As financial services firms deal with an uncertain economy and other distractions, they might be wise to consider what regulators are seeing as important in 2023
A complex cocktail of high inflation, volatile interest rates, supply chain disruptions, and slowing economies is creating challenging operating conditions for the financial services industry. Regulators’ preoccupations are with ensuring that firms manage their own financial and operational resilience and continue to support their customers.
Against this background, boards and executive teams should ask themselves two broad sets of questions. The first concerns what steps are being taken to remain resilient and support customers through near-term economic pressures; and the second, whether their own strategic plans align with medium-term structural changes in their operating environment.
Indeed, a strong grasp of the ever-evolving regulatory environment must inform how financial services firms answer these questions.
Near-term economic pressures
Disruptive economic factors will command attention in the near term. The credit risk outlook is increasingly precarious, and lenders will need to be able to demonstrate to supervisors how they are managing the associated risks. Many insurers and investment funds will also face credit-related pressures in their portfolios and may need to boost their credit teams if the volumes of defaults and corporate restructurings begin to rise.
Where credit risks crystallize, they will feed through to regulatory capital positions. Firms will also need to be vigilant for sudden bouts of volatility within the capital markets.
Central banks and regulators will be working hard to understand market vulnerabilities, with continued stress-testing of individual firms, funds, and the wider system. Margining practices will be under scrutiny.
There is also a major conduct risk component to the current economic situation, with consumers feeling the cost-of-living squeeze. Conduct supervisory standards are substantially higher now than in previous downturns, and firms will rightly be expected to support their customers through a period of economic hardship.
This is a particular dilemma for lenders, who will need to make judgements about when and how to exercise forbearance. It will also be a challenge for insurers, who may see rising numbers of policyholders struggling to cover their premiums, creating the possibility of protection gaps that will draw supervisory attention.
Embedding climate & nature risks
Climate and nature risks will increasingly shape the financial services operating environment. Less advanced firms may find themselves given progressively less leeway for shortcomings in the year ahead.
Efforts are underway in numerous arenas to improve the structure and content of transition plans, and firms will need to shift gears to keep up with new rules, guidelines, and greater supervisory scrutiny.
Firms will also need to keep an eye on the still-evolving nature-related risk disclosure framework being developed by the Taskforce on Nature-Related Financial Disclosures, a financial services industry advisory group whose members represent more than $20 trillion in assets. The Taskforce’s risk disclosure framework is due to be finalized in Fall 2023.
Technology transforming the sector
Technology enables firms to provide new and better products and services, develop deeper insights, and do so ever-more efficiently. However, as supply chains and delivery services models become more complex, both the regulatory regime and firms’ risk management and control frameworks have struggled to maintain pace with technological innovation.
Nowhere is this clearer than in relation to digital (and particularly crypto) assets. Regulated firms have increasingly been engaging with an evolving ecosystem of digital asset technology providers and developing client offerings. The European Union’s Markets in Crypto-Assets framework will enter into force this year, but a further regulatory response may be needed to tackle issues such as leveraged trading and crypto-lending as regulatory uncertainty and gaps will persist.
In the United Kingdom, meanwhile, the Financial Services and Markets Bill, once passed, will give authorities the power to oversee digital assets markets. The secondary legislation that will clarify which activities and market participants they will regulate, however, is yet to emerge.
The transition period for the U.K.’s operational resilience framework will soon enter its second year, and U.K.-based firms need to demonstrate measurable progress with regards to important business services. The 24-month implementation period for the E.U.’s Digital Operational Resilience Act begins this month, and firms within the E.U. will need to begin their work post-haste to be on track for the early 2025 deadline.
The resilience of the delivery of financial services in which third-party suppliers are involved is a major issue. In some cases, firms will need to develop contingency exit strategies and business continuity plans for third-party exposures, including substitute service delivery methods.
Long-standing concerns about model risk management also now have a distinctly technological flavor, with supervisors scrutinizing how firms are deploying artificial intelligence and machine learning. When finalized later this year, the U.K. Prudential Regulation Authority’s (PRA) proposed principles on model risk management will require a large amount of work to catalogue, categorize, and risk-assess models that for some firms could number in the thousands given the PRA’s expansive definition of model.
A general principle will be relevant for firms across all sectors and regions: people, and not models, should be responsible for decision-making. Boards and executive teams should be able to demonstrate that they understand the functioning of their models, including those based on new technologies such as machine learning.
Rising geopolitical tensions
Finally, rising geopolitical tensions will continue to be another feature of the changing risk environment in which financial services firms are operating. International markets are increasingly fragmenting, as nations and business leaders look at how to build supply chain resilience and security through greater localization of production and supply.
Given the volume of alerts generated by transaction monitoring systems, the inherent limitations of legacy systems and data, and strengthened baseline expectations, it is no wonder that some firms feel they are having to run ever-faster just to keep up. The status quo does not appear sustainable, and operating model reform will need to be part of the response, including considering changes to internal structures, resourcing models, and technology strategies.
Resilience and strength
Financial service firms face many headwinds as the new year begins but will do so from a position of resilience and strength, having successfully navigated the vicissitudes of the last three years. The major challenge will be to navigate the choppy near-term waters without losing sight of the medium-term processes of structural change playing out in relation to geopolitics, technology, and sustainability.
Regulation continues to be a major force that will shape the operating environment for financial services, and an integrated view of the regulatory landscape — as well as an ability to connect such a view with business strategy decisions — remain imperative for firms looking to stay at the forefront of the industry.
This blog post was taken in part from a recent report written by David Strachan & Suchitra Nair of Deloitte. You can sign up to receive Deloitte’s Financial Markets Regulatory Outlook report, due to be published later in January, here.