Financial Institutions’ navigation of Covid-19: where are we now?
It’s now two years since the World Health Organization declared Covid-19 to be a pandemic in March 2020 triggering the first lockdowns. Initially, the media, consultants, academics and other commentators were speaking about and advising on the immediate impact and business interruptions in general. While a lot of commentary and advice initially addressed what businesses were already discovering to be unfolding right in front of them, it seemed that not enough time or thought had been committed to answering the tougher questions about the shape of the future.
The questions our clients were asking
In response to this we developed a series of special briefings — Finding Balance — to discuss how Covid-19 could affect the financial services industry, treating each diverse subsector separately. We focused on analysis and resources beyond the legal sector, including media commentary, economic analysis, consultancy and political insight and — key to this — reflecting our clients’ own views on what was happening and how this could change markets. One constant piece of feedback we receive from clients is the need to provide intelligence on what is happening beyond their own immediate horizons. All clients know what’s happening to them and can use internal resources to analyze that, but they really want to hear about what they can’t see: what’s happening elsewhere, what are the underlying causes and hidden effects of headwinds and where will the future opportunities emerge from. Finding Balance, looks across the industry at banking, insurance, financial sponsors, as well as financial infrastructure and payment providers. It seeks to re-assess our understanding of the significant global market shifts and trends in financial services, including ESG and the impact of digitalization and new technology. The series also considers the risks to and pressures on financial institutions presented by increasing corporate indebtedness, the rise of alternative finance, and increasing regulatory scrutiny originating from the 2008 financial crisis.
Most commentators underestimated the strength of national economies’ capacities to bounce back and the ability of society and business to adapt to a world with Covid-19 restrictions. This was partly due to the prompt nature of government and central bank interventions in financial markets and in the wider economy such as bounce back loans and employee furlough schemes. The already substantially-progressed trend to digitalization also came to the rescue and, in turn, was the subject of heavy and immediate investment. Technology allowed remote working dramatically reducing business interruption — although within financial services it posed conduct risk from a supervisory perspective. In consequence, we did not see the level of distressed loans some predicted, at levels that would have tested bank capital adequacy and put pressure on financial sponsors’ portfolios and holdings. While the reforms of the 2008 financial crisis that strengthened the resilience of the financial sector were never fully tested, we anticipated that the system of regulation — with enhanced prudential and conduct standards — would be key to stable markets. This proved to be the case. We also anticipated that supervisors were likely to be emboldened in their approach. While there was a slow start as regulators adjusted to the events unfolding around them (in common with every business) they did stand up to be counted. Appropriately tough and risk-focused supervisory scrutiny maintained a sound financial platform.
As to our focus on each financial subsector, we emphasized the need for traditional banks to offer customers more revenue-raising products and services — using technological innovation to support a besieged market. Without that, we argued, retail and commercial sectors ran the risk of a low-return utility status. Major legacy institutions have surpassed expectations in terms of maintaining or even growing market share. We discussed the growing pivot to Asia by many insurers, with China on track to become the largest insurance market by the 2030s in line with the region’s economic growth. The jury is still out on the extent to which future geopolitical rivalry will interfere with this trajectory. Financial sponsors are a diverse subsector making it difficult to generalize, except that their importance to financial markets and as a source of finance to business continues to grow. Prior to the pandemic, the sponsor sector (particularly Private Equity and Sovereign Wealth Funds) were sitting on substantial sums of unallocated cash. The pandemic has seen significant price rationalization in some, but not all, quarters and this has been the trigger for an uptick in investment activity. As a corollary, we flagged the pressure on the sector to increase transparency over ownership, mandates and fees and also the likelihood of more rules to address a relatively unrestrained sector that would be increasingly active. The proposed US SEC rulemaking announced this spring for private equity is a good example.
Our briefing on financial infrastructure — in effect the sector’s vital organs, emphasized the speed of change and the need for consumers and businesses to adapt. Until a few years ago, infrastructure was viewed as a sleepy backwater, but over the course of the pandemic we have witnessed a transformed subsector driven by market disruptors — the rise of competitive innovative information data businesses, a wave of market consolidation, expansion and diversification across value chains. Moreover, big technology businesses and fintechs from outside the regulatory perimeter raise new challenges. We did not focus on what turned out to be an exponential growth of cryptoassets and currencies. Nor did the regulators, which are now scrambling to catch up, understand and control markets that they were not built to regulate. We emphasized that operational resilience (and in turn regulatory enforcement risk) would become an increasingly critical concern, especially where operational failure would be likely to affect financial stability and the orderly working of markets. Digitalization — with the capacity to impact both speed and scale of success or failure — has demanded investment in cyber resilience.
Global drivers of change
Sustainability and digitalization were both high profile, growing priorities before the pandemic but 2020 increased momentum further. A greater appreciation of the need for resilience in the supply of goods and services has reinforced momentum towards more support for a sustainable economy and boosted the “social” and the “governance” aspects of ESG. Covid-19 has pushed businesses and customers to embrace technologies out of necessity rather than choice, but also required financial institutions both to explore new ways of delivering services and to offer new products.
Our prediction was that in the aftermath of a crisis, enforcement and compliance activity would increase as conduct risk events, loopholes and inadequate control environment responses came to light. We can already see regulators in various markets increasing pressure on institutions. It is still too early to identify a noticeable uptick in investigations and enforcement actions in relation to conduct, theft and fraud and inadequate systems and controls, but we still consider this highly likely as a downstream effect following public inquiries, regulatory reporting and internal audit and investigation within firms.
Rising corporate indebtedness is an area where concerns over serviceability continue to increase. Lightly or non-regulated alternative finance providers can be more exposed than banks. Our analysis anticipated losses by commercial banks and private equity which have yet to materialize. However, now with higher inflation and rising interest rates there are reasons for increasing concern over debt, especially in emerging economies that are most vulnerable and among businesses that may have been fighting to stay alive during or making bold decisions to grow their businesses during the pandemic period. Such businesses could be vulnerable to the significantly deteriorating market conditions and profoundly increased levels of geopolitical instability that we see in 2022.
You can visit our page – Finding Balance: The Post-COVID Landscape of Financial Institutions – for the briefings and podcast episodes we developed over the last two years. You can also check our other resources relevant for financial institutions on BakerMcKenzie.com.