Theme #3: The need to build sustainable, responsible financial institutions
Among sustainability issues, climate change looms especially large. Leaders across the financial sector increasingly recognize climate change as a source of systemic risk. For example, in a survey of insurance actuaries released in October 2019, 22% cited climate change as the top emerging risk.5
Climate change risk materializes through two primary channels: physical risk and transition risk. Physical risk refers to the direct impact of a warming climate, including damage from more frequent and catastrophic weather-related events such as floods, wildfires, and droughts, as well as more gradual changes such as rising sea levels. The insurance sector faces several direct effects of physical risk: increased property damage will drive higher claims and higher premiums for policyholders, while failure to adapt risk models to a changing environment could result in severe and unexpected losses. Transition risk stems from efforts—spurred by policy, technological developments, or public opinion—to mitigate climate change and transition to a low-carbon economy. In carbon-intense sectors, these efforts could strand trillions of dollars of assets.
In light of these risks, supervisors are asking financial institutions to incorporate sustainability into their risk management frameworks in a number of ways: increasing climate-related disclosures; including climate in risk management frameworks and capital regimes; and stress-testing. And, there are several industry-wide initiatives to encourage the integration of sustainability into the operations of financial institutions. The United Nations Environment Programme Finance Initiative has spearheaded the establishment of the Principles for Sustainable Insurance (PSI), and the Principles for Responsible Banking (PRB). To date, over 70 insurers have signed on to the insurance principles, while 130 banks representing US$47t in assets have signed on to the banking principles.6
While it’s becoming more common for FIs to divest and exit activities and relationships that don’t adhere to sustainable principles, participants cautioned that such efforts are complicated and require nuanced decision-making. One director described his bank’s decision to cease lending to coal-related projects: “It was a very difficult decision. Ultimately, it made sense for our broad base of constituents, but it was not this clear-cut moral decision some might paint it as. There are a lot of factors.” Some participants advocated efforts to engage with clients to influence decision-making, rather than exiting those relationships.
Another risk is that as central banks, policymakers, regulators, and supervisors make responding to climate risk a central part of their mandates, priorities can conflict. For example, after insurers began to reduce their exposure to wildfires in California, the Insurance Commissioner of California asked the legislature for power to compel insurers to write insurance in those locales.
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Theme #4: Traditional business models face disruption
Truly systemic disruption is often referred to as the “Uber or Netflix moment”—when a new entrant or entrants, enabled by emerging technologies, completely upends traditional business models in an industry, changing the economics and the competitive dynamics.
This moment has yet to arrive for the financial services industry—at least in developed markets. FinTechs and InsurTechs have positioned themselves as customer-friendly alternatives to incumbents by offering a more streamlined experience and enhanced digital features; meanwhile, incumbents increasingly view these challengers as less an existential threat than as potential partners in their own digital transformations.
The industry, however, may be reaching a tipping point. The potential business model risk is quite real and mounting. Big Tech has already transformed the financial services industry in China, where Ant Financial and Tencent have redefined mobile payments and much of the financial services industry. Western financial firms and their regulators have wondered for some time if similar disruption could occur in their markets.
The threat that tech companies disintermediate financial services firms from their customers is the biggest concern. What’s happened in China is the nightmare scenario for US banks said one executive. “The big Chinese banks are dumb pipes and make money off debt and the float; that’s it. WeChat and Ant Financial own the customer and have all the data from people’s lives and everything they do.”
Facebook’s Libra project is another example of how Big Tech could shake-up financial services. Within a month of Facebook’s announcement of Libra, the US House Committee on Financial Services sent a letter to Facebook calling for a moratorium on the initiative. While participants were skeptical that Facebook’s digital currency project would proceed as planned given the quick political response, Libra has opened a new dialogue around the potential benefits of digital currencies, particularly those backed by fiat currencies.
The Financial Times recently reported, “When Facebook announced its plans for a private digital payment token called Libra in June, its intention was hardly to goad governments into creating a public electronic currency instead. But that may turn out to be just what it has achieved, by injecting political urgency into a technical debate previously confined to the research papers of central banks.”7 A sovereign-backed digital currency that challenges the US dollar and achieves mass adoption would represent a fundamental systemic disruption.
Given the potential disruption posed by Big Tech and emerging technologies, financial services firms and regulators are grappling with the appropriate response. Senior leaders are contemplating a range of options that include becoming the disruptor, partnering with start-ups and adopting agile ways of working to adapt quickly to external technological changes.
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Theme #5: Risk governance is evolving in a changing risk landscape
Following the financial crisis, supervisors, boards, and management teams focused heavily on enhancing risk management and board oversight. Much of their efforts focused on developing risk appetite frameworks, addressing risk culture, and refining the functioning of board risk committees.
Since then, the nature of risk has changed: nonfinancial risks, which have always been more challenging to model and embed in risk appetite frameworks, are more prominent. The competitive landscape is now crowded with new entrants and new partnerships and vendor relationships. The exogenous risks resulting from a volatile geopolitical environment and emerging issues like climate risk are increasingly of concern to boards.
Participants considered whether adequate attention has been paid to these evolving risks, and they reached a number of broad conclusions: boards must remain vigilant under pressure; nonfinancial risks will continue to challenge board oversight; and effective oversight requires substantial time and new sources of expertise.
More specifically, boards must be vigilant to ensure that standards, such as those around loan covenants and underwriting, remain high even as companies pursue opportunities to improve margins in a low interest-rate environment. Boards also need to look more closely at issues like concentration risk, including across traditional risk silos.
And given the intense pressure to control costs, boards must be vigilant not to allow cuts that unintentionally create other risks. One participant noted: “Cyber is not going away, so you cannot cut expenses there. AML and related compliance costs are not going away, so you can’t cut back there. And, digital transformation is not going away, so you can't reduce your spending there.” This dynamic means that firms “need to retain the same level of diligence, but do it smarter,” by leveraging robotics, artificial intelligence, and machine learning to automate and improve processes.
Participants also discussed specific steps to improve governance of cyber and operational resiliency risks. These included: diligence around basic IT “hygiene;” understanding the institution’s data strategy; ensuring sufficient testing and training; understanding third-party dependencies and potential weak spots; monitoring the rapid spread of (mis)information through social media that creates reputational risks; and improving response planning.
This new era of risk governance requires boards to commit significant amounts of time and to access new types of expertise. It also means getting the right information to assess financial and nonfinancial risks and to benchmark their companies against peers and understand best practices.
The five themes in this article are based on five Viewpoints from the 2019 Financial Services Leadership Summit held on the 16th and 17th of October in Washington, D.C., and aim to capture the essence of these discussions and associated research.
Summary
Business and operating models, and the environment in which large financial institutions operate, are changing. As a result, new risks are moving up the agenda: operational and technical resilience are increasingly in focus, as are questions about the sustainability of business models and the risks of exogenous factors such as climate change and geopolitical volatility.
