The global regulatory landscape

Banks⁶ and non-banks (which have significantly increased their exposure to credit markets in recent years) face elevated credit risks. Financial stability authorities have signalled particular concern about two areas: the commercial property sector (in particular office properties), given its vulnerability to lower growth, heightened inflation and interest rates⁷ and reduced occupancy levels after COVID-19; and private credit markets, given their rapid growth, sensitivity to rate rises and covenant-lite loan practices⁸.

Concurrently, with cost-of-living pressures continuing to bite, firms should seek to ensure fair outcomes for vulnerable customers, and expect proactive supervisory intervention if they fail to do so. Although the circumstances are different (given the absence of government guarantees and moratoria) supervisors may start taking firms’ actions during COVID-19 as the benchmark for fair treatment of customers.

For both firms and their supervisors, maintaining financial resilience in this testing macroeconomic environment remains a top priority.

At first glance, the banking sector appears to be entering 2024 in relatively resilient shape, with strong capital and liquidity ratios (see figures 3 and 4 below). Yet the failure in 2023 of several mid-sized US banks, followed swiftly by the rescue of a global systemically important bank (G-SIB), offered a timely reminder of two things: firstly, that customer and investor confidence in banks is far from unshakeable, and secondly, that robust capital and liquidity buffers need to be accompanied by strong risk management, controls and governance, robust recovery and resolution plans, and proactive supervisory oversight.

The latter of these points will be the focus of the near-term international policy response.¹¹ But even ahead of any near-term policy change, supervisors will expect banks to enter 2024 with a renewed focus on understanding how changing market conditions are affecting their business. Longstanding supervisory concerns around the sustainability of some banks’ business models – including regional banks in the US, Europe and Japan – will come into even sharper focus this year, given the banking turmoil in March 2023 and the change in the interest rate environment. This applies particularly as the initial positive impact of higher interest rates on bank margins recedes and risks that built up during the ‘low-for-long’ era begin to crystallise.

Supervisors will also be vigilant to the impact of inflation¹² and rising interest rates on insurers, although insurers may be able to offset inflation-driven increases in expenses and claims via increased premiums in the medium to long term. Life insurers may earn higher investment returns as a result of higher interest rates, but they may be subject to higher lapse risks if interest rates continue to rise.

Of equal, or perhaps greater, concern to financial stability authorities will be the resilience of non-bank financial institutions¹³ (NBFIs) - especially in the context of elevated market risk and volatility in global bond markets. Financial stability authorities have expressed growing concern at the potential effect of the growth of speculative positions by hedge funds in US Treasuries, with net short positions in 2023 reaching comparable levels with Treasury market turmoil in 2020.¹⁴

Until a comprehensive, NBFI-specific framework is in place, supervisors will continue to use banks as proxies to manage risks in NBFIs – including through further stress testing and scenario analysis, and scrutiny of banks’ ability to monitor leverage in NBFI counterparties. Longer term, we may see the macroprudential framework used to improve banks’ resilience to NBFIs. The European Commission, for example, is considering¹⁹ NBFI-related changes to the macroprudential toolkit.

In an uncertain and volatile economic climate, supervisors will expect firms across the whole FS sector to ensure that they are financially and operationally resilient. Boards should consider working through various scenarios to test their firms’ resilience in a range of possible events.

While the above issues will draw the attention of both firms and policymakers in the short term, firms must not lose sight of the medium-term structural changes that are shaping the FS regulatory landscape. The three themes that we have picked out are unchanged from our 2023 Outlook: geopolitics, technology and climate change. Yet all three have experienced sufficiently significant shifts in the past 12 months that they require revisiting.

If new administrations choose to adopt stronger positions on economic security, de-risking or de-coupling, FS firms could feel the impact through sanctions or indirectly through economic and trade flows. Geopolitical risks could also act as drivers of other prudential risks for both cross-border and purely domestic firms, for example: affecting market risk through increased market volatility; operational risk through increased risk of direct or indirect cyber-attacks; strategic risks where firms have to exit a market quickly; or credit risks to the extent that any of those risks affect clients’ ability to service debt.

For FS firms, navigating this uncertain geopolitical environment will be challenging, and it will be vital to set a robust risk appetite and tolerance levels, use scenario analysis and reverse stress testing, and put in place contingency and recovery plans where risks are particularly elevated.

The politics of sustainability are increasingly complex. Given the macroeconomic headwinds and impending elections in many jurisdictions described above, political impetus behind long-term measures in support of net zero could recede if they result in higher costs for consumers and businesses.²⁴ If this political dynamic persists, and the private sector in turn delays its ambitions, less favourable transition scenarios (such as an abrupt or even a failed transition to net zero) will become more likely. Moreover, climate stress tests undertaken in previous years by FS supervisors indicate that significant deferrals or weakening of sustainability policies could be costly for FS firms in the medium to long term.²⁵

FS firms continue to seek ways to leverage new and emerging technologies. In the face of a challenging macroeconomic outlook, firms may be able to achieve short-term cost-efficiencies from use of new technologies, although truly transformational change will require significant up-front investment, a pro-innovation regulatory agenda and widespread adoption for inter-operability.

For firms with a global footprint, embracing technological innovation will require navigation of an increasingly complex global regulatory landscape with jurisdictions moving at different speeds. Regulators are grappling with the ever-challenging questions of when and how to intervene when a new technology emerges, and how to supervise, directly or indirectly, third party providers that are normally outside of their remit. Differing answers to those questions will inevitably fragment the regulatory landscape.

For example, regulators around the world are coming to terms with how to regulate the use of Artificial Intelligence (AI), and are doing so at varying pace and with varying approaches. The EU’s AI act²⁸ will set out a highly prescriptive set of requirements, while the UK and US are planning higher-level, principles-based approaches²⁹. FS firms using AI also need to comply with potentially divergent cross-sector regulations (such as the General Data Protection Regulation (GDPR) in the EU³⁰), and sector specific regulations (such as operational resilience requirements, governance and risk management requirements, consumer and investor protection requirements).

The evolving digital assets regulatory landscape is similarly complex. Regulatory frameworks and perimeters across the globe tend to treat the different types of digital assets and underpinning activities in distinct ways. Unbacked digital assets are a case-in-point. Japan, Hong Kong SAR and Singapore are among the first movers globally, with rules already in place to capture key intermediaries. The EU is closely following. Meanwhile significant work remains to shape detailed rules for this segment of the market in the UK, USA and Australia. Frameworks for fiat-backed stablecoins are also emerging asynchronously across jurisdictions.

The last few years have been bruising for FS firms, and 2024 could be equally challenging.

In choppy economic waters, the natural inclination for FS firms will be to focus time, resources and bandwidth on short-term issues. But the structural changes to the FS sector driven by geopolitics, climate and technological innovation are not going away, and will shape the regulatory landscape and broader operating environment for years, or even decades, to come. Boards and senior executives have a crucial role to play in ensuring that firms take decisions and make investments now that future-proof their business models.