Bank profits have been boosted by the recent increases in interest rates and consequent improvement in net-interest margin. But with geopolitical tensions, the cost-of-living crisis and a possible recession, banks face considerable challenges for the remainder of 2023. Individuals and businesses will also need effective support, and it’s essential to embed Consumer Duty principles ahead of the 31 July 2023 deadline to promote good outcomes and protect vulnerable customers.
It is more important than ever to instil good conduct and focus for all banking activity around customer needs. All this, of course, with a relentless need to automate.
1 Macroeconomic uncertainty
Until recently, most G20 countries were bracing for a recession, but the scenario may be less severe than originally thought. Initial predictions of a two-year recession have been replaced with the UK avoiding a ‘technical recession'. The Office for Budget Responsibility (OBR) predicts a -0.4% contraction in Q1 2023 and an overall contraction of -0.2% for the year, with a return to growth in 2024. This change in growth is driven by the Spring Budget (including tax measures and new investment zones), and lower interest rates than predicted. These lower interest rates are due to inflation falling faster than expected and the recent bank collapses, which have spooked markets.
Autumn Statement on a page: everything you need to know
Inflation is expected to drop further in 2023, reflecting the decline in global price pressures and the impact of wholesale energy costs. The OBR’s forecast for the headline rate of inflation (CPI) was one of the biggest surprises following the Spring Budget. A reduction from 10.7% to 2.9% by the end of 2023 was better than anticipated. However, in February, CPI inflation unexpectedly moved from 10.1% to 10.4%, and the Bank of England will have a tough time meeting the 2.9% end-of-year figure – particularly if it has to prioritise economic stability. Producer price inflation, which is the measure of input cost inflation, has remained stubbornly above CPI. That said, energy prices are falling, and the government has extended the household energy scheme.
Businesses and households appear to be feeling more confident, partly due to Spring Budget announcements including free childcare (although it will take years to feel the effects). This is important if the government is to meet its targets for inflation and growth. However, the OBR expects real household disposable income (RHDI) to fall by a cumulative 5.7% from FY 22/23 and 23/24. This is the largest fall since records began in 1956/7 and consumption is also expected to drop by 0.8%. Businesses will look at how they can manage this fall in demand while being ready to take advantage of the following upturn.
Public sector wage increases are a contentious issue, with the government dealing with multiple walkouts. However, if public sector wages rise too much or too quickly, it could harm progress on inflation. It will be a delicate balancing act in the coming months, with public sentiment testing the government's resolve.
2 Interest rate environment
We expect the Bank of England’s interest rate to drop as inflation eases. In February 2023, the Monetary Policy Committee hiked the interest rate by 50 basis points (bps) to 4%. Projections suggest interest rates peaking at 4.5% in 2023 and falling to 3.7% in 2024, then to 3.4% in 2025. Any increase in 2023 is likely to come later in the year than initially expected as the Bank of England reacts to recent bank collapses, by targeting economic stability over inflation.
High-interest rates could cause affordability issues for some borrowers, but this isn’t as big an issue as originally thought. For example, our mid-market business tracker shows that 80% of firms have enough working capital to weather a recession – often because they have already sought financial support. However, many businesses and individuals will struggle, and the FCA has reinforced the need to treat customers fairly. This will be the first recession where banks will need to think about Consumer Duty and its impact on recovery strategies and loss-given defaults.
Plan and succeed in 2023
In addition to interest rates, most credit risk models also look at unemployment and housing prices to inform provisioning. Unemployment is currently low, and although it will probably rise, it will most likely remain low compared to long-run averages. We expect negative equity in the real estate sector, which could lead to mortgage prisoners when combined with unemployment. Regulators will keep a close eye on how banks treat these individuals.
Regulators are also looking at non-banking lenders, as they can mask the true extent of borrowing, and often come with high costs and unclear terms. Buy now, pay later schemes are particularly concerning and the government is consulting on how to move these products under the FCA’s remit. Helping customers through this difficult period and acting to secure good financial outcomes is essential, and there's the potential for a political backlash if banks are seen to be profiting from higher interest rates.
3 Risk management
The Prudential Regulation Authority’s (PRA) Dear CEO letter highlights risk management as a key supervisory priority for 2023 – no surprise in this macroeconomic environment, which brings greater systemic and firm-specific risks. It also reflects a number of high-profile market incidents over the last two years, due to failings in risk management and governance processes.
The current regulatory focus includes financial resilience in volatile markets and non-financial factors, with further emphasis on conduct and operational risk. Model risk is a priority. Reliable models are essential to assess the macroeconomic impact on portfolio performance or to manage newly acquired legacy books. Basel 3.1 has gone some way towards fixing these issues through greater use of standardised financial models across the market, liquidity, credit and counterparty credit risk. But effective oversight and assurance are essential across every stage of the model life cycle, from development and implementation through to validation. It’s also important to make sure risk management teams use models for their intended purpose. The PRA’s final rules on model risk management are due in the first half of 2023. This follows CP 6/22, which expanded the regulator's remit beyond internal ratings-based models and stress testing.
Regulators are also increasing their focus on risk culture, including the agents and intermediaries. This is particularly important in areas such as financial crime prevention where banks have a specific duty to provide their agents with suitable training on anti-money laundering and countering the financing of terrorism.
ESG is a top priority for UK banks, which play an important role in supporting sustainable growth in the UK. The deadline for banks to embed climate risk principles was the end of 2021 but the PRA’s October 2022 Dear CEO letter demonstrates the need for more work to meet regulatory expectations. Most banks offer green or sustainability-linked products and incorporate aspects of climate risk into the pricing for customers that have credible strategies, metrics and transition plans in place. Our mid-market tracker also shows 32% of firms plan to invest more in ESG.
To achieve meaningful sustainability targets, banks need to look beyond climate risk to biodiversity loss and nature and to consider social and governance factors, such as diversity, equity, and inclusion (DE&I) or wellbeing. There's much emphasis now on having the right processes and controls in place, drawing on internal and external data sources. Tangible data will improve management information, and enhance governance and accountability for ESG, ensuring that firms are fulfilling their obligations and putting claims of sustainability into action that will ultimately mitigate greenwashing and reputational risks.
There's been some progress on diversity, equity, and inclusion in larger and listed firms, particularly around gender balance in senior roles. But there's still a long way to go for smaller and unlisted firms, especially in the private equity sector. The FCA’s recent review found that many firms in financial services follow a more targets-based, compliance-led approach to diversity and inclusion, rather than embedding good practices to reflect genuine commitments. The emphasis on gender balances at a senior level – often due to lateral moves – can leave junior and middle management struggling to develop and move up.
Firms should consider diversity across the whole firm and the effect of intersectionality. Drawing on a wider range of entry-level recruitment practices helps: considering different ways of advertising and targeting roles, ensuring shortlists are diverse and providing a greater range of opportunities for those returning to work, for example. Innovations in this space include a rules-based approach to DE&I, with blind applications and promotions. Tackling unconscious bias is essential to promote good DE&I outcomes and to embed the PRA/FCA’s upcoming DE&I framework (with a consultation paper due later this year).
The way corporate and retail customers want to interact with their bank has changed, driving a shift to automated self-service apps and better use of emerging technology, such as chatbots. But customers also need a seamless service across all communication channels and the ability to switch channels mid-journey. This supports a consistent quality of care in line with Consumer Duty expectations. Boards realise that good customer experience generates a greater market share so they're investing in improved infrastructure, cloud technology, and automated services.
Banks are also using automated processes more effectively within the business itself, particularly for risk management, reporting processes and financial crime detection. This makes the organisation more responsive to customer needs, market demand and regulatory changes. Our mid-market tracker found around three-quarters of businesses are increasing their use of automation and digital, helping to reduce the impact of post-pandemic labour shortages.
Regulatory priorities may shift throughout the year as the cost-of-living crisis continues to unfold, particularly if unemployment rises more than expected and housing prices continue to fall. Both the Edinburgh Reforms and the Retained EU Law Bill could substantially alter the upcoming regulatory agenda. The delayed Regulatory Initiatives Grid highlights the potential tensions between the government’s agenda for growth and the regulator’s drive for safety and soundness.
Edinburgh Reforms – key announcements
Consumer Duty remains a priority. The FCA has written to retail banks and building societies following its review of implementation plans and outlining key focus areas ahead of the July 2023 deadline. The FCA expects firms to actively support clients in financial difficulty, provide fair value to retail customers, and monitor the impact of economic developments on small and medium enterprises. The key challenge is to create meaningful management information to monitor outcomes, track behaviours and demonstrate compliance.
The PRA is also consulting on Basel 3.1, largely following the international standards with implementation set for January 2025. The final wave of post-2008 financial crisis reforms significantly change how risk-weighted assets (RWAs) are calculated for risk-based capital ratios. The framework aims to increase the use of more standardised, robust models for credit, counterparty credit risk and market risk. While these models are more complex, they provide more rigorous alternatives to the optional internal models used by most of the larger banks. Data capture, quality and analytics will be key challenges for effective implementation.
Basel 3.1: getting started with the PRA’s plan
The FCA is also keen to ensure banks can wind down in an orderly manner, with minimal adverse impact on clients, counterparties or the wider market. The regulator’s 2022 review of wind-down plans found widespread weaknesses, with many 'at an early stage of maturity' and not meeting the expectations set out in the Wind-Down Planning Guidance (WDPG). Banks need to improve their wind-down planning, processes and documentation as a priority for 2023.
In a few months, the Financial Services and Markets Bill becomes law, bringing new processes for formulating regulation post-Brexit. It essentially delegates powers to the regulators,implements the new secondary objective on growth and competitiveness, and brings greater Parliamentary scrutiny of the PRA and FCA.
Data is a recurring issue for banks throughout many themes listed here, with increasingly large amounts of data needed for compliance and reporting. Ideally, banks want to get to a point where they can aggregate and review risk and financial data in near real-time, helping to quickly identify and remediate red flags. In reality, most of the larger banks aren’t there yet but are making good inroads towards that goal.
The PRA is also concerned with data, specifically its impact on the accuracy and timeliness of regulatory reports. Banks that repeatedly show weaknesses in their reporting data, governance, systems and production processes may face a Skilled Person Review (s166). Improving data quality and governance is therefore paramount.
Beyond technical and financial data, there’s an increasing demand for data covering less tangible areas, such as behaviour, conduct, and ESG. This presents a significant challenge: to identify the right metrics to track, isolate the necessary data sources (both internal and external), and analyse the data to draw value-adding insights. With banks continuing to increase their data and technology budgets, we expect to see big leaps in this area over the next few years; banks that don’t invest may struggle to compete.
9 Operational resilience
Operational resilience requirements are now in full swing, but many banks struggle with the scale of the regulation. Key concerns include third-party risks and contracts, governance frameworks and benchmarking. After mapping critical services and important business functions, there’s also a question of how to maintain these in the long term. Processes, people, and suppliers change over time, often so gradually that it’s hard to see the collective impact. This requires effective monitoring, review and oversight in the long term.
Testing tolerance levels is critical, with banks now focusing on scenario development, ownership and testing schedules. Good management information, feedback loops and reporting processes for senior management and the regulators support effective implementation.
10 Costs and return on equity
Most boards have made hard commitments to investors to get their actual return on equity back above the market cost of equity. In higher interest rate environments, banks are generating greater incomes through an increase in net interest margins. Banks need careful cost control to convert that into profit, however, largely through the use of technology and automation. Many banks are reticent to embrace automation and often don’t realise the cost savings available, but it could make all the difference to their bottom line.
For smaller, regional or specialist banks, we expect to see some innovation in back-office infrastructure to embed cost savings and stay competitive with the larger players.
11 Financial crime
Financial crime compliance remains a key concern. While challenger banks are under scrutiny following the FCA’s Dear CEO letter, many older institutions are managing ongoing remediation projects and, in some cases, enhanced supervision of financial crime. With further regulatory change due later this year, controlling the cost of financial crime is a constant challenge. Firms that haven’t invested enough in their financial crime teams may struggle with the pace of change or to manage high demand, such as last year’s surge in sanctions activities. Meanwhile, the FCA’s new data-driven, thematic approach to financial crime work makes it easier to compare firms with peers and identify outliers.
The financial crime regulatory change agenda for this year is extensive. One obvious highlight is the increased focus on crypto currencies, with the Treasury simultaneously consulting on stablecoin and updating money laundering regulations to enhance obligations for exchange service and wallet providers. This year’s Economic Crime and Transparency Bill also enact long-awaited changes to Companies House and introduces a new corporate criminal ‘failure to prevent’ offence – this time for fraud.
The Financial Services and Markets Bill has new provisions to promote intelligence sharing. It also increases regulatory powers in a number of areas, which could have consequences for financial crime. This is notably the case for the FCA’s planned new power to require ‘access to cash’, which plays out against a background of heightened concern over cash controls at shared branch facilities, such as the Post Office, and for the new power allocated to the Payment Systems Regulator to compel banks to reimburse ‘push payment’ fraud.
Overall, 2023 is set to be a busy year, which is likely to add to banks’ obligations.
For more information and guidance, contact Paul Garbutt.