The new working environment that we had to adopt in March 2020, meant that bank staff had to adapt almost overnight, including remote work and branch COVID-19 safety measures, as well as disruption to outsourced service providers in both the UK and overseas. Thanks to hard work and goodwill on the part of all involved these initial operational challenges were overcome; indeed, many learnt that their teams and governance structures were far more fungible and adaptable than was believed possible.
There were no high profile, extended operational failures which would have damaged confidence in the system, although we should remember the Wirecard failure in June did cause disruption to those least able to bear it in some payment firms. Externally, there were many well publicised measures where the UK banking sector was at the fore in executing government strategy – government guaranteed loans pumped out in record amounts and forbearance for millions of customers otherwise facing coronavirus-related financial hardship.
As we go through 2021, the detailed economic impacts of COVID-19 on businesses and individuals will become clearer. There is still enormous uncertainty over the benefits to come from vaccines and government economic measures. The details of the recovery process for loans made under government-backed lending schemes have yet to work through. At the same time, the impacts of Brexit and a new administration in the US have still to work through on trade and geopolitics. In this first quarter of 2021 the enduring feature is the new uncertainty facing the banking sector.
In this insight we explore the top ten themes for the UK banking sector's journey to recovery in 2021 and beyond.
The current circumstances have put strain on the financial sector, but banks have been well-prepared to manage the situation and weather the economic shock. Post-2008 regulatory reforms established robust capital and liquidity buffers to cushion the impact of shock events, and regulators have taken steps to help protect those buffers as COVID-19-related disruption continues into the long term.
Most banking institutions will suffer some operational losses: their borrowers' financial strength will fall and extended low interest rates will also reduce net interest margins (NIM). Banks’ will need to review their risk profiles, operating models, and strategic approach to manage the financial impact. For those still building capital buffers, there is a real challenge on how to achieve an acceptable return on equity – or indeed stay in / return to profit – for the foreseeable future.
One of the biggest challenges for the UK banking sector is balancing their losses, while continuing to provide loans, debt-moratoria, and intervention schemes to support financial stability. Under IFRS 9, loans that look more likely to default will trigger loss provisioning upfront, potentially reducing the ability to offer credit.
In 2020 we saw the expected uptick in loan loss provisions under IFRS 9. Those banks with larger investment banking, especially trading, operations saw those loan losses offset by revenues arising off increased market volatilities. The question in 2021 for the UK banks will be whether further losses need to be recognised, although that is not widely anticipated at the time of writing. In the short term, it is unlikely that directors will not rush to reverse previous provisioning levels – notwithstanding the more mechanical nature of IFRS 9 provisioning, human judgement and model adjustments have been widespread and there is also inherent uncertainty for the modellers on the financial strength of borrowers just now.
Banking institutions need agility and business resilience to evolving customer needs. Actioning lessons learned from the last few months, particularly around burst capacity processing and operational resilience, will improve customer service and responsiveness. They will also inform recovery, resolution and wind-down plans, operational continuity in resolution, and stress-testing scenarios, which will all strengthen financial stability in the long term.
Resilience plans are moving away from traditional disaster recovery sites, with the focus shifting to remote-working models. There is also a widely discussed move to reduce the size of physical office space at either branches or head offices as customers and staff adopt remote access more routinely as lockdowns end. Increasingly, we are seeing the overlap of operational efficiency and economic efficiency as part of strategies to increase resilience through the better use of modern technologies. Institutions that do not keep pace with technology risk falling behind in their economic performance as well as resilience.
Working from home has become a bigger part of many business models, leading to a more distributed workforce and greater workspace rotation. While this will reduce overheads, banking institutions need to review customer access points and establish the right balance between digital and face-to-face service delivery options.
We have seen that banks have remapped their workforce to locations and functions, adapt to collaborative technologies and support greater flexibility. Whilst this is true of the UK market, it is interesting that this shift is not evenly spread across all geographies. Banks with global operations are having to adopt different responses in different countries.
Agility goes beyond working from home and fungibility is one of the recurring themes we have seen from banking institutions. A greater flexibility in the roles that individuals perform has promoted operational resilience and will most likely be part of the new normal.
As the situation has evolved, banking institutions have made cost reductions and initiated restructuring projects as needed in the short term. Many of these changes will not be appropriate for the long term, and banks will need to review and update their approach regularly, in line with the macro-economic landscape and business needs.
It will be challenging to balance risk exposures, while allocating capital and resources to core and periphery business lines. Banking institutions need to take an innovative approach to manage their expenses, for example, by commercialising technology assets to supply third-party services to other firms or leveraging balance sheets of large technology providers.
Reduced physical mobility under lockdown has forced an increase in the use of digital services – by both employees and customers. This acceleration in adoption increases digital transformation efforts and will affect distribution strategies and a reprioritisation of enabling investments. This will continue the need to manage operations and reporting by maximising data assets and insights.
Coping with the change aligns to cultural support in using new organisational tools to better support banking service delivery. There will be pressure to maintain the speed of adopting technology solutions that we saw in protecting franchises throughout 2020, notwithstanding other budgetary issues described here.
As more customer services are digitised – and the true 'cost to serve' at an individual level is clear - there will be an increased political and regulatory focus on ensuring that certain cohorts and elements of society are not left behind.
Central banks and regulators have focused on maintaining financial stability and operational resilience. To support this, they have offered greater flexibility for regulatory reforms such as Basel III and introduced new fiscal policy measures. As such, banking institutions have been able to focus their resources on governance, cyber security, and conduct, as well as essential programmes, such as the Libor transition, which remains on course for the end of 2021.
We anticipate further changes to regulatory priorities and tools as events unfold; not least if additional capital needs or the conversion of existing instruments are threatened. As with other initiatives, we anticipate this will always need more and more frequent review to keep organisational effort focused on the right areas and responsive to official sector initiatives and priorities.
In 2021 we anticipate there will be a focus in the UK on fair outcomes for retail and small and medium sized enterprise (SME) customers. The FCA's ongoing work on the needs of vulnerable customers is widely expected to again be a strong theme in 2021. In parallel, the introduction of both Intermediate Parent Undertaking requirements and Minimum Requirement for own funds and Eligible Liabilities (MREL) for the larger UK groups will keep the pressure on the prudential requirements and add to the challenge of making economic returns on equity. There is still a bedding down process in the relationship with EU regulators post-Brexit to go through, in an environment where personal accountability is being pushed. Staying on top of the regulatory agenda will require agile governance and technology approaches.
As with the financial crisis, short-term to medium-term pressure will lead to market consolidation or a shift in product offerings. Pre-existing issues in the business model will be amplified under stressed conditions, and smaller and medium-sized banks may join forces to restore balance sheets and regain a positive return on equity. Larger banking institutions may look to acquire discounted firms, or indeed their technology assets, and view this as an opportunity to expand or streamline their product lines.
One frequent observation in 2020 was that the environmental agenda which had been at the fore in 2019 had been paused. While it is true that the change agenda had to focus on short term operational matters in 2020, the basic issue of climate change and the role all parts of society, including financial services need to play in managing it could never really have gone away. The change of administration in the USA and the upcoming UN Climate Change Conference of the Parties (COP 26) in Glasgow in November this year have brought Environmental, Social and Governance (ESG) criteria, particularly 'Environmental,' back to the top of the UK banking agenda.
The UK is leading regulatory developments and we anticipate that 2021 will see advances in common, global standards. The external impact will be on the risk-appetite banks have for balancing their loan / securities portfolios. Internally, there will be enormous challenges on the use of data and data accuracy and completeness to allow the sorts of sophisticated environmental impacts and stress tests that will be required.
Many operating models rely on third parties to perform near and off-shore services, and it has been challenging for many banking institutions to maintain their supply chains. Existing third-party arrangements may need a rethink.
For example, some of these services could be achieved through FinTech and ecosystem platforms. Alternative solutions could improve business continuity, stability, and agility, while supporting innovation across the business. The use of offshore centres is a key area of interest, and many firms post-crisis found that elements of these supported their operational resilience. Feedback we are hearing is that the use of 'cloud' technology has met with mixed success and several global regulators are reluctant for banks to use cloud in critical service provision. Expect changes throughout 2021 to meet the pressures on cost bases.
During the financial crisis, banking institutions were perceived to be part of the problem but in the current situation, they are an integral part of the solution. Authorities across the globe have called on banks to offer financing and credit as part of a co-ordinated macro-economic response.
In the UK ring-fenced banks have played a central role in the Treasury’s response, and it has been challenging to balance the pressures of long-term financial stability and short-term shareholder interests. Moving forward, there may be a degree of re-alignment between the financial sector and the government, with new governance arrangements and regulations to support it.
There are also clear signals that leading banks are looking at how they avoid 'greenwashing' and play an active part in supporting actions to limit climate change. Banks are also making real efforts to better reflect society in their leadership – for a few, pressure from disclosure requirements gives that added incentive. Banking culture has changed in the last 10 years and shareholder (or employee) return is now being balanced with the role of the institution to provide good customer outcomes and support the right (higher) levels of diversity.
The UK banking sector certainly has a lot to think about on its journey towards recovery, and these themes will remain active beyond 2021. By truly taking them into account and reflecting on how best to solve the operational and regulatory issues indicated in them, banking institutions can make a good start on this journey.
To continue the conversation about the challenges facing the banking sector, contact Paul Garbutt