Banking is being reshaped by technological innovation and growing regulatory demands, giving rise to an opportunity for disruptive innovation.
New players are emerging – some from outside traditional banking – and new business models are taking hold. The industy is currently caught in a pincer movement between rising regulatory costs and challenging market conditions against a background of rapid technological progress, which is both a threat and an opportunity.
Huge regulatory pressures emanating from G20 initiatives following the financial crisis and more recently anti-money laundering (AML) and anti-terror legislation have forced banks to lean more heavily on technology to counter dwindling returns on capital.
“Capital levels have gone up dramatically,” says John Liver, global regulatory reform leader for Europe, the Middle East, India and Africa (EMEIA) financial services at EY. “Compliance teams have increased considerably, with much of the recent hiring around financial crime, transaction monitoring, testing and AML. It all adds up to big numbers.”
For instance, Federal Financial Analytics, a policy analysis firm, estimate that the six largest US banks spent a staggering $70.2bn in 2008 – 2013 on regulatory compliance. One of those banks spent $50m in 2015 on technology and talent just to deal with US resolution rules.
The main regulation-related costs are for building systems, establishing processes and higher capital requirements. Though the regulatory reform agenda is nearing completion, particularly on the prudential side, banks still face years of investment while also digesting a fast-growing volume of conduct rules.
Spending needs to cover not only compliance, but also changing customer requirements around digitization and convenience, in order to help fend off competitors.
“At Barclays we’ve been rolling out a program over the past three to four years, where we’ve spent more than £150m transforming our compliance function,” says Mike Roemer, Group Head of Compliance at Barclays Bank. That investment has been split between two areas: technology, and in defining the role of compliance officers by training them in new ways of operating.
Barclays’ technology spend has been heavily dedicated to e-commerce surveillance, combating crime, compliance and electronic communication capabilities, and could end up absorbing another £100m over 2016 and 2017 to keep pace with rapid technological change.
Know your customer (KYC) and AML, always important for banks, are receiving more attention as regulators continue to tighten rules. “It’s one of the most expensive areas for compliance. It’s very competitive as there’s a lot of poaching of talent, as well as a need to keep pace with technology because of cyber risks and data privacy issues,” says Mr Roemer.
Though technology is crucial for business sustainability (some banks still use traditional approaches to maintaining profitability) others “are attacking [higher capital requirements and charges] through complex treasury management systems that aim to optimise collateral,” says Neil DeSena, the Managing Partner of SenaHill, a merchant bank bringing together global banks and financial technology (fintech) innovators.
“Others approach it from a non-traditional way, such as creating new instruments to offload credit risk, which will virtually eliminate billions of dollars in capital requirements and charges,” he adds.
A silver lining in this regulatory raincloud is the accompanying demand for data needed for regulatory compliance. True, it is proving enormously expensive to put all the new systems in place to collect and process all this data, but this is forcing banks to become more efficient and data-centric. One exciting development is the creation of ‘data lakes’, where the various banking functions can pick up on new trends and compliance can detect unusual activity that requires investigation.
One important area where data will play a role is in restoring trust between banks and users. So-called ‘de-risking’ is making banks nervous of dealing with some of their peers or taking on certain clients in case AML issues surface, which could lead to harsh regulatory sanctions. The emergence of e-passports should in future make checking identities far easier and more robust, and will help restore ‘trust’ among participants. However, most big banks have been built out of merger and acquisition sprees and remain an amalgam of different processes, cultures and IT systems. The current cost pressures are a catalyst to finally integrate these various bits of the organisation.
“You need to get all these systems to talk to each other before you can get the efficiencies and economies of scale,” says Fran Reed, an ex-investment banker and Regulatory Strategist with financial research solutions provider FactSet. He adds that though this process is challenging, it can drive big rewards.
Meanwhile, investors are becoming impatient as they watch banks deploy vast amounts of capital to remain in business while their returns on equity have languished for years. “The cost pressures are such now that boards and investors have been asking to see the value in all the investment that’s gone into new systems, and they want to see the difference it has made before they go through another round of investment,” says Mr Liver.
One route to lower costs is collaboration. A recent example is Project Sentinel, a multibank initiative to share implementation costs on the pieces of the EU’s Markets in Financial Instruments Directive II (MiFID II) requirements for dealing in over-the-counter securities.
Sentinel aims to automate, generate economies of scale, create consistent interpretations of MiFID II and build in flexibility so it can work with other regulatory regimes such as Dodd-Frank in the US.
But third-party providers are also bringing financial institutions together in new ways to offset concerns for example over falling secondary market liquidity in fixed income. Toronto-based Overbond, a platform that brings together bond market participants, is one of those initiatives. Chief Executive Vuk Magdelinic explains that broker-dealers, many of which are bank-owned, often only have a limited number of relationships, which is a problem with falling liquidity levels.
“The platform offers them the ability to form relationships with more market participants,” says Mr Magdelinic. He adds that it leads to better pricing, and for new issuance it allows originators and sponsors to get a better feel for where new issuance might be priced.
Banks are also capitalising on technology to enhance their competitiveness. For example, over the next three to four years, BNP Paribas is looking at how to deliver better customer experience and is adapting its client relationship models using new technologies relating to the web and virtual agents. “We’re still in the early stages and are working on several prototypes,” says Philippe Ruault, Chief Innovation and Digital Officer at BNP Paribas.
He says the bank is looking at increasing automation to improve reporting to clients and regulators, and investing in new technologies – including digital signatures and optical recognition – to support the customer experience and protect against cyber crime.
Areas such as automation hold real promise for delivering cost savings and improving data quality. “The whole field of robotic process automation is effectively looking at the work done by humans that a robot can take over, such as data collection, aggregation and reporting – that has been a huge area of focus for efficiency gains where vendors promise savings of 30% to 50%,” says Patrick Craig, Regulatory Technology Leader for EMEIA financial services at EY.
Banks are particularly keen on using automation for tasks relating to KYC, due diligence, transaction monitoring, investigations and sanctions. These areas can involve a lot of manual labour and create risks from human error. For instance, when analyzing the work of due diligence and investigative teams, it is not uncommon to find up to 80% of their time dedicated to data collection and aggregation, while just 20% is spent making a judgement call or passing it further up the chain of command for a final decision.
Mr Ruault believes that in the future banking will move towards platforms that might host products from other providers but would ultimately leverage a large bank’s diverse client base, capital position, trust and brand name. This could be a basis for developing new business models involving third parties or enabling clients to more easily do business with each other.
“Play forward the fourth industrial revolution around data and analytics – this shifts how you begin to imagine future banking services,” says Mr Craig, who also sees a future where customers coalesce around trusted platforms or ecosystems to obtain the financial services they want. “Think of it as being a bit like apps on a smartphone,” he adds.
Mr Craig also foresees greater specialization taking place in financial services, particularly around high-risk areas that require advanced risk management skills.
Contributors: John Liver, Financial Services Advisory Partner at EY and Patrick Craig, EMEIA FSO Financial Crime Strategic Offering Leader