Up Again: Financial Services

1. What does the surge in online working and client servicing mean for physical operations in the medium to long term?

Given that the migration to working from home was relatively seamless for most companies, many will now be considering whether they still require all of their current office space. Several leading CEOs have already said that their review is under way.

Work places will need to be redesigned first to make staff feel safe, with reduced density, clear demarcation between desks, circulation routes and touch-free technology to reduce the risk of disease transmission; and, second, to create an environment that makes people want to return.

We will see a new balance of the desire to work from home (including avoiding the perceived risks of the commute), health and wellbeing of colleagues and collaborative gains from being physically in the office. Technology will play a big part as we adapt.

The pandemic will hasten changes that were already present in the property market. Online retail will hasten its inexorable rise, with logistic firms benefiting from the change in consumer habits. Others who will do well include health and life science companies and food store operators, who each, ironically, require considerable property space. But the improved technology will see further review of the need for disaster recovery sites, particularly in the finance sector. There was an emergency, but they were barely used.

2. What will the impact of the pandemic be on fintechs from both day-to-day business but also on capital raising perspectives? Will they be able to raise capital from traditional sources (e.g. venture capital investors) and, if not, how will this affect their business?

As a result of the pandemic, consumers in the financial services sector have been forced to increasingly engage with digital financial services and adapt to having no (or very limited) in-person interaction.

Due to concerns over infection and the change in consumer habits driven by the lockdowns across the globe, the digitalisation of the financial sector will inevitably see a huge acceleration.

There will, therefore, be an increased focus on technology in the sector, and all organisations (including established financial institutions like high-street banks) will need to adapt. This will inevitably create huge opportunities for agile, dynamic fintechs that can raise (or already have) sufficient capital to implement their business models.

However, raising capital from traditional sources (such as venture capital funds) will prove challenging for fintechs in the short to medium term. Although there will still be new investment from financial investors in fintechs, the level of investment will inevitably be lower, more difficult to obtain and at lower valuations than in the pre-COVID-19 world.

Financial investors will prioritise companies they have already invested in, and may need to deploy further capital to protect their investments. IPOs are also likely to be few and far between across all sectors.

As established financial services institutions adapts their business models to the post-COVID-19 world, it may be easier and quicker for them to acquire or enter into a relationship with a fintech than to create equivalent technology or expertise in-house.

Given the likely reduced ability to raise capital from financial investors and other exit opportunities for founders, there is likely to be increased investment in and acquisitions of fintechs by established financial services institutions in the short to medium term. Established financial services institutions will take a different approach to their investments than financial investors, and are likely to seek greater day-to-day involvement in and control over a fintech’s operations. However, the ability of a fintech to remain agile and dynamic and the increased oversight required by an established financial services player will need to be carefully balanced – and will be a key area of negotiation.

3. How will banks deal with defaults, non-performing loans and provisioning? What are the pressures and considerations for banks in dealing with defaulting loans?

Recently, the banking industry has seen a succession of actions and statements from prudential authorities – such as the European Banking Authority (EBA) and the Basel Committee on Banking Supervision (BCBS) – on using flexibility in accounting and prudential frameworks to support individuals and businesses.

Banks have a critical economic and social role and responsibility in the current crisis. Though banks are being encouraged to use the flexibility noted above, they must ensure that risks continue to be appropriately identified, to maintain trust in, and the reliability of, bank reporting.

It may be appropriate that short-term interventions in response to the COVID-19 crisis do not automatically give rise to a spike in non-performing loans, increased provisions and associated stress on regulatory capital.

However, banks must continue to measure risks in an accurate, consistent and timely manner. Banks are required to adequately identify situations where their customers might face longer-term financial difficulties and classify them in accordance with the existing regulatory regime.

In particular, banks should prioritise reviewing those customers who are more likely to experience payment difficulties. Securitised exposures must also be considered. The arrangements announced by the EBA and others are complex, time-limited and with potential side effects.

The particular features of moratoria and other interventions differ from jurisdiction to jurisdiction, so banks must assess each against the applicable EBA or other requirements.

For more guidance, see our COVID-19: The Governmental Response microsite, which covers the key measures taken by governments across 46 countries, including moratoria and other interventions in the banking sector.

Banks also need to be prepared for a deteriorating economic outlook, increased risk and further pressure on profitability. They must preserve (or reinforce) their capital base and capacity to continue to serve customers.

Again, the required actions will vary by institution and jurisdiction, but will likely require detailed assessment of particular sectors and customers. This may lead to single or portfolio sales of certain types of credit exposure. Additional capital raising or capital relief trades might also be considered. Changes to credit policies and processes will be necessary. The (re)building of restructuring capability also seems likely – perhaps this time with greater efficiency (e.g. using technology) and the learnings from the last global financial crisis.

4. What are the implications for payment service providers?

In accordance with the Commission Delegated Regulation (EU) 2018/389 of 27 November 2017 supplementing directive (EU) 2015/2366 of 25 November 2015 on payment services in the internal market (PSD II) with regard, notably, to regulatory technical standards for strong customer authentication (the SCA Delegated Regulation), payment service providers are allowed not to apply strong customer authentication requirements where the payer initiates a contactless electronic payment transaction, provided that certain conditions are met, and especially when the individual amount of the contactless electronic payment transaction does not exceed EUR50.

However, in France, payment card (cartes bancaires) authorities (namely, the Groupement d’intérêt économique Carte Bancaire (GIE CB), Visa and MasterCard, together the Payment Card Authorities), had decided to limit contactless electronic payments to transactions below EUR 30.

However, the GIE CB highlighted that, since the beginning of the COVID-19 crisis, contactless payments had appeared as one of the barrier gestures likely to limit the risks of contamination for customers and merchants during their daily purchases.

Therefore, to limit the spread of COVID-19, the Payment Card Authorities announced, in a press release on 17 April 2020, that the maximum amount would be increased from EUR30 to EUR50 by 11 May 2020, in accordance with the maximum amount set by the SCA Delegated Regulation. By raising the maximum limit for contactless card payments, the Payment Card Authorities expect contactless payments to rise from 60% to more than 70% of in-store card payments.

Yet, payment service providers delivering payment cards that had mentioned, in their general terms and conditions, the maximum amount for contactless payments, needed to amend these terms and conditions to implement the increase to EUR50.

PSD II provides that any change in the framework contract or in the information and conditions must be proposed to the payment services user by the payment service provider. The deadline is no later than two months before their proposed date of application, that is, for an entry into force of the increase noted above on 11 May 2020 as suggested by the Payment Card Authorities.

To avoid any delay in the implementation of this measure aiming at fighting against the spread of COVID-19, the French government adopted the Ordinance n° 2020-534 dated 7 May 2020, providing that payment services providers may, until one month after the date of cessation of the state of health emergency, increase the maximum limit for contactless payment by payment card, without complying with the two-month period, provided they inform their clients by any means of communication before the end of the state of health emergency.

5. Is there any relaxation or postponement of regulatory capital requirements?

To provide liquidity to the economy in the context of the COVID-19 pandemic, the European Commission released on 28 April 2020 a new banking package especially amending EU regulation 575/2013 of 26 June 2013 on prudential requirements for credit institutions and investment firms, as amended (CRR). These draft amendments propose the following exceptional temporary measures to alleviate the impact of the COVID-19 crisis:

  • Adaptation of the timeline of the application of international financial reporting standards (IFRS) 9 on banks' capital: To mitigate the risk that the implementation of IFRS 9 leads to a sudden significant increase in the banks’ expected credit loss (ECL) provisions, the EC proposes an extension of the transitional arrangements by two years, from 2022 to 2024, allowing banks to adjust the calibration of the transitional arrangements for adding back provisions (incurred as of 1 January 2020) to common equity tier (CET1):
    • 100 % during the period from 1 January 2020 to 31 December 2021
    • 75 % during the period from 1 January 2022 to 31 December 2022
    • 50 % during the period from 1 January 2023 to 31 December 2023
    • 25% during the period from 1 January 2024 to 31 December 2024
  • Favourable treatment of public guarantees granted during the crisis: The minimum loss coverage requirement for non-performing loans aims at ensuring that banks keep a certain amount of funds to cover the risks arising from loans that became non-performing. The calculation of the amounts to be set aside depends on certain criteria. For example, non-performing loans guaranteed by official export credit agencies, on behalf of national governments, receive a preferential treatment. The EC proposes to temporarily extend this preferential treatment to non-performing loans guaranteed by the guarantee schemes put in place by Member States, “temporarily” meaning during seven years following the date of entry into force of this proposed amendment.
  • Postponement of the date of application of the leverage ratio buffer: Under CRR, global systemically important institutions were to implement a leverage ratio buffer requirement by 1 January 2022. The EC, taking into account the financial difficulties arising from the COVID-19 pandemic, proposes to defer this dated by one year, to 1 January 2023.
  • Modification of the way of excluding certain exposures from the calculation of the leverage ratio: Whereas banks where initially only required to calculate, report and publicly disclose their leverage ratio (bank's capital / bank’s exposures), a revision of CRR had introduced a capital requirement based on this leverage ratio, which should become applicable on 28 June 2021.
  • However, CRR provided that banks could benefit from an exemption, granted by the national competent authority (i.e. the ACPR in France) according to which central bank reserves could be excluded from banks' leverage ratio calculation, for a maximum period of one year. As a consequence of this exemption, the effects of the exclusion would be offset via a mechanism increasing the banks’ individual leverage ratio requirement (adjusted leverage ratio). To enhance banks’ flexibility, the EC proposes that the bank only calculates the adjusted leverage ratio once (instead of quarterly), at the moment it exercises the discretion.

Along with these proposed amendments, the EC published a Commission Interpretative Communication on the application of the accounting and prudential frameworks to facilitate EU bank lending, the purpose of which is to provide a coordinated and consistent interpretation specifying how to use the flexibility embedded in IFRS 9 and prudential rules.

For example, the EC specifies, that:

  • banks’ assessment of a significant increase in credit risk should be based on the remaining lifetime of the relevant financial assets; sudden punctual increases in the probability of default, for example because the ones caused by the COVID-19 crisis, which are expected to be temporary, should not lead to a significant increase in the probability of default;
  • loans should not automatically be considered to have suffered a significant increase in credit risk simply due to becoming subject to private or statutory moratoria resulting from the COVID-19 crisis;
  • banks are encouraged to implement the IFRS 9 transitional arrangements to reduce the effect of ECL provisioning; and
  • the prudential rules do not require a bank to automatically consider an obligor in default when it calls on a guarantee.

6. What are the implications of the various government and EU inspired lending schemes to provide liquidity? 

Most countries have introduced government lending schemes to provide liquidity to businesses during the pandemic. The precise nature of the lending arrangements vary from country to country.

In Germany, for example, arrangements have been put in place for lending, mainly to SMEs, at both the federal and state government level. Federal lending is mainly channelled through the KfW, a federal government development bank, rather than through commercial banks.

In Ireland EUR6.5 billion has been set aside for a mix of lending and tax deferrals, while in the UK three lending schemes have been created (CCFF, CLBILS and CBILS), each catering for different sizes of businesses. CLBILS and CBILS are schemes involving commercial banks lending but with government guaranteeing repayment of a substantial portion of the loans. CCFF involves a subsidiary of the Bank of England backed by the UK government purchasing commercial paper issued by investment-grade equivalent companies.

The various schemes represent a substantial expansion of credit to business. This is intended to be relatively short term. Most schemes envisage lending for around a year or so at most – and in some cases, it is simply through extensions of overdrafts.

One implication of the gradual return to a more normal economy is that, depending on the speed with which the economy picks up again, the expansion of credit could potentially be inflationary. As much of the world, particularly Europe, has been going through a period of low interest rates, this may not be a major risk – but governments will be keen to wean businesses off this sort of credit reasonably quickly to prevent it having a longer-term negative impact on the economy.

In those countries where the liquidity has been provided by government development banks or funds, another effect will be to reduce the potential for commercial banks to lend to customers benefiting from the government schemes.

Where, as in the UK, much of the scheme lending has been undertaken by commercial banks, they will need to monitor credit performance of borrowers carefully and default rates both for borrowers in the schemes and borrowers generally in view of the strains put on businesses by the pandemic.

Though regulators have loosened some of the capital requirements for banks to help them to lend, they will still be obliged to allocate capital in accordance with the national capital rules, which are typically drawn from the Basel Accord and, consequently, need to undertake rigorous credit management during a period when, despite a return back to work, defaults are likely to rise.

They will also run the risk, if businesses become insolvent as a consequence of the pandemic, of difficult recovery processes, with the pandemic likely to be used as a basis to challenge attempts to recover monies owed or realise security. In doing this, they will need to take into account the fact that most regulators are taking a customer-friendly approach and discouraging lenders from anything other than a cautious approach to calling in loans.

7. What are the issues around access to courts and effectiveness of remote trials/hearings?

Financial institutions need ready access to courts (and arbitral hearings) at all times, especially so in times of crisis when events evolve so swiftly that economic, operational and fraud risks can escalate – and when the usual systems relied on fall away or need to be varied at very short notice.

Accordingly, there has been a response to the COVID-19 outbreak.

Experiences of virtual hearings have been mixed, however, not only in respect of technological issues, but also in terms of the quality of the judicial process, the application of new guidance from official sources, and wider risks relating to increased reputational challenges. So it’s important all financial institutions are fully apprised of how best to protect their business interests at this critical time.

Though the ability to resolve matters through an alternative dispute resolution process, such as mediation, remain available – again using technology to enable remote access – different approaches are necessary to maximise the chances of the optimal outcome, so financial institutions should be fully prepared for the new challenges.

8. What are the implications for increased fraudulent activity on customers, be it malware or other APP frauds, with banks facing increased liability?

Just as businesses and the workforce have had to rapidly adapt to new working conditions as a result of the COVID-19 pandemic, fraudsters too have been quick to react. Scams that have spread almost as quickly as the virus itself have included fake websites and apps promising updates on the pandemic or purporting to sell PPE, fraudsters impersonating HMRC and other government agencies in phishing attacks, and investment scams where investors are duped into investing in pharma and medical research organisations said to be working to develop a vaccine.

Government, law enforcement and industry bodies and regulators across the globe have been swift to identify the increased threat of financial crime during the pandemic, and are working together to monitor and respond to that threat.

One question will be what role banks have played in either facilitating or slowing the spread of COVID-related financial crime. As fraud increases, so too will claims against banks. Banks are also likely to find their client-onboarding and AML systems and procedures falling under scrutiny, at a difficult time when face-to-face customer due diligence is almost impossible and there has been a surge in applications for new loans, products and accounts with the introduction of new economic programmes and incentives.

One key risk here is litigation not only over the customer’s entitlement to a refund of the sum defrauded but follow-on claims, at a time when many businesses are facing existential financial pressures as a result of the pandemic, that a failure to detect fraud or to provide a refund, or to do so quickly enough – despite banks’ own operational challenges – caused or contributed to a business’s failure.