New year, new pressures, new opportunities
Coming through the pandemic, the banking sector market landscape is rapidly changing. Financial institutions are seeking clarity and situational awareness to accelerate change, driving the need to take deliberate action. Banks large and small are evolving their mission, focus, and program prioritization from a historically regulatory-response strategy to a more proactive, strategic-growth agenda. The last decade of compliance investment has created a permanent cost burden and banks are looking for ways to re-gain operating efficiencies and refocus on growth and business execution by leveraging innovation, and responding to changing market dynamics based on a number of disruptors currently in the market including:
- Established tech firms pursuing banking services that now compete with traditional banks
- Emerging platforms and integration technologies coming online to expand the potential banking connectivity, and possibilities to enrich customer experience
- Changing customer demographics that are demanding a digital experience
- Recognizing that scale and efficiency are critically important requiring a clear platform strategy
- Heightened risks associated with a connected tech landscape that are forcing banks to prioritize their risk strategy
- Shifting skill requirements away from traditional banking roles and toward data experts, data scientists and technologists, escalating the war for talent
These disruptors have a magnified effect on regional and larger community banks, largely due to their limited access to key resources and capabilities, which hobbles their ability to formulate and execute a strategy that will drive growth and profits, delight customers, and mitigate risk in a new and fast-changing environment.
Beyond the market disruptors, with the Biden administration appointees in charge, new regulatory priorities, mounting ESG pressures and an accelerated transition toward digital transformation, banks face a variety of key challenges and opportunities in 2022. Following are areas banks should focus on this year.
Regulatory environment: Several new sheriffs in town
With an ever-increasing focus on consumer protection as well as protection for commercial and consumer interests facing heightened fraud risk, cyber, and related threats on a global level, the regulatory landscape will continue to strive for more vigilance, enforcement, and challenge that will continue to require banks to up their focus on regulatory compliance.
Grant Thornton’s regulatory experts advise preparing for a historic and dramatic shift in priorities with significantly increased regulatory focus. Leaders with diametrically different policy perspectives from the previous administration will continue to direct key agencies, heading powerful committees and drafting influential executive orders.
Grant Thornton Principal, Regulatory and Compliance Risk, Tariq Mirza predicts that “Regulatory policy efforts will focus on practices that tend to harm vulnerable populations. These include fair lending, credit reporting, overdraft protection and appraisal bias.”
For example, on October 22, 2021, the Justice Department announced its Combatting Redlining initiative, which will expand analysis of mortgage data and intensify enforcement of fair lending regulations.
Regulators will be collecting more mortgage data than ever before. That data may well be scrutinized for disparate impacts. Under this analysis, facially neutral policies which have a disproportionate effect will prompt increased attention and may be the subject of additional regulations.
For banks, tracking changes in regulations as well as the issues on which regulators choose to focus will be vital to a successful 2022.
AI and ESG: Visualizing bias
AI’s ability to consider massive amounts of data makes it uniquely suited to discerning biases managers might miss. Data stores can help you capture this data more efficiently. Additionally, current visualization tools can provide valuable information by pulling data from multiple sources. Grant Thornton National Automation Leader Vivek Rodriquez recommends “visualization tools such as Power BI, Tableau, etc. to quickly provide insight into patterns in your credit issuance and mortgage forbearance practices, testing algorithms, and compliance data.”
ESG: Responding to mounting pressure
While some leading banks have already begun inculcating ESG-related risks into their annual portfolio assessments, middle-market and regional banks have been slow to adopt this change, exposing their consumers and investors to critical risks. Fast-approaching, standardized national and international disclosures, technology shifts, changing consumer and investor preferences, and evolving social sentiment will hasten this transformation in the banking sector in 2022. Grant Thornton Director, ESG and Sustainability, Angela Jhanji, maintains that “ESG risk, once perceived as largely reputational (which is serious in itself), is now a financial risk.” For example, according to a 2020 Ceres report, more than half of current bank lending is exposed to transition-related climate risk.
To ensure a smooth shift to a greener economy, banks need to provide capital to incentivize businesses to move toward sustainability. The global financial sector, including the top 6 U.S. banks — through the Glasgow Financial Alliance for Net Zero (GFANZ) — has committed $130 trillion of capital investments toward transition activities. Other banks should review their portfolios as well to facilitate a steady redirection of investments toward decarbonization.
Banks also face continued scrutiny around inclusive product design. Today, most retail loan and credit card applications for banks are reviewed by algorithms and software, making proxy discrimination an unintended consequence for these organizations. As digital bounty hunters and regulatory bodies increase scrutiny, banks must pay close attention to equity in their financial product designs. This is especially true as millennials and Gen Z start to accumulate larger shares of wealth, given their penchant for holistic profits. For banks that wish to attract and retain this population, they must rethink all areas of operation in a way that embodies the ESG imperative.
The finance sector has been put on notice regarding their role in promoting ESG initiatives globally. Banks should expect greater consolidation and direction in terms of how and when to embed ESG principles within their business strategy at an industry level in 2022, as well as the watchful eyes of millennial consumers ensuring responsible governance and profits.
Digital assets: Reaching its maturity date
Sometimes boring is a good thing. The very conservatism of traditional banks — born of structural stability, durable business models and aggressive supervision — is the very thing that makes them key to the future of digital currency. The rise of digital assets is inevitable — and institutions which don’t get on board will be left behind — but some important changes need to happen first. In short, non-bank issuers of stablecoins need to become banks (or obtain bank charters), and the overall crypto market will see comprehensive regulation. That’s the direction envisioned by a recent paper issued by the President’s working group. Also, banks need to be prepared for increased competition from crypto companies as their customers want to invest in cryptocurrencies.
Stablecoins — essentially, a digital version of a dollar — will become more important. “Stablecoins’ stability makes them well-suited to real world transactions,” said Grant Thornton’s Digital Asset Practice Leader and Partner, Markus Veith. “It should enable much more efficient funds transfer.” Cryptocurrencies such as Bitcoin, whose value fluctuates, will continue to grow in prominence as a speculative investment and store of value (like gold), but its transactional value is limited.
A potential risk to market stability is posed by the fact that, currently, the vast majority of stablecoin dollar reserves are held by a handful of smaller banks. And while a run on these banks is highly unlikely, it could destabilize the payment system. Ideally, once a clear regulatory framework is introduced, more and larger banks will enter the market and provide custody, trading, and digital asset services for clients.
Mortgage: New challenges in a shifting market
As rates rise, 2022 should see a major shift in origination demand the mortgage markets. For this reason, mortgage players will be hyperfocused on offering the best possible customer experience and digital execution they can deliver. In addition, operational weaknesses and strategic miscalculations, which the high tide of mortgage applications obscured, will be exposed. Operationally, banks are still ahead of non-bank mortgage companies, but remember, they have ceded the lion’s share of the market to these hungry competitors. Many have invested in the technology required for smooth, efficient and customer-friendly processes. Yet there is still a great deal of leakage in their pipelines which better processes could reduce. Attention to process execution, training and portfolio visibility will help originators get the most out of the existing pipeline. There is also a significant opportunity for companies with a servicing arm to maximize recapture. According to Grant Thornton’s Mortgage Industry Practice leader and Global Head of Banking, Matt Cooleen, “If your recapture rates aren’t over 30%, you’re absolutely leaving money on the table.” Don’t ignore the customer experience of your servicing clients because they are the refi clients of your future — customer retention should be a critical pillar of 2022 and beyond.
Process improvement will also be crucial to the other mortgage challenge of 2022 — forbearance into modification. Regulators will be closely evaluating how banks handle forbearance. It’s important to scrupulously follow the process and double- and triple-check your decisions and reflect upon whether a fair servicing lens has been observed. Be absolutely sure you’ve treated everyone fairly. In fact, Grant Thornton Transformation Principal Jeff Kelly suggests that “mortgage companies map every process from the perspective of both the customer experience and regulator expectations.”
Audit: Credit loss models require flexibility, agility and understanding
January 1, 2023, is the final effective date for all remaining entities to adopt the current expected credit losses standard (CECL). Unlike the SEC filers that had to adopt the standard effective January 1, 2020, if your company is in the final stages of preparations to adopt, you can take advantage of the many lessons that were learned from adopting a lifetime expected credit loss standard during an economic recession and global health pandemic.
In our discussions with companies that have not yet adopted CECL, both traditional banking entities and other lenders have recognized the importance of building a model that is flexible to adapt to the sudden onset of an unpredictable economic environment. Vendor solutions are increasingly popular, and management is aware that working closely with a vendor to understand how they are able to assist the entity in making their estimation is critical.
Grant Thornton Partner and Banking Audit Leader, Jeff Honeycutt commented, “We always share with our clients that they can outsource the task but not the responsibility. While regulated financial institutions are familiar with obtaining external model validations to comply with regulatory standards, other lenders should ensure they adopt best practices around the control environment and governance of their estimation method, and related tools. At the end of the day, management will be taking responsibility for this significant accounting estimate, and must know how their methodology works, and how to make any necessary changes.”
This applies regardless of whether an entity is using a vendor or developing an in-house estimation method. Grant Thornton Senior Manager, Professional Practice, Rachel Binder, observed that “While the details of when and what the next economic crisis will be may remain unknown, both entities that have already adopted the standard and those that will adopt in 2023 should continue to evaluate how to provide for increased flexibility and agility of their CECL estimation methods.”
Whatever the future holds, entities will continue to rely on complicated models to determine significant estimates. Flexibility, agility and deep understanding will be the key to quality financial reporting.
Tax – R&D, indirect taxes among savings opportunities in 2022
The accelerating drive toward digital banking means many banks have made substantial investments in new or improved software — which can have very positive tax consequences.
Grant Thornton Strategic Federal Tax Services Partner Dan Lynes sees a common misperception stop efforts to seize R&D tax credits before they even start. “Banks often believe that investment in software — such as ERP implementations — are not eligible for an R&D tax credit.” Portions of those implementations might well be tax credit worthy. If you, or a third party you’ve engaged, have added value to an out-of-the-box solution (for example, by developing custom APIs), the expenses incurred to do so may well qualify for the tax credit.
Of course, a more detailed test then needs to be applied, and individual aspects of the implementation need to be identified and tied to the credit. If you’ve spent a significant amount on digital transition, it’s a discussion worth having. The result can decrease your effective tax rate and increase your earnings per share.
Grant Thornton State and Local Tax Principal Michael Cronin suspects that “sales tax enforcement — including state audits — may be ramped up as states look for revenue wherever they can find it in our current/post COVID environment.” You can help avoid tax liability by systematically examining your purchases to determine if tax liabilities and/or historic overpayments/refunds (prospective cash savings) may exist.
Indirect taxes such as sales tax can account for 65–70% of your tax expense, and it is incumbent on you to determine if sales tax is due. Often, that determination is left to accounts payable professionals who are neither trained in tax nor incentivized to identify tax issues or cash tax savings opportunities. Moving the responsibility to tax specialists can help reduce liability and, in many cases, identify positive gains through missed deductions or refunds. You can generally look back up to three to four years to identify and secure overpayments.
Operations transformation — Current trend or accelerated evolution?
As a result of the pandemic, the banking sector landscape has been forced to rapidly evolve. In an effort to extend their competitive advantages, financial institutions are looking for ways to stabilize their global processes while addressing a more dynamic market landscape with a focus on growth. In recent years, banks have been impacted by several disruptors in the marketplace, including the need to:
- Evaluate the ability of some geographic regions to effectively respond to a major health crisis and support the workforce’s need to be sequestered in their homes and still be productive
- Expand banking platforms/service offerings and integrate new technologies to enrich the customer experience by addressing an evolving customer demographic that is demanding a more robust digital experience
- Meet expectations for a swift, efficient and fully digital customer onboarding experience for new account openings
- Recognize that efficiency, resiliency and straight-through processing are now higher priorities when developing a transformation strategy
- Understand the heightened risk environment (especially around cybersecurity and resiliency) associated with staying connected in a dispersed technology landscape
Global banks are not the only ones feeling this pain. These disruptors have a magnified effect on regional and larger community banks, largely due to their limited access to key resources and capabilities, which impairs their ability to execute on a strategy to drive growth and profits, meet customer expectations, and mitigate risk in the pandemic environment.
The pandemic shined a spotlight on resiliency plans as banks found their foreign operational centers emptied out as the workforce shifted to a remote work environment. Previously abstract disaster recovery plans were suddenly invoked. What does a bank do when a global health crisis impacts its ability to deliver?
These past two years have been an ongoing disaster recovery operation. Banks continue to struggle with resource shortages while shifting strategic, back office and customer-facing operations to a more online/digital model — all while improvising a digital and telephone-based customer experience for those customers who no longer want to bank in person. How banking will be delivered in the future is yet to be completely determined in the changing landscape.
The correct solutions for moving forward vary from bank to bank, but some common factors to consider include:
- Further diversifying and/or consolidating work locations
- Mitigating risk by fine-tuning the mix of offshore, on-shore or near-shore operations
- Reassessing the operations and technology ecosphere to identify ways to increase straight-through processing and reduce manual touchpoints and processing times
- Developing a long-term human capital strategy to address the challenges of shifting to a partial or fully remote workforce to remain competitive while attracting and retaining top talent
Andrew Nerone, National Operational Transformation - Banking and Capital Markets Practice Leader, states, “It is generally accepted, from physicists to philosophers, that change is a constant. The pandemic accelerated the adoption of new business methodologies, which emphasizes that a bank’s ability to be simultaneously agile and resilient are defining characteristics of a strong operational model.”
Banks that successfully incorporate these characteristics should find themselves able to thrive in adverse conditions through timely investments in agile processes, scalable technology systems and robust controls that are capable of withstanding unforeseen events and responding quickly and effectively to market disruptors. Being agile and resilient at the same time may sound counterintuitive, but successful strategies need to incorporate both concurrently.
Matt Cooleen is a partner in Grant Thornton’s Risk Advisory service Practice, and serves as the RAS Mortgage Industry leader.
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