‘There are more than 430 financial services companies operating in Ireland today including 20 of the top 25 global firms contributing just under 14% to the economy in 2019. The international bank community provides a diverse set of services across a broad geography including corporate and wholesale banking, global transaction services, corporate and structured ﬁnance, treasury and cash management, trading, prime brokerage, securitisation, trade ﬁnance and foreign exchange services to their EMEIA-based clients. Like other financial services institutions they faced the initial high level of market volatility in response to C-19 and over the past two months have adapted to take account of governmental and regulatory responses in the countries in which their parent is based as well as those jurisdictions in which they operate. Their business models have proven resilient with a largely seamless transition from working in the office to working from home, with the exception of some trading desk activities which require teams to be onsite.
Q: How well has the FS sector done to date since C-19 began, and can you give us some broad indications by sector, for example wealth and asset management, and the international and domestic insurance sectors?
Some challenges are synonymous across the industry, and some are sector specific. Interest rates in Europe have remained flat for more than a decade which on the one hand has eased consumer and corporate debt repayment pressures but on the other has significantly impacted net interest income for lenders. Banks for example are a key conduit in transmitting liquidity and funds into the economy and ensuring many essential businesses remain functioning and individuals cared for. However, they are also corporations with boards that have fiduciary responsibilities. There is therefore a delicate balancing act that banks and supervisors must manage. Apart from restructuring debt and granting payment holidays, banks must manage the significant increase in exposures from the drawdown of committed lines of credit and assess the new risk profiles emerging. In addition, there are significant operational issues to contend with.
In general, the banking sector in Ireland as elsewhere was in better shape entering this crisis than some of the other financial services sectors, given the level of regulatory scrutiny and increasing capital requirements over the past decade following the 2007/8 financial crisis. Domestic retail banks are still carrying legacy levels of non-performing loans which are likely to increase in the short term – as reflected in the increase in provisions published by the banks at the first quarter end. The international banking sector in Ireland is highly capitalised, with diversified lines of business and geographical spread. Like all financial services institutions they posted increases in provisions for credit losses at the end of Q1 of this year reflecting the forecasted expectation of a deterioration in credit risk.
The wealth and asset management industry has coped well operationally with the pandemic, and teams quickly moved to work from home. Asset values have fallen, and this will have a significant direct impact on managers’ top line revenue. The industry has already started tweaking operating models, improving straight through processing ratios, this being done largely to facilitate working from home. Longer term, the industry will look to drive out further costs to protect margins. We will see artificial intelligence deployed in the money management and sales & distribution front offices and the deployment of robotics and machine learning in the middle and back offices will be accelerated.
The crisis will further accelerate the ‘barbell’ trend with new monies flowing to either the very largest managers or to niche managers with proven track records, further squeezing the middle ground. Institutional investors are looking for returns uncorrelated to the stock markets, e.g. private debt & equity and real estate. Investment in the public markets will favour those companies embracing ESG principles. Managers will work hard to differentiate themselves, both their investment propositions and their customer service models. Wealth managers are investing in technologies that enable a more effective ‘remote relationship management’ experience.
At an EMEIA level the insurance sector has withstood the initial impact of C-19 as measured in solvency ratios and balance sheet resilience, in part due to the structures of Solvency II. That said the underlying picture is much less benign and the outlook is somewhat concerning for the sector, whether life insurance or non-life insurance with potentially something of a flat or positive perspective for some segments of reinsurance or the consolidators.
Specifically the main concern manifesting itself is the anticipated reduction in revenue coming into the sector as a result of weaker GDP and risk aversion as both companies and individuals retrench somewhat. For non-life companies this is particularly an issue in the anticipated drop off in revenue associated with personal lines protections and commercial protections, in particular where premiums are linked to revenue or headcount. For life insurance companies quarter one was not so bad. Let’s not forget it was ten good weeks and two bad weeks there and pipeline sales still followed through into execution. The real challenge starts now as there is a challenge to originate and execute new sales let alone a willingness and availability of individuals to put money away into savings contracts.
So the real work starts now and a lot of focus will turn to Q2 reporting when the first real view of C-19 is expected to be shared with the market and there will be avid reading of not just the numbers but the related disclosures and wider outlook statements and guidance.
Q: What priorities are IFS companies addressing and need to address in dealing with the pandemic crisis - e.g. cutting waste, accelerating the use and development of technology and fintech. What managerial realities are likely to change as a result long term?
As with all financial services firms, the key priorities to date have been the well-being of employees and clients and operational resilience to ensure the day to day functioning of the bank could continue to meet client, business, reporting and (increased) regulatory interactions and requirements. Liquidity was an early and remains a significant area of focus given the level of market volatility and the need to keep markets and the financial system liquid. In March and April banks were also focused on completing their financial year end processes and their first quarter-end reporting cycle remotely, with the challenge of accruing for potential losses arising from C-19 at this early stage and managing shareholder and market communications.
On an operational basis banks are now focused on return to work strategies and planning. Some banks believe productivity may have gone up during the crisis and there will be acceleration of existing trends such as the location strategy of the business and deployment of new ways of working through digital enablement to facilitate sustainable and controlled remote working.
Based on C-19 experience banks will enhance financial and nonfinancial risk management with a focus on data enablement and real-time monitoring of a wider set of risks and exposure leveraging artificial intelligence (AI) to augment supervision and surveillance capabilities.
Q: What are the key differences in the problems being faced, distinguishing between short, medium and long term questions. Have we begun to see all of the likely long term issues yet?
As well as operational resilience and employee wellbeing and welfare, maintaining cohesive governance and control and the three lines of defence framework is difficult with so many challenges and responses occurring simultaneously. Banks are prioritising high risk areas such as cyber risk, financial crime, outsourced services both inter-affiliate and to third parties, trading control and mis-selling. Resiliency remains a key focus and it is critical for banks to remain operational, transmit stimulus as efficiently as possible – where they are required to do so - and at the same time begin to incorporate a view of the increased liquidity, market and credit risk.
Banks need to develop new modelling approaches to test the impacts of C-19 under various scenarios. New approaches are utilising epidemiological models and detailed sectoral analysis focused on the supply and demand chain impacts. This will feed stress testing, IFRS 9 and recovery planning. They also need to create a dynamic capital and liquidity monitoring and assessment process that is continually refined to reflect the actual business outcomes and forward-looking C-19 modelled outcomes.
In addition, non C-19 areas of focus are beginning to resurface including the IBOR reform, the UK/EU relationship matters and the Investment Firm Directive/Regulation which becomes effective in 2021 and will result in the largest broker dealers across Europe being re-designated as credit institutions and sustainable finance. The European Central Bank published its draft Guide last week on what it expects of banks in relation to their assessment, stress testing, monitoring and reporting on climate-related risks by end 2020. Managerial responsibilities are specifically called out in this Guide on climate change risk, and also, in Ireland, managerial responsibilities will become more prescribed for senior accountable executives under the Individual Accountability regime, legislation for which is being drafted.
Andrea Enria, the chair of the Single Supervisory Mechanism, noted recently at EU Parliament that banks had played their role so far but as the economy deteriorates, asset quality will deteriorate and put downward pressure on interest income and upward pressure on credit impairments. This will impact those banks whose business models rely significantly on lending to customers, clients and corporates. Larger international banking institutions have diversified business models and stronger starting capital ratios so will be less vulnerable to this than domestic banks. However, a prolonged period of dislocation in financial markets will dampen demand for financial services and the impact of this in terms of bank profitability and sustainability is not yet known, although some central banks have published interim stability reports showing that the banking system is adequately capitalised to withstand GDP decline forecasts in 2020.
And as to whether we have begun to see all the long term effects yet, I think the answer is no. As Robert Louis Stevenson said, ‘the obscurest epoch is today’.
Q: Regarding Brexit, and IFS, what is your expectation currently as to what will be the outcome at the end of June? What are the likely consequences of this, positive and negative, and how will they balance out for the economy, and more narrowly for the FS industry?
Naturally the focus of governments and business has been on C-19 over the past months and aspects of Brexit such as no-deal, tariffs and negotiations suddenly felt less relevant when put in perspective by C-19. There have been developments, however, one of which was the outcome from discussions in April which is a rejection by the UK of any extension beyond 31 December. The draft negotiating text published by the UK last week covered key aspects of a deal such as free trade agreement, level playing field, good tariffs, business visits, streamlined custom arrangements and tax governance inter alia. Progress undoubtedly but reaching agreement by the 31 December deadline on all of these seems highly unlikely at this point. Equivalence for financial services is notably excluded from the free trade agreement and the UK will seek ‘adequacy’ and ‘equivalence’ rulings from the Commission. 30 June is the intended date for financial services equivalence as well as being the deadline to agree any one-time extension to the transition period – again whether this is achievable at this point seems unlikely.
Q: What is your current call on the overall impact of the pandemic on the economy and the FS industry?
The immediate economic impact of C-19 is becoming clearer with record falls in surveys of business activity and over 1 million of Ireland’s workforce now in receipt of either C-19 pandemic support or the wage subsidy scheme. The data shows that every region and every sector has experienced disruption, it is not only the consumer and tourist businesses one might imagine when thinking of economic impact.
The great unknown is how quickly will business bounce back? Will we enjoy a late year surge as people and firms race back to spend and catch-up on what they missed during the lockdown? Or will lingering health concerns and weaker balance sheets hold both consumers and businesses back for a longer period? Forecasters are beginning to move more toward the latter. Latest EY forecasts project a contraction of roughly 11% this year in Ireland, though the margins of error are much greater than usual given the circumstances. Employment is projected to be over 200K lower at the end of the year than it was at the start, which does suggest most workers laid off or furloughed get back into employment, but still pushes unemployment up to over twice its pre-Covid rate, ending the year around 13 per cent.