and managing climate risks. It also wants firms to adopt a strategic approach to managing this risk, including through the use of scenario analyses.
The firms impacted by the PRA's requirements on managing climate-related financial risks are UK insurers, reinsurers and their groups including the Society of Lloyd's and managing agents, as well as non-Solvency II firms. This also applies to UK banks, building societies, and PRA-designated investment firms.
As regulation evolves around ESG and the sector matures, more regulators will follow suit on disclosure requirements for firms. This is an important distinction, as environmental, social and corporate governance are well-established and appropriate risk management frameworks are widespread. Climate risk can lead to significant financial risk or crystallise in material losses for firms if not addressed and must be disclosed against the above regulations. With a clear need for financial disclosures around ESG, the question becomes one of how and when. Firms should focus on training key personnel and the board for a better understanding of ESG and setting the strategic direction and risk appetite. Appropriate firm-wide risk management frameworks need to be built and the right tools and reporting mechanisms are vital to begin to monitor ESG and implement effective controls.
A number of high-profile outages have raised concerns about the financial sector's operational resilience. With new rules taking effect in March 2022, this is what firm's need to do now.
Operational resilience is also captured in the Senior Managers and Certification Regime (SM&CR), with a senior manager such as the Chief Operating Officer (SMF 24) holding ultimate responsibility for compliance, and personal liability if they cannot demonstrate reasonable efforts to comply. Firms may also face claims from customers and counterparties who have suffered financial harm as a result of an outage or service disruption.
In their planning and implementation, firms must also consider the overlap with other regulatory approaches, including operational continuity in resolution, wind-down planning, recovery and resolution planning, and regulatory reporting – in addition to the crossover with business continuity and operational risk. With a short timeframe for implementation, operational resilience is not about re-inventing the wheel, it's about extending and reshaping existing processes to consider the same issues from an external perspective. A holistic approach supports a sustainable implementation, with minimal duplication of effort and a streamlined response in the event of a service outage.
Following Brexit, the PRA is reviewing several areas of UK Solvency II. EIOPA is simultaneously conducting its own review. It will be interesting to see the extent to which UK and EIOPA Solvency II regulation may diverge over time.
Selected insurers will be submitting the results of the PRA’s QIS results by 20 October, together with qualitative information to assist the PRA with its cost-benefit analysis of potential changes to key areas of Solvency II.
The quantitative side will demonstrate the impact of potential changes to the methodology for calculating the transitional measures on technical provisions (TMTP), the matching adjustment (MA) and the risk margin (RM), while the qualitative side will focus on the practicality, business impacts and costs of potential policy changes.
The industry has various views on how well these ‘big ticket’ items are operating under Solvency II, and how they should change in terms of size and methodology. The results of this QIS will be used to inform that debate and support future policy revisions.
The PRA has announced its next round of insurance stress tests (IST 2022). The focus for life insurers will be on economic stresses, while general insurers will be asked to apply stresses which cover natural catastrophe perils and cyber underwriting risk.
Firms can share the scenario design with the PRA in advance for comment and feedback. This will assist in achieving consistency among companies.
These stress tests are seen by the regulator as a useful addition to the solvency capital requirement (SCR) and own risk solvency assessment (ORSA), since they provide additional insight into the financial resilience of both individual firms and the market.
On 1 October the PRA published its DLT assessment, which is ready for implementation in January 2022. It looks at the volumes and numbers of trades within each currency and is used in the construction of the PRA’s risk-free curves, and to value liabilities under Solvency II.
The key change is a reduction in the last liquid point (LLP) for USD from 50 years to only 30 years, reflecting initiatives to shift liquidity from USD Libor to the Secured Overnight Financing Rate (SOFR). The long end of the risk-free curve is extrapolated from the LLP to the ultimate forward rate (UFR), leading to some movement in the value of insurers’ longer term USD liabilities.
The LLPs for GBP and EUR remain at 50 years and 20 years, respectively.
Following SS3/19, the PRA issued a Dear CEO letter in July 2020 spelling out the requirement for firms to fully embed their approach to manage climate-related risks by the end of 2021 through additional focus on climate change in the areas of governance, risk management, scenario analysis and disclosure.
Since the HMT review of Solvency II specifically mentions making investments consistent with the government’s climate change objectives as one of its objectives for insurance, we may see some changes to give preferential treatment to green investments in the capital calculations.
The FCA’s supervision strategy throughout 2021 has included a focus on financial and operational resilience together with an orderly wind down.
In a November 2020 Dear CEO letter the FCA put Lloyd's & London Market Intermediaries and Managing General Agents (LLMI) on notice that it would be engaging with and testing firms to see what they have done in these areas, including the wind down planning requirement. Throughout 2021, great progress has been made by LLMI on their wind down plans, with several of our clients submitting plans to the regulator, at its request.
Currently, there is no regulatory requirement for insurers and capacity providers to have equivalent wind down plans (recovery and resolution plans). However, we expect that this may change soon. Indeed, both the FCA and PRA have recently been expanding the range of firms requiring them, and it seems only a matter of time before it is a mandatory regulatory requirement for insurers.
This should not feel like another regulatory hurdle. Indeed, many of the internal processes required will already be in place from firms’ focus on operational resilience and governance.
Leadership focus on putting together a plan, with the associated emphasis on identifying and stress-testing scenarios, tightening management information, and then monitoring these dashboards, will better equip companies to identify early warning signs and mitigate risk.
For more insight and guidance on these issues contact Rob Benson.
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