UK: Regulation Takes Centre Stage - Securities and Banking Update May 2005

As the financial services industry stands at a new watershed, Chris Gentle, Director of Research at Deloitte Global Financial Services, explains which issues will drive the reshaping of the industry and forecasts some major changes.

The pendulum is swinging. Not for a generation has regulation played such a central role in the destiny of financial institutions. In the 1970s and 1980s the walls that separated activities of financial institutions were torn down in an era of great liberalising reforms. A period of rapid and sustained transaction activity took place changing the financial services landscape.

Today we stand at a new watershed. The confluence of an avalanche of regulations, ill-prepared IT and compliance procedures and low-growth-low-inflation environment is likely to bring about this watershed. What is different is that the walls have not been reconstructed; rather regulators are using the levers of market practice and capital management to shore up financial services markets. As a consequence, there are likely to be four issues that flow from this confluence of events that will reshape the financial services landscape.

Firstly, the confluence of a regulatory avalanche and new business economics has brought the financial services industry to a major turning point. Arguably, not since the wide-ranging liberalisation of financial services activities in the 1980s has regulation driven such dramatic change. The shift from bull market and high inflation to uncertain stock markets and low inflation was already changing the economics of financial services. But wide-ranging regulation is adding further pressure. With little evidence of a strategic shift in thinking towards regulation from compliance to business issues, a continuing piecemeal response of many financial institutions could prove fatal. A large proportion of senior management is not being briefed in key areas around regulations and the pace of implementation needs to be quicker. Banks and insurance companies need to adapt their business models to the new environment. By 2010 the financial services landscape will look very different and this change will accelerate in 2005.

Secondly, as financial institutions move to a new regulatory environment, some firms will have distinct advantages over others. Broadly speaking, the high ground belongs to the large, diverse companies with captive distribution and capital strength. Although some niche organisations will benefit from their focus and ability to move swiftly. A combination of current capabilities, past business legacies and management action will cause a polarisation in fortunes. The banks have a natural edge, while all but the largest life insurance companies may struggle for success unless they evolve. There will be consolidation amongst intermediaries. Transactions will be driven by new capital regimes. There will be more cross border competition.

Thirdly, making the transition to the new environment requires capital whether defined by Basel, Solvency II, economic capital or rating agencies. For all types of Financial Services institutions, adapting to a regime where lower margin products have longer pay back periods requires capital. In the case of life insurance, this is happening at a time when balance sheet capital is already in short supply. This points to a continuation in the trend of life companies raising capital – often in innovative ways. We also expect that many smaller (life) insurance companies may have difficulties generating an acceptable return on capital.

Finally, expect to see new policy issues arise in two areas: the provision of medium and long-term savings products, and consumer choice. First, the general public is likely to be offered a narrower range of standardised savings products with less access to quality advice. The proportion of "unsaved" within society could grow. Second, the combination of pressures is likely to force firms to differentiate even more between different income groups, with the lower income groups being offered even less advice and, possibly, more expensive credit products.

The key for all financial institutions lies in the alignment and balancing of investments and operational activities around the three Cs – Capital, Cost and Customers. None of the three C’s are new to financial institutions. However, what is new is that the changing environment requires a much greater degree of the interdependencies within the business. The three C’s provide an appropriate lens. For instance, Financial Services Authority (the UK regulator) guidelines around Treating Consumers Fairly demands not only that a financial institution reorganises the interaction with customers over the lifetime of a product, but also requires a detailed understanding of the cost to serve that customer and the capital efficiency of operating in that marketplace.

All-in-all, the new regulatory challenge means the financial services marketplace is likely to look radically different by the end of this decade. 

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