As we enter 2019, firms will naturally ask themselves what they should be doing to prepare for the year ahead. When it comes to the all-important subject of regulation, firms will want to know what issues and concerns are at the top of the regulatory agenda and how they can best respond. To help firms with these vital questions, Deloitte publishes its annual Financial Markets Regulatory Outlook. The Outlook’s perspective is deliberately strategic, both in analysing regulatory strategies and priorities and in considering the implications for firms’ strategies and business models.
Nearly ten years after the financial crisis, the long shadow it has cast has started to fade. Most post-crisis prudential policies have now been decided, and banks in particular are better capitalised than before the crisis. Regulators are switching from redesign and reform of the regulatory system to practical supervisory implementation. Their attention is now acutely focused on culture and governance, the challenges of new technology, operational resilience and emerging economic and market risks as the interest rate environment begins to normalise. Firms need to be prepared to respond to this shifting regulatory focus and the new demands it will place upon them.
With this in mind, this year’s Outlook identifies six key areas that will feature prominently in the regulation of all firms across the financial services sector; issues that we call “cross-sector themes”. These are:
- A shift from implementing new regulations to ongoing supervision,
- Preparing for Brexit,
- IBOR reform,
- Climate change and sustainability,
- Building resilience to operational disruptions, and
- Value for money.
We have also identified six areas that we expect supervisors will have as top priorities for their “business as usual” supervision throughout 2019; these we call our “supervisory constants”:-
- Culture and governance,
- Scrutiny of the resilience of firms’ business models,
- Firms’ protection and use of data,
- Access and vulnerable customers,
- Testing for cyber vulnerabilities, and
- Model risk management.
In what follows we set out the Outlook’s assessment in three relatively new areas of cross sector regulatory focus:-
Climate change and sustainability
The regulatory response to a transition to a greener economy has accelerated rapidly and will continue to do so in our view. Against a backdrop of institutional investor pressure and industry actions, central banks and regulators are focusing on the financial risks that arise from climate change and will expect firms to make these a core focus of their governance and risk mitigation.
The BoE, a founding member of the global Network for Greening the Financial System, and the FCA, are already consulting on their supervisory expectations of firms’ management of financial risks from climate change, particularly through their governance, risk management, scenario analysis and disclosure of sustainability risks.
As a first step, firms will need to assign clear responsibilities to manage the financial risks from climate change, and aim to address them through their existing risk management framework in line with their risk appetite. The PRA has proposed that banks’ ICAAP and insurers’ ORSA should include any material exposures relating to the financial risks from climate change, while the FCA has made clear that investment managers must consider the impact these risks have on valuation of underlying investments as part of exercising stewardship.
While the first FSB Task Force on Climate-related Financial Disclosure progress report has highlighted that few firms have quantified and disclosed the financial implications of climate change, the UK regulators have signalled that this will become an imperative for firms. To tackle the shortage, and inadequacy of historical data on the impact of climate change, firms will require technical solutions to inform their risk assessment and modelling of potential future trends and risks. They can begin their risk identification process through high-level, and largely qualitative scenario analysis and stress testing, before establishing quantitative metrics and tools to measure short and long-term risks.
The most committed industry players have already started making concrete changes: some banks have started analysing the impact of climate change on their corporate loan portfolios, while advanced insurers are improving risk reserving to account for more severe and frequent weather-related insured losses. Leading investment managers are holding corporates to account by disclosing the best and worst performers in mitigating climate change, and will increasingly deploy divestment strategies, particularly if they detect long-term devaluation risks. We expect adoption of these leading practices to broaden.
Following the LIBOR rigging scandal and recommendations by the Financial Stability Board, the reform of LIBOR and other Inter Bank Offered Rates (IBORs) has become a major regulatory priority for 2019. LIBOR underpins contracts affecting banks, asset managers, insurers and corporates estimated at $350tn globally on a gross notional basis. Regulators are pressing firms to undertake a market-led transition to alternative overnight Risk Free Rates. Momentum has increased following recent statements by FCA CEO, Andrew Bailey, that by end-2021 the FCA would no longer compel or expect panel banks to contribute to LIBOR. This made clear that reliance on LIBOR thereafter was no longer sustainable.
In the Eurozone, outstanding derivative instruments referencing EONIA and Euribor are valued at €22tn and €109tn, respectively. Neither EONIA nor Euribor is compliant with EU Benchmarks Regulation. The administrator of both benchmarks has indicated that EONIA will not meet the requirements of the Regulation, but is planning to apply for authorisation of Euribor. Accordingly, firms will not be able to use EONIA in new contracts from 1 January 2020, when transitional provisions expire, and Euribor only if authorisation is obtained.
This broad regulatory timetable will require firms to make substantial progress in benchmark transition in 2019, notwithstanding a backdrop of some uncertainty with major issues such as term Risk Free Rates still outstanding. Firms face one of the biggest transformation projects they have undertaken, affecting almost every business unit; the financial and operational implications are potentially huge.
In our view, Boards will need to establish a co-ordinated, senior Steering Committee to manage and oversee transition, including operational and systems changes. Firms will need to assess their exposures to LIBOR, EONIA and Euribor as soon as possible. This includes deciding which contracts require renegotiation; how they will manage exposures in the meantime; and when to issue Risk Free Rate-linked products to help build liquidity (some have already done so) and discontinue issuance of IBOR-linked products. Operational and systems changes will also be required.
Value for money
Conduct regulators have become increasingly focused on the economic outcomes financial products and services deliver for consumers, in addition to the way in which they are sold and distributed. In short, ensuring financial products and services deliver value for money is rising rapidly up the regulatory agenda across all sectors.
The impact of fees and charges on investment funds will remain a particular area of focus. ESMA will produce guidance to address concerns about divergent practices across the EU in relation to performance fees, while the FCA is consulting on requiring performance fees to be calculated net of all other charges.
Firms will need to demonstrate that their costs and charges are clear and fair and that their funds deliver value for consumers. In particular, where they charge performance fees, regulators will expect that these have been fairly calculated and the impact of them adequately disclosed to consumers.
Where information and disclosure alone will not produce the outcomes they desire, regulators will be increasingly willing to reach for stronger remedies to correct poor value. Notably, from December 2019, AFMs will have to appoint a senior individual with prescribed responsibility for the assessment of value for money and publish these assessments annually.
Following on from its high cost credit review the FCA will introduce a price cap on rent-to-own products and to make further reforms to overdraft fees and charges. In the cash savings market it favours the introduction of a basic savings rate, which will require cash savings providers to set a default rate of interest on all savings products open for longer periods of time, whilst its review of GI pricing practices could also lead to pricing related interventions in the household and motor insurance markets.
Previous pricing interventions in the UK, most notably the cap on payday loans, have radically altered the market’s operation and hence the business models of participating firms. Firms that are reliant on these products should be proactively modelling the impact of these potential changes on their profitability and business model and considering whether action is necessary.
Although the post crisis reform of regulation is coming to a close, the Outlook concludes that 2019 will see little let up in the challenges regulation poses for firms. Regulators will want to assess how well the reformed regulatory system is operating and whether new regulatory requirements have been implemented. But firms should also be prepared for sustained regulatory scrutiny, both in “traditional” areas such as governance and the fair treatment of customers, and in newly emerging areas of concern such as climate change and IBOR reform.