The defining regulatory issues of 2018 for financial services firms

Regulatory strategy in 2018

The European financial services industry faces considerable strategic challenges in 2018. There is a large volume of implementation work being carried out, alongside uncertainties around the future shape of regulation.

And though many initiatives have their roots in the financial crisis  (now ten years past), others – such as work to address cyber resilience, Brexit, and Open Banking – reflect more recent concerns.

Looking at the breadth of topics covered in this year’s Regulatory Outlook, we are struck by a number of common threads that emerge from the detail:

  • The industry faces many resource constraints and numerous competing priorities. With business models already under pressure, it will be difficult for regulated firms to do the bare minimum, let alone invest to become best in class. There is considerable uncertainty across the board: the outcome of Brexit remains unknown, there are important regulatory technical standards outstanding in several areas, and the impact of new rules on markets will take time to play out. The ecosystem of financial services is changing. MiFID II will intentionally overhaul the trading landscape, but old and new players will forge different types of connection, particularly through technological innovation and third party service providers. The shape of markets is changing, and with this the nature of risk in the system.
  • Customers’ relationships with Firms are changing. Firms are looking to use customer data in novel ways, but customers are also set to gain stronger rights over how their data is used, while new technologies are enabling new types of interactions between customers, firms and third parties.

How individual firms respond to these issues will dictate who will succeed and who will struggle in the years ahead.

Our Regulatory Outlook for 2018

We have identified seven cross-sector issues of strategic significance for all sectors of the European financial services industry in 2018, alongside a number of additional sector- specific issues.

  • Technology provides opportunities to do old things better and to introduce new products, services and ways of working. But it also creates risks for firms whose business models will be challenged, and risks for consumers where its use is not well understood or controlled. Our cross-sector issues span a wide range of issues. 2018 is a year of multiple regulatory deadlines, including MiFID II, PSD II and GDPR, and our first theme examines industry’s efforts to “get over the line” in terms of compliance. Our second theme is Brexit, and we set out what industry will need to do against a backdrop of political and regulatory uncertainty. Third, we look at the business model challenges posed by the macro-economic environment, competition initiatives, and regulatory change. Fourth, we examine whether and how industry efforts to utilize customer data in novel ways can be reconciled with new data protection rules and supervisory expectations of the fair treatment of customers. Fifth, we observe significantly higher supervisory expectations and approaches regarding the treatment of vulnerable customers. Sixth, we consider the ever-present threat posed by cyber-attacks, and the increasing supervisory emphasis on cyber resilience. Last, but not least, we assess the evolving landscape for model risk management in an environment in which a large proportion of assets in the financial system, and the level of capital supporting them, are managed using approved internal models.

Beyond our cross-sector themes, we also highlight a number of issues we consider to be “supervisory constants”. These remain the core priorities and activities of supervisors.

Although we do not see major new formal policy initiatives emerging in 2018, these issues should nevertheless be given the attention they deserve by firms owing to the high importance placed on them by supervisors. Competitive pressure, coupled with continued strong regulatory scrutiny from both fairness and competition perspectives, is likely to lead to a steady compression of the margin between active and passive fund management costs, most notably for retail funds. There is an increasing risk of declining market share and reputational damage for those firms that cannot keep up with the many rule changes, enhanced regulatory expectations and increased competition. In particular, this is likely to a effect mid-sized asset management firms and incentivize consolidation.

The most innovative asset managers will be able to use greater transparency around costs and charges, including through the introduction of more innovative, performance-based charging structures, to gain an advantage and increase their market share. Specifically, active managers need to have a coherent business model and pricing response to the growing shift towards low cost passive management. Asset managers that are unable to offer consistently good returns or competitively priced services are most likely to be at risk of losing market share and suffering reputational damage.

As fee disclosures become more transparent, asset managers need to take a position and explicitly justify their charges to investors, including, for example, where they pass on investment research costs to investors. Some larger asset managers have used the focus on fees to demonstrate that they will absorb costs rather than pass them on to investors, prompting a few firms to change their plans and implement the same approach. However, consideration should also be given to innovative fee structures. One approach could include tying fees, or a variable component within them, more explicitly to investment performance. Some firms have already advanced plans to differentiate themselves in this way.

Product innovation or greater automation through distribution channels should be considered. Opportunities for greater innovation may, for example, be facilitated through the EU Capital Markets Union.

Additionally, there may be scope to develop activities in areas beyond traditional corporate debt markets, to alternative forms of debt finance, such as broadening direct lending to, and investment in, companies.

There are also examples of fierce negotiations over the provision of investment research and this could create opportunities for cheaper research platforms to flourish. Firms might consider whether AI or machine learning solutions could lower costs around research, particularly where research is being produced in-house.

Daniela Baldoni
Chairman and Promoter