Financial institutions are likely to face a tough operating environment in 2023, driven by stagnating or negative economic growth rates, high inflation, surging interest rates and heightened geopolitical tensions. Economic conditions would be particularly difficult in the US and Europe, despite the respective governments supporting their banks. However, banks and other major financial institutions have built resilience since the 2008 subprime crisis, as evidenced by their capital and liquidity parameters (tier 1 capital of 14–15% at present versus 10–11% in 2007, with loan-to-deposit ratios below 85%) and shedding non-core activities, which should help them survive the stress of the current economic slowdown.
We list below six salient banking trends that may emerge in 2023:
1) Higher NIM offset by higher costs: Rising interest rates have led to wider interest spreads and increased returns for lenders, with banks in developed countries reporting close to an 8% gain in earnings in 1H22 over 1H21. However, surging rates would dampen economic growth, especially in developed countries, and reduce demand for credit for investment and consumption. Higher deposit rates and rising wage inflation and infrastructure costs may further offset benefits of interest rate hikes. The Economist Intelligence Unit states that although US and European lenders have benefited from the recent widening in interest rates, these would narrow again soon, while Asian financial institutions would maintain their margins. Moreover, sustained high interest costs, combined with low demand, may lead to increased corporate delinquencies and arrears, although there is no clear distress visible at present (barring the Chinese property developers’ defaults).
2) Tighter underwriting standards: 79% of the large US banks’ senior loan officers surveyed by the Federal Reserve stated that their banks tightened credit underwriting standards for commercial and industrial loans in 3Q22 due to an unfavourable economic outlook, reduced risk tolerance and industry-specific concerns. Demand for C&I loans was also subdued, more so from smaller firms. Stringent underwriting norms included mandating higher premiums for riskier loans, charging higher costs and interest rate spreads, lower maturity periods for loans and credit lines, and tightening loan covenants.
European banks also tightened their loan-approval criteria, especially for new loans, and expected to tighten them further in 4Q22. Higher collateral requirements, widening margins and stringent loan conditions were also reported by banks in the Eurozone. The following image shows the change in conditions for providing credit facilities to enterprises:
This increased scrutiny is also visible in the UK, where a record-low proportion of just 43% of loan applications by small firms were approved in 1H22. Even in relatively unscathed Asia Pacific, banking regulators are likely to further tighten macro-prudential policies in 2023.
3) Greater scrutiny of sustainable finance: Sustainable finance (referring to financing the transition to cleaner technology and processes) is a sizeable market (close to USD6tn in 2022). S&P estimates that green, sustainable and social bonds surpassed USD3tn in 1H22 and will account for c.12% of global debt issuance in 2H22. However, the focus would now be on ensuring greater transparency in ESG reporting by banks, and increased assessment of their ESG methodologies and impact. Banking regulators have identified greenwashing (companies using data to project an image that their products and policies are environmentally friendly) as one of the main challenges that need to be overcome in the coming years. The US SEC fined Bank of New York Mellon and Goldman Sachs in 2H22, and European regulators are investigating Deutsche Bank, over misleading claims relating to ESG investments. Environmental groups criticised National Australia Bank for labelling a AUD515m loan to the world’s largest coal shipping port as “sustainable”. European banking regulators have identified focus areas for improving ESG reporting in the near term, including upskilling their capabilities to assess and monitor ESG risks, sharing supervisory best practices, identifying common supervisory guidelines and leveraging current data-analytical practices (such as stress testing and scenario analysis) for sustainable finance.
4) Widespread acceptance of open banking and APIs: Banks and corporate borrowers have traditionally been concerned about the impact of open banking and application programming interfaces (APIs), where third-party technological applications integrate with a bank’s core banking systems to increase functional efficiency and enhance user experience. Banks were reluctant to lose their monopoly over borrowers’ data, while companies worried about data privacy. However, continued digital innovation has increased the benefits of open banking, which may lead to greater adoption of APIs in 2023 and beyond. A study by McKinsey states that 75% of the top 100 global banks have made APIs available to the public. North American and Asia Pacific banks are leading the trend, with Europe following closely behind. Key benefits of API use include the following:
- Data accessibility and intelligence through extracting borrower data from different silos and presenting it in useful ways, while customers obtain all their banking data from one place
- Banks can integrate their disparate legacy banking systems to resolve data communication challenges
- Automate manual tasks such as data extraction, data entry and numerical calculations
- Improve banks’ internal functioning and data management
- Greater data security by using renowned programming standards such as REST and Open API
- Enhance revenue-generating sources and cost reduction
For instance, Singapore’s DBS Bank now offers its corporate customers an API digital tool called DBS Rapid that can integrate with the customers’ systems to provide real-time banking data and the ability to conduct transactions. APIs such as Plaid and Yodlee are commonly used in the small business lending market to integrate borrower data directly with lenders’ systems, while PrimaDollar is used extensively for trade finance functions.
5) Challenges relating to implementing Basel norms: The date for implementing Basel 4 norms has been extended repeatedly, but regulators are now firm on 1 January 2023, despite concerns from banks.
The new norms are expected to constrain banks’ use of internal risk-rating models such as adopting a standardised approach to credit risk, quantifying credit valuation adjustment risk, changes in market risk and operational risk, enhancing the leverage ratio framework and determining the output floor. These changes would force banks to reframe their risk models, rework and possibly reprice product offerings, update policies on collateral and guarantees, and even optimise their legal-entity setup. Banks are concerned that these new norms may lead to additional capital being required at a time when they are struggling amid the impact of a global slowdown, soon after the effects of the pandemic. Thus, implementation of the complete Basel 4 framework in 2023 seems optimistic, and forced implementation by regulators is likely to result in “watered-down” compliance by banks.
6) Future of work: Managers may have to redefine post-pandemic workplaces to develop an agile and tech-enabled workforce, while facing challenges such as a talent crunch, resistance to technology adoption, experimental hybrid work models and gig economies. For instance, 4 in 10 financial services leaders surveyed by Deloitte stated that their employees were unwilling to reskill or take up new roles amid the pandemic. To counter these challenges, leaders would have to rely on softer skills such as understanding employee motivations, managing a distributed workforce, eliminating inequities between remote-working and in-office employees, and encouraging diversity. For example, managers would need to learn to recognise “unseen” work and pivot to task-based workdays rather than tracking employees’ screen time. While these strategies may help retain and recruit talent, banks may still need to increase reliance on outsourced workforces and gig-based contractors to augment capabilities in niche areas such as credit analysis and treasury operations.
How Acuity Knowledge Partners can help
A legacy generic approach to credit risk mitigation may not work amid a crisis. We develop bespoke risk-integrated lending frameworks to address the need for depth, speed and frequency in credit risk assessment, and to achieve operational efficiency and profitability.
With two decades of experience in delivering research and analytics services, we have built a robust ecosystem of people, process and technology. We have unmatched credentials within the corporate and commercial banking space in supporting banks and financial institutions across the lending value chain, enabling them to centralise, standardise and digitalise lending processes.
We facilitate the following key transformations:
- Adopting a comprehensive risk-based underwriting approach– we have helped several clients streamline the credit review process and achieve front-office effectiveness
- Centralising and standardising data infrastructureby consolidating internal and external data sources
- Proactive portfolio monitoring to effectively manage loan exposures– we develop early-warning systems with tailor-made, sector-specific triggers and headroom indicators, current and predictive credit scoring and remediation strategies
- Using alternative credit data for improved risk decisions and making this data available through APIs for almost-real-time input of information critical for underwriting decisions
About the Authors
Narayan has over 14 years of experience in lending services offshoring supporting multiple corporate and investment banks, commercial banks, retail banks, and credit unions. At Acuity Knowledge Partners, he leads multiple client engagements within the lending services supporting SME, Syndicated, Consumer Lending and Asset Based Lending divisions. He is experienced in loan portfolio monitoring and performing activities such as annual and interim credit reviews, spreading, covenant monitoring and borrowing base monitoring. Narayan has expertise in loan process consulting and support, end-to-end loan underwriting and credit monitoring, including process transformation. He is well-versed in regulatory requirements in the US and Europe with respect to loan portfolio monitoring. Narayan holds an MBA with specialisation in Finance from ICFAI Business School and B.Com (Hons.) in Accountancy.
Hitesh has over 14 years of experience in working with leading global organizations in the banking and commercial lending domains. His expertise spans a broad range of analyses, including credit appraisal, leveraged lending, stressed assets, industry reports, cash flow modelling, and client pitch presentations. At Acuity Knowledge Partners, he has led sector and product-specialist pilot teams in Commercial Lending, focusing on diverse sectors such as real estate, manufacturing, aerospace and defense, transport and logistics, and business services.
Hitesh holds a Masters in Management Studies from K.J. Somaiya Institute of Management Studies and Research, University of Mumbai, and a B.Com from University of Mumbai.
Originally published at https://www.acuitykp.com