Financial Services in the Twenty Teens
The banking sector has changed irrevocably in the past 10 years, with a seismic power shift away from the big incumbent players; and towards the regulators, challenger banks, FinTech firms and shadow banking entities. The big banks have been lumbered with far reaching and stringent regulation, based on the premise that the stability of the financial sector will be safeguarded for many years to come. However, some argue that origins of the risks of the next crisis may be just shifted to other players who are not so regulated. Notwithstanding, this state of affairs is exacerbated by banks really struggling to adapt to this new regulatory environment in an efficient and cost effective manner.
The structure of the financial services industry is changing with financial technology or FinTech firms emerging to disrupt this industry. These firms can combine the latest technology whist innovating with incumbent business models to provide new, efficient and agile solutions to meet customer expectations of a seamless “customer journey”. Additionally, FinTech firms are reducing the cost of financial intermediation, and are allowing previously unserviced or overcharged segments of the market to be serviced. This is evidenced by the availability of new sources of funding, new methods of payment facilitation, and new tools to allow customers to manage their finances more easily. In turn customers are more attracted to these offerings due to the lowering of the cost of switching, and, the perception that FinTech firms are more socially aware and customer focussed.
Is the growth of FinTech to lead to the demise and death of the incumbent big players? There are diverging views on this question, but perhaps one description and analogy from the CEO of a German challenger bank, who described FinTech ultimately as the apps which rely on the underlying banking infrastructure, since banks have banking licences and FinTech firms do not. He further analogised that customers currently perceive a bank as the “pig”, whilst even though customers perceive FinTech as flashy, or the “lipstick”; putting the lipstick on the pig, still makes it the pig. Henceforth some banks are realised that they need to either improve their “digital” offering, or, they need to partner of buy out these FinTech firms to prevent erosion of their market share. However, with the lumbering of regulation as described in the first paragraph, this is increasingly difficult for banks to action well.
So, why write about the challenges impacting the big banks? Why the interest in writing this article about big banks?Well, for me, I’ve worked on risk management IT change programmes for some years, where the business case has been driven both by internal reporting requirements and by regulatory mandated requirements. Post crisis, the driver has more significantly shifted towards regulatory mandated requirements. In 2013 I embarked on a part time Executive MBA programme, which culminated in me writing a thesis towards the end of 2014. I wanted to examine if the banking sector could use this regulatory induced change as an opportunity to gain competitive advantage. For instance, if the regulatory bodies mandated that banking organisations improved their data quality, could these organisations use this data asset to their advantage to derive business value that would exceed merely complying with local regulations. The process led me to meeting many interesting professionals both within and outside the industry who offered an array of insights. I used these findings to complete the thesis which was then published within the business school. Now that it is 2016, I want to share the more interesting, relevant and salient details of the research with a wider audience. Moreover, I want to update this research and add new insights to bridge the intervening 15 month time period, and the rapid emergence and growth of the FinTech industry.
The regulatory spaghetti
The financial services industry is widely blamed for the global financial crisis of 2007/8, which culminated in the collapse of Lehman Brothers in September 2008. This event precipitated a near-collapse of the world financial system, which was halted by government and central bank intervention with huge monetary and fiscal stimulus packages, the effects of which are still apparent today. The crisis highlighted that banks did not have strong internal risk control mechanisms, nor did they have an adequately robust and effective external regulatory control framework which they were forced to adhere to.
In response, financial services industry regulators around the globe have each issued their own series of new or updated regulatory frameworks which they mandated their banks to comply with. These frameworks are in the areas amongst others, of capital and liquidity buffers, risk control mechanisms and financial conduct, and are formed at a global level, regional level and domestic level by a combination of banking supervisors, central banks and other governmental and non-governmental agencies (though guided at a global level by the Basel committee).
As well as promoting financial stability, the regulatory bodies have responsibility for regulating and enabling change in the following areas:
- Higher capital requirements with increased capital requirements to shore up bank balance sheets in times of stress. The Basel III regulation proposes new and enhanced rules including more strict definitions of capital and the introduction of new global liquidity standards including the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).
- Structural changes: Structural separation of a bank’s trading and deposit taking activities. Federation of foreign branches into subsidiaries to comply with host regulations. Senior management re-evaluation of where core activities should take place
- Conduct, Markets and Culture: Imposition of mis-selling directives to foster a more “customer centric” model amongst banks. Encouraging cultural changes through recommendation of organisation structure changes and roles and responsibilities realignment.
- Risk Governance: Enhanced oversight of banks to ensure better governance structures and firm-wide view of risk management
Each of these regulatory areas has its own set of regulations and directives, and often each regulatory instigates their own version of these regulations to be tailored towards the domestic banking market.
Though these rules are intended to make all banks more resilient to future shocks, these rules force banks to raise and hold more capital. In turn, bank profitability is impacted, and ultimately the magnitude of lending flows into the wider economy. Given these rules are more penal on bigger banks, they arguably create an uneven playing field.
Regulators are also very concerned that banks are not in a position to quickly uncover or report any shocks in a timely manner owing to poor data quality and inadequate IT capabilities. More formally, in the area of risk data aggregation and risk reporting, the Basel committee has reported that ‘banks’ information technology (IT) and data architectures were inadequate to support the broad management of financial risks’; and in some cases
‘were unable to manage their risks properly because of weak risk data aggregation capabilities’; which impacted the ‘stability of the financial system as a whole’
In response the Basel committee have enacted BCBS239 to mandate banks to improve their data and IT systems architecture, to facilitate enhanced risk reporting capabilities adhering to the principles of completeness, timeliness, accuracy and adaptability.
Cost to the banking sector
The costs of complying with the new regulatory landscape can be otherwise described as the cost of regulatory change, and as well as financial cost consists of significant opportunity costs. For a bank such as HSBC, its Group Chairman Douglas Flint, says the level of regulatory pressure on the business is “unprecedented”. He says:
“The demands now being placed on the human capital of the firm and on our operational and systems capabilities are unprecedented. The cumulative workload arising from a regulatory reform programme that is unfortunately increasingly fragmented, often extra-territorial, still evolving and still adding definition is hugely consumptive of resources that would otherwise be customer facing”
Its Group CEO, Stuart Gulliver, disclosed that HSBC is spending $700–800m per annum (up by $150–200m from last year) with 24,300 staff in risk & compliance — nearly 10% of entire workforce, which has pushed its cost efficiency ratio up from 53.5 to 58.6 per cent.
Deutsche Bank is reported in the Financial Times, iterating that regulatory
‘costs could consume up to 40% or more of the annual IT budget, and make it harder for banks to invest in the innovation they need to keep up with customer demands’
Globally, across the banking sector, Grant Thornton reports regulatory projects make up 60% of bank change projects and prevent 88% of organisations from addressing their business priorities.Globally and in the UK, shareholders are demanding more focussed revenue streams accompanied by cost reductions. According to KPMG, banks are targeting a cost to income ratio improvement of 3.3% over the next 3 years; however increased regulation costs, the complexity or re-aligning banks’ business models and pay-outs for regulatory and mis-selling breaches are leading to no consistent reduction in these costs. The volume of regulation along with the material impact on the cost base creates significant concerns within the banking organisation regarding the most optimal way to adapt to this increasing complex regulatory environment. Most significantly this environment creates dilemmas in terms of accountability, where ownership of regulatory responsibility is disparate with impact and analysis and implementation split between change, risk and compliance teams.
The regulatory environment is driving significant changes in how a bank manages its’ relationships both with its’ external and internal environment, thus leading them to re-examine their internal strategy and business models to find ways of reducing the impact of the regulatory burden to their bottom line.. Thus, the implications and potential benefits from these changes could have far-reaching implications beyond just meeting regulatory stipulated guidelines. Moreover, the organisation that aligns these relationships and its’ business model more optimally could be conferred a competitive advantage.
In the next blog I will look “under the hood” to drill down into the deeper issues that regulation is highlighting and how these organisations could respond………