Volume 12016 January / 2014

FINANCIAL SERVICES OUTLOOK 2016 OVERVIEW OF THE KEY CHALLENGES FOR FIRMS IN 2016

CONTENTS

Abstract

4

Regulatory Change

5

Digital Transformation

11

Business Optimisation

13

How can we help?

15

3

Abstract

Abstract 2016 promises to be another challenging year with more extensive regulatory involvement and further disruption of existing business models. Whilst financial industry firms will continue to rebuild their balance sheets and implement new regulations designed to strengthen standards for a simpler and safer industry, this year will bring additional challenges of dealing with new entrants, including fintech companies, and the necessity of business restructuring and portfolio rebalancing to achieve viable capital and cost bases. This paper sets out our views on some of the key challenges for firms in 2016 across three key areas: • Regulatory Change – The continuing challenge to remain compliant with new, tougher and more extensive regulatory requirements. • Digital Transformation – The disruption of existing business models by technological innovation. • Business Optimisation – The challenge to reduce costs and protect margins and market share in the face of increasing regulatory and capital costs, in addition to competition from new market entrants. We believe that 2016 is going to be an interesting year, and we hope that it is also prosperous for you.

Regulatory Change

Regulatory Change The volume and pace of regulatory change over recent years

Following are some of the key regulatory challenges that we

resulted in a degree of regulatory fatigue expressed by many;

anticipate will demand firms’ attention in the EU, UK and US

however, the journey is far from complete.

during 2016.

Although in some cases (such as Basel III, MiFID II, the Volcker

Bank Supervision: SREP

Rule, and Recovery and Resolution) high level regulations are now agreed, detailed implementing regulations and technical

Regulations around the Supervisory Review and Evaluation

standards are still being discussed, and implementation

Process (SREP) are evolving further, particularly in the ECB

dates are shifting, making it extremely challenging for firms

SSM1 area. Business Model Assessment, Governance, ICAAP2/

to implement the changes in line with the tough timescales

ILAAP3 and Data form the main pillars. We have seen the first

being imposed.

year of ECB SSM SREP letters issued during 2015, and we have held a number of SREP knowledge-sharing events with

In other cases, high level regulations are still being drafted

clients in key SSM countries. Joint Supervisory Teams (JSTs)

and, while specific requirements remain opaque, firms are

are becoming more familiar with their institutions and have

at least able to plan change activities to analyse, lobby and

been seen attending Supervisory Board meetings. Integration

implement changes as they emerge.

of EU regulations (ICAAP, ILAAP, RRP4 -related), the changes needed in National Discretions and the levelling of national

Perhaps most problematic for firms are the unexpected

Deposit Guarantee Schemes will form an interesting playing

changes, either arising from specific failures (such as

field against a political backdrop in which the EU pursues

benchmark abuse in the LIBOR rigging scandal which broke

progressing an integrated Capital Markets Union, stimulating

out in 2012), or preventive action (such as the US ban on

financing of growth and employment in the SME segment.

short selling in the wake of the financial crisis), which demand

The ECB is clearly moving to more data-driven supervision,

fundamental modifications to products, processes and

applying BCBS239 standards to SSM banks and implementing

operating models, but for which firms are unable to plan.

their Statistics program, such as the AnaCredit5 initiative.

Regulators shift their expectations and areas of focus in line with the risks they perceive in the market, and firms need

In the US, an integral part of the supervisory process is

to retain sufficient flexibility in their change agendas and

determining a banking organisation’s composite rating under

budgets to respond to these “black swans”.

the Uniform Financial Institutions Rating System (UFIRS) or “CAMELS” ratings from six component areas: Capital

Furthermore, recent comments by BIS executives discuss

adequacy, Asset quality, Management, Earnings, Liquidity

whether Basel is ‘done’ now. The framework for revised

and Sensitivity to market risk. The requirements for advanced

bank capital requirements is arguably in place and the road

approaches banking organisations have been previously

ahead is one of calibration. However, the Committee remains

established by guidance covering comprehensive supervisory

concerned about exposures and concentrations in the non-

review of capital adequacy, compliance with regulatory capital

banking sector. New regulations to manage shadow banking

requirements, and the internal capital adequacy assessment

exposures can be expected, such as the recent consultation

process.

on Step-In risk. We also believe that the Basel Committee will need to respond to the calls to include global sustainability governance into regulation following the recent Paris accord.

1 Single Supervisory Mechanism 2 Internal Capital Adequacy Assessment Process 3 Internal Liquidity Adequacy Assessment Process 4 Recovery and Resolution Planning 5 ‘What is Anacredit?’, European Central Bank, 11 November 2015, available at: https://www.ecb.europa.eu/explainers/tell-me-more/html/anacredit.en.html

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BCBS 239: Principles for Effective Risk Data Aggregation

appetite of the subsidiary) in both normal and stress periods. 


and Risk Reporting However, as also noted by the BCBS in December 2015, BCBS 239 implementation last year proved to be challenging,

there are differences in thresholds (e.g., materiality) and

not only due to outdated and fragmented systems, manual

in supervisory priorities (e.g., timelines and assessment

processes and poor data quality, but also due to misplaced

frameworks) between Group and subsidiary levels.

organisational focus; response to BCBS 239 has been primarily IT-led, although it fundamentally requires business

An international Group approach is likely to be complemented

involvement. We expect similar challenges to persist for D-SIBs

by a regional layer to ensure and demonstrate full compliance

and those G-SIBs not initially designated as such, unless the

with BCBS 239 Principles at the legal entity level.

focus of their programmes is shifted towards, the support of efficient decision-making rather then mere compliance with

In the US, the Federal Reserve Board has highlighted data

the principles.

issues related to the Comprehensive Capital Analysis and Review (CCAR) process as an area of concern; its Large

The reality is that delivery of complete, accurate and timely

Institution Supervision Coordinating Committee (LISCC) has

data may not enhance the decision-making process if this data

increased the collection and use of consistently reported

lacks business context and is not converted into actionable

and timely firm-specific data. The heightened expectations

information. The fundamental challenge for risk managers

guidelines of the OCC establish standards for design and

remains to present the right information, to the relevant

implementation of risk governance frameworks, including

audience, at the right time, in an easily understandable way,

board involvement and penalties for compliance failures.

in order to facilitate effective decision-making. Therefore, the ideal solution for BCBS 239 should cover governance,

MiFID II/MiFIR

risk processes and end-user experience, as well as data aggregation techniques, data matching approaches and data

The second Markets in Financial Instruments Directive

lineage enhancements. The banks initially identified as Global

(MiFID II) and the Markets in Financial Instruments Regulation

Systemically Important Banks (G-SIBs) by the FSB should have

(MiFIR) constitute the backbone for the upcoming financial

met these principles by the beginning of January 2016, but

market reforms. Since the first MiFID II proposal drafted in

there is still much work to be done.

October 2011, this regulatory framework has undergone over 2,000 amendments. The current version of MiFID II still

In the December 2015 third assessment supervisors note that

requires a great deal of attention from the regulators to re-

“banks still fall short of full compliance and additional work

address contentious issues around the links between MiFID

must be done to meet the intent of the Principles.” The report

II and other regulatory frameworks, such as the European

acknowledges that BCBS 239 Principles may apply to the UK

Market Infrastructure Regulation (EMIR) and the US Dodd-

subsidiaries of an international group because:

Frank Act. Although the costs of implementing MiFID II are

• The Group “supervisor may want a banking group with

not clear due to legal and regulatory uncertainty, they are

a number of large subsidiaries to also apply the Principles

expected to be significant. However, 2016 will provide firms

equally stringently at the solo level;” or

with the opportunity to reduce MiFID II costs relating to post-

• UK subsidiaries “may in fact be required to comply with the Principles on a standalone Basis.”

trade optimisation and to recognise synergies in reporting requirements between MiFID II and other regulations.

UK subsidiaries of an international group that are subject

Regulators and firms alike have a large change agenda ahead

to

of them.

PRA

supervision

should

be

able

to

demonstrate

compliance with all BCBS 239 Principles (in line with the risk

Following the adoption of MiFID II, the industry

faces significant change over the year to 3 January 2017,

the MiFID II date of application. Recent announcements have

Senior Managers Regime and CEO Attestations

suggested that a delay in the final implementation date of up to one year is to be expected in the coming months. It has

The UK Senior Managers Regime, which partially replaces the

become increasingly clear that the national regulators will

Authorised Persons Regime, will have a large impact on senior

themselves have difficulty meeting the original deadline, and,

individuals in financial services. The FCA has taken aim at

of course, this is having a knock-on effect on the readiness

banking culture by making individuals increasingly liable for

of the financial institutions themselves. Timelines are being

any malpractice in their organisations. Under the new regime,

discussed by relevant authorities at the time of writing, but we

senior managers will effectively be held guilty until proven

expect an announcement by the end of Q1 2016.

innocent. Furthermore, a manager found guilty of the offence of reckless misconduct will be liable for an unlimited fine and/

EMIR – Integrating Cleared and Uncleared Derivatives

or up to seven years of imprisonment. These changes are likely to lead to increased investment by senior management

In a bid to increase transparency and mitigate systemic risk,

in compliance monitoring and attestation activities, as they

regulators, through EMIR in Europe and Dodd-Frank in the US,

seek to align their firms’ behaviour with the personal risks

are requiring banks to clear standardised over-the-counter

they face. It is also likely to improve the clarity of individuals’

(OTC) contracts through central counterparties (CCPs). These

remits as executives seek to compartmentalise their liability

changes will see an increasing number of vanilla and exotic

and remove their risk of censure for activities in areas over

trades cleared through CCPs in 2016. Any derivative contracts

which they do not have direct control. Less desirably from a

that are not centrally cleared will, under the new regulations,

regulatory perspective, this could also lead to difficulties in

be subject to higher capital requirements than CCP-cleared

recruiting and increases in remuneration as individuals seek

contracts. Clearing trades on a bilateral basis, as opposed to

additional rewards in exchange for the additional risks to

using CCPs, will mean that the capital requirements can rise

which they are exposed.

by a factor of 50 or more in certain instances6. In the US, a banking entity subject to the enhanced minimum From 1 September 2016, both variation and initial margining

standards for compliance programs under the final Volcker

requirements for non-centrally cleared trades will apply for

Rule must provide an annual CEO attestation that the entity

the largest institutions. From 1 March 2017, variation margining

has in place processes to establish, maintain, enforce, review,

requirements will apply for all other institutions that are within

test and modify its compliance program. The first such CEO

scope of EMIR. There will be an annual phase-in of initial

attestations are due 31 March 2016.

margining requirements such that all other institutions that are within scope above a minimum threshold will be subject to such margining from 1 September 2020. Central to this initiative is the need to invest in resources and

develop

solutions

to

integrate

pre-

and

post-

trade systems, as well as databases to comply with the increasing regulatory demands for greater transparency and efficiency and stronger related risk management practices. With this in mind, 2016 will see a new level of integration of cleared and uncleared derivatives, along with the compliance challenges faced for each by themselves. 6 ‘Regulatory reform of over-the-counter derivatives: an assessment of incentives to clear centrally’, Bank for International Settlements, October 2014, available at: http://www.bis.org/publ/othp21.pdf

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Fundamental Review of the Trading Book The Basel Committee published the comments received for its third consultation on the Fundamental Review of the Trading Book (FRTB) and conducted another related Quantitative Impact Study (QIS) during 2015. The QIS results, published in November, showed that the proposed standard would result in a weighted average increase of 74% in aggregate market risk capital, compared with the current framework. The Committee intended to finalise the FRTB by the end of December 2015, including the schedule for its implementation. Due to a delay, this is now expected in early 2016. The overall increase in regulatory capital requirements for trading book assets will clearly reduce their profitability. The challenge for firms in 2016 is in identifying optimal structures and strategies to mitigate the impact of the reforms when they are implemented. Capital Floors and Standardised and Internal Models Approaches Over the last several years we have observed growing scepticism by the EBA and the UK PRA about the calibration of AIRB risk weights. Inconsistencies in approaches and outcomes have been highlighted by various hypothetical portfolio exercises (although the industry has tried to explain why — and regulators have to an extent accepted that — such apparent inconsistencies result, at least in part, from inherent differences in banks’ credit risk portfolios and capabilities). This scepticism has resulted in greater regulatory scrutiny of models themselves, a push to replace expert judgement with empirical evidence, and LGD floors imposed for low-default portfolios. The Basel Committee plans to establish a framework for capital floors based on standardised approaches, and practitioners’ comments on a consultative paper were published in 2015. The new framework is to replace the current transitional floor, which is based on the Basel I standard, and the forthcoming regulatory changes aim to ensure that the level of capital across the banking system does not fall below a certain minimum level. Such an approach is believed to embark on

a path toward setting a minimum average risk weight by risk

In December 2015, the US OCC proposed enforceable

category (such as credit risk, market risk and operational risk)

guidelines for recovery planning by insured national banks,

that is calibrated to percentages of the respective standardised

insured federal savings associations, and insured federal

approaches. The Committee is continuing to work on finalising

branches of foreign banks with average total consolidated

the design of the capital floor framework.

assets of $50 billion or more. One year prior, the FDIC issued guidance for resolution plans that insured depository institutions

The Committee is also working on revising the standardised

with assets greater than $50 billion must submit.

approaches across the regulatory framework to enhance their robustness and risk sensitivity. It will conduct a QIS in early

Sovereign debt issued by countries with high leverage may

2016 on proposals for the revised credit risk approach; in

come back into focus in 2016 due to increased global political

choosing the way forward, it will follow the path of simplification,

instability and deflation pressures. This means that financial

which may include the use of external credit ratings in a non-

industry firms should be prepared to assess the impact of

mechanistic manner. It is considering changes to its proposals

sovereign debt deterioration on their portfolios in a timely

for operational risk and will consult on a revised standardised

manner, and to include such a scenario in their recovery

approach by the end of the year.

planning. Furthermore, firms should be in a position to assess, at short notice, the capital impact and direct and indirect

Furthermore, the Committee will soon consult on, or finalise,

exposures to specific countries in the case of their potential

a set of measures arising from its strategic review of the

exits from the EU and/or the Euro zone. Ensuring that a firm’s

role of internal models. It is continuing to review possible

analytical and reporting capabilities are up to the task is one of

modifications to the IRB credit risk framework to narrow the

the priorities for 2016.

modelling choices available to banks, particularly in areas for which the use of models may not be suitable for calculating

In Europe the Single Resolution Board (SRB) is taking shape.

regulatory capital; these reforms are to be finalised by the end

Processes,

of 2016. It will consult on removing the use of the Advanced

increasingly being detailed. Actual bank resolution case

Measurement Approach (AMA) for operational risk; capital

experience may be closer than we think and will undoubtedly

requirements for all banks are to be based on the revised

further clarify requirements and expectations.

protocols

and

reporting

requirements

are

standardised measurement approach for operational risk, and the measures are to be finalised, following a consultation, by

Changes in outsourcing in 2016 will continue to be dominated

the end of 2016.

by recent regulatory changes. With the introduction of the Single Resolution Board in Europe, UK banks with European

Recovery and Resolution Planning

operations will be affected directly, and domestic banks will be affected indirectly, by the increased requirements and

Following the EU Bank Recovery and Resolution Directive

expectations regarding bank recovery and resolution. In

(BRRD), most firms have now begun to submit their resolution

particular, we see the inclusion of bankruptcy-remote provisions

information packs and recovery plans to the authorities. In

and exit planning from outsourcing arrangements, which will

the UK, however, the initial submissions by firms which are

come under increased scrutiny, as outsourcing is a key part of

prudentially regulated by the FCA have been phased in, and

the resolvability of financial institutions.

some recovery plans are not due until 31 March or 30 June 2016.

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Ring-fencing and Operational Continuity Linked to Recovery and Resolution Planning are proposals of UK regulators on ring-fencing and operational continuity. In October 2015 the Bank of England published two consultation papers: one on ring-fencing and one on operational continuity. These proposals are designed to ensure that ring-fenced banks are protected from shocks originating in other parts of their groups, as well as the broader financial system, and can be easily separated from their groups in the event of failure. Firms should expect final rules on ring-fencing to be published in 2016 and be ready to start putting feasible implementation plans in place. Although the implementation deadline of 1 January 2019 seems to be a long way away, the sheer complexity of some organisations and the requirement to have sufficient financial resources and liquidity on a standalone basis, and separate IT and operational systems post-implementation, presents substantial challenges requiring the utmost attention early on. Leverage Ratio The Basel III framework introduced a non-risk based Leverage Ratio, Tier 1 Capital to total exposure, to act as an additional “backstop” measure to the risk-weighted capital requirements. The associated parallel run proceeded with public disclosure starting in 2015. The EBA announced in August 2015 that it will incorporate additional analysis into its calibration report on the Leverage Ratio, following a request by the European Commission to obtain further advice so as to ensure its possible future policy actions in this area are well informed. The EBA is mandated to produce a calibration report on the Leverage Ratio by October 2016, but it has stated that the delivery date is likely to be advanced to July 2016. The final calibration is to be completed by 2017, with a view to migrating to a minimum requirement treatment in 2018.

Digital Transformation

Digital Transformation The rise of smartphones, Big Data, artificial intelligence and the

dealing and model conduct risk. Innovation in analytics is

digitisation of all aspects of life are fundamentally changing the

expected to accelerate as firms find new ways to leverage

way that individuals and companies conduct their day-to-day

their data and start to combine their own proprietary data with

lives and interact with others. The first-generation iPhone was

external sources.

introduced as recently as June 2007, but has proved to be a game changer across society. By 2018, it is widely expected

Cybersecurity

that there will be more that 10 billion mobile-ready devices and connections globally. It is clear that the digital age is upon us

With innovation, IT resilience and cybersecurity are becoming

and that people are receptive to these innovations. Digitisation

critical concerns. The potential for online fraud is growing in

is changing the ways consumers shop, how they pay, and the

line with the volume of digital transactions, and firms need to

businesses from which they buy.

be increasingly vigilant against new and creative scams. In addition, new groups such as “hacktivists” are now threating the

Digital Propositions

security of firms’ infrastructures. The growth of cryptocurrencies (such as BitCoin) is, in part, a reaction to concerns about the

Financial services firms are no exception to this technological

security of digital transactions. Payment systems that avoid the

revolution. Lloyds Banking Group (the UK’s largest provider

need for participants to share confidential information (such

of digital banking products) is now opening about 3.5 million

as account details) will form an increasing part of the financial

products online each year, and firms are investing heavily in

services infrastructure. The UK’s Payment Systems Regulator

their digital propositions. Innovations such as use of smart

began to regulate payment services in 2015.

beacons, mobile payments and apps to streamline insurance claims are helping firms to differentiate and customise their

In December 2015 the US CFTC proposed two regulatory

customer experiences. Behind the scenes, firms are replacing

amendments addressing cybersecurity testing and safeguards

costly and error-prone manual processes with straight-through

for the automated systems used by critical infrastructures.

processing, enabling them to accelerate delivery, reduce errors

The proposals identify five types of cybersecurity testing as

and slash operating costs. The number of bank branches

essential to a sound system safeguards program: (1) vulnerability

continues to drop, and we expect to see a similar reduction in

testing, (2) penetration testing, (3) controls testing, (4) security

bank service centres as these efficiency gains bear fruit.

incident response plan testing and (5) enterprise technology risk assessments. They would require all derivatives clearing

Risk Analytics

organisations, designated contract markets, swap execution facilities and swap data repositories to conduct each of the

The falling cost of both computational power and data storage

five types of testing, as frequently as indicated by appropriate

is revolutionising firms’ analytical and predictive abilities.

risk analysis. In addition, they would specify certain minimum

Financial firms have access to huge quantities of data about

testing frequency requirements, and require certain tests to be

their customers, products and employees, and are already

performed by independent contractors.

developing new ways to mine and analyse this information to enhance credit scoring, dynamically monitor customers’

This proposal followed the November release of a letter by the

likelihoods of default, detect insurance fraud, identify insider

New York State Department of Financial Services regarding

11

potential new regulations aimed at increasing cybersecurity defences within the financial sector. New Competitors New technologies are bringing new competitors. Google (which has banking licenses), Apple (whose iOS has massive payment capacity) and Facebook (which holds an e-money license) are all getting closer to entering markets historically covered by retail/corporate banks. In addition, firms such as Amazon and Tesco are manufacturing low cost tablets to enable them to control the portal consumers use to access online services — a significant competitive advantage when these start to actively promote digital banking services. While existing firms continue to be constrained by the antiquated design and lack of resilience of legacy IT systems, we anticipate the IT powerhouses taking business from institutions that are unable to modernise in time.

Business Optimisation

Business Optimisation Immediately post-crisis, firms’ focus was simply to survive. As the

divesting some non-core and less profitable businesses. Increased

industry and wider economy recover, firms are reviewing their

supply of “unattractive” assets is likely to drive their prices further

strategies to optimise how they can best deliver shareholder returns

down, potentially shifting the balance from the sale of selected assets

in the new environment. Regulatory change and the increasing costs

to the sale of entire business lines and even whole businesses, thus

of capital have introduced new constraints, and firms are seeking to

fuelling M&A activity in financial services.

exit non-core operations and reduce costs in their core businesses merely to stand still. It is likely that this will drive some consolidation

Collateral Optimisation

amongst existing market participants as firms seek to build scale in their chosen core businesses and to acquire the assets and business

With regulations such as EMIR and Dodd–Frank forcing financial

units deemed to be non-core by competitors.

institutions to clear more and more trades through CCPs and post high quality collateral, the need for collateral optimisation has become

At the same time, new market participants are launching and new

more important than ever before. New regulations around collateral

business models are challenging the models of the past. Sectors

management are aimed at facilitating more effective risk management

such as peer-to-peer (P2P) lending are growing exponentially, and as

and enhancing trading relationships. However, these changes have

firms operating in this model are able to issue loans without holding

vast operational implications for financial institutions, which will need

debt on their balance sheets, they have a competitive advantage

to deliver collateral in an efficient way while complying with the new

over traditional banks. Similar advantages exist for the new payment

rules and ever-increasing trade volumes.

service providers, and regulatory changes in the retirement market are likely to see insurers face significant falls in new business. If

Back Office Operations

traditional firms are to remain relevant, they need to adapt their service offerings to meet changing customer needs, reduce costs

With changing customer expectations about the speed, accuracy

and improve focus on their core business areas.

and cost of executing transactions, firms that continue to rely on costly, slow and error-prone manual processes will be at a significant

Finally, financial institutions are increasingly in the public eye, and

disadvantage to more agile competitors.

political and reputational risks are increasingly important to their profile and share price. Firms will need to move beyond “green wash”

Financial institutions have been focusing on improving the efficiency

to actively monitor their social and environmental impact.

and performance of their revenue-generating front office (FO) operations to increase profits and maximise return on investment

Some of the key challenges that we anticipate will demand firms’

(ROI) for a long time. However, changing market dynamics are

attention in 2016 are set out following.

forcing banks to recognise that it is very important to meet customers’ expectations and provide quality services in order to remain

Divesting Non-core Businesses

profitable. In pursuit of this ncreasing the efficiency of their back office (BO) operations, which assist FO units, will become more important

Increased capital requirements and more expensive pricing of

than ever before.

risk, coupled with increased regulatory scrutiny, will result in certain businesses being either banned or no longer attractive for banks. Banks are already in a process of structural change that will involve

13

Environmental Risk Investors’ decisions are increasingly influenced by how well firms adhere to Corporate Social Responsibility (CSR) and Environmental Social Governance (ESG) policies in conducting their affairs. This means that the firms that understand their impact on society and the environment, and put in place adequate measures to be “green”, can improve their reputation and increase their competitiveness through better access to capital, improved customer relationships, cost savings and increased innovation capacity. It is also important to note that the European Commission encourages enterprises to “have in place a process to integrate social, environmental, ethical human rights and consumer concerns into their business operations and core strategy in close collaboration with their stakeholders.7” It might not be long before encouragement turns into regulation, especially in the wake of recent Paris accord.

7 ‘Corporate Social Responsibility: a new definition, a new agenda for action’, European Commission, 25 October 2011, available at: http://europa.eu/rapid/press-release_MEMO-11-730_en.htm

How can we help?

How can we help? Avantage Reply have an excellent track record in working with our clients to address the challenges of keeping pace with regulatory and technological change. With offices throughout Europe and the US we offer a comprehensive mix of risk management knowledge, industry experience and delivery expertise for our clients. Most of our consultants have worked within financial services organisations for many years, often through the economic cycle, and as such we truly understand the demands associated with managing complex change. Our work with the Regulators in the UK and EU further demonstrate our ability to understand and interpret evolving regulations for our clients. We would be happy to have an informal meeting about any of the areas mentioned in this paper or indeed in other areas that are specific to your organisation. We look forward to hearing from you.

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