The credit crisis has had profound effects on the world of financial services and there will be a new financial market model as a result. Previously, banks were expected to grow their bottom line faster than the gross domestic product (GDP), which obviously meant that they were taking far more risks and looking at more complex products, both of which have come undone in the current dip.
Corporate treasurers will also go back to basics, such as funding the balance sheet from the company’s own resources instead of relying on the markets to do it, although they will also continue to need a credit provider. One of the ways a corporate can reduce funding needs is to reduce working capital requirements. Improving cash management is an integral part of being able to reduce working capital.
Therefore although it seems like a new market model, it’s actually a return to the old model that has not been seen in recent years of big acquisitions, an increased focus on investment banking products and international growth. Predominantly, banks make money on their core businesses; it has been the peripheral activities where they have experienced the biggest losses, such as in assets generated from the investment banking model of originate and distribute. Also, with the increase in government ownership, stakeholders will resist financial institutions continuing with the investment banking model. Instead, governments will be encouraging banks to provide services for retail clients and the middle market, for example encouraging mortgage lending. Therefore, senior management will be re-defining and focussing on their core business.
Previously, when financial institutions looked at their fundamentals, they always identified payments as a core business. But that is changing with the implementation of the single euro payments area (SEPA) and the Payments Services Directive (PSD), which aims to harmonise payments across European national borders. Some banks are beginning to realise that the clearing and settlement of a payment is not actually core to their business and it is possible – as well as more cost effective – to outsource that activity to another. A bank’s core business is fundamentally based on client and account ownership, which allows it to control its liquidity balance.
Increasing Regulatory Pressure
The average person on the street is concerned by the credit crisis because they are watching billions of dollars being used to support the financial industry, whereas in previous years the executives responsible for these institutions had received large bonuses. Until recently banks said that open market conditions were the best way forward – now people are questioning whether the free market works and are increasingly demanding that governments impose much more onerous regulation.
Most financial services professionals expect governments to react accordingly and significantly increase the regulatory burden on banks. Additionally, governments now own fairly large slices of the banks; or if they don’t own them, they have taken some of the banks’ risky assets into their portfolios. That type of action comes at a price – the freewheeling market process must change to a more regulated market with greater oversight and control.
The extra compliance and regulatory pressure will create problems for a number of financial institutions because in order to adapt they will need to invest. But many banks will not want to invest at this time as their margins are being squeezed. At the end of the day, they will be forced to invest in regulatory compliance because it is mandatory, and therefore some investment will be tied up in compliance rather than investing in building the systems and infrastructure they need in order to grow.
Will heavier regulations solve the crisis facing the financial markets? Not necessarily, but governments are under pressure to be seen to be doing something to alleviate the pain and will increase the pressure on financial institutions to act in accordance – therefore the industry has no choice but to respond.
Challenges in Implementing SEPA and the PSD
With SEPA Direct Debits (SDD) and the PSD due to be implemented in November this year, the biggest impact on the financial services industry will be falling revenues across the payments business. By removing value dating and improving price transparency, prices will fall to the lowest common denominator because corporates and institutions can pick and choose from institutions across Europe. The implication of both sets of regulation is that it is going to cost money to implement changes and payments institutions are going to see a revenue fall as a result. This creates a significant problem for a bank when it is trying to build a business case around investing to meet these regulatory changes.
The implementation of SEPA is moving more slowly than perhaps needed, primarily because it is not market-driven but regulatory-driven change. The majority of payments within the SEPA framework are domestic and the existing systems are cheap and proven, therefore why would a bank or corporate want to change the process and spend a lot of money building a new infrastructure when cross-border payment volumes are so low?
Most corporates, government agencies and institutions will do the minimum to meet SEPA requirements for cross-border transactions and will probably leave their domestic transactions unchanged. Some countries have said that their systems are already SEPA compliant and they don’t need to do anything. Some banks may say they are ready for cross-border SDD or SEPA Credit Transfers (SCT), for example, without actually implementing any major changes because the expected volumes are too small to merit the change, i.e. the minimum to comply. To modify their transactions for domestic SDDs could mean that a bank will have to change all its mandates. A bank that has five million mandates within one country would question why it would want to do that. In order to force the issue, the industry will need more regulatory pressure.
Another issue that has to be addressed before SEPA can truly be implemented is that presently all banks are running legacy systems, platforms and clearing, etc. If SEPA becomes a reality, they will be required to build a new model. Once again, banks are baulking at throwing money at the problem because they feel the pressure on their margins, business and investment dollars.
Across the board most firms will be cutting their investment budgets. In order to remain operational, banks can’t cut their operations budget – they can trim it but they can’t really cut it significantly. This means that marketing and investment budgets are more discretionary and, therefore, many banks will be taking the decision as to whether they must make the investment this year or if they can put it off.
The accepted norm is that a bank can stop investment in infrastructure and systems for a period of six months to one year and won’t lose anything in the meantime. This is a short-sighted view because the bank then has to play catch-up – but some banks will still decide that they are not going to invest in the short term. Some institutions will concentrate on what is core and not do anything else – they will only do what is needed for their existing business. This results in many taking a ‘wait and see’ approach, which is another reason why SEPA is currently moving slowly – too many institutions are waiting to see what is going to be the market model, and only then will they invest.
Hence, there will be low investment in existing legacy infrastructure and only a few major banks will invest in new infrastructure and systems to meet the SEPA requirements. Many of the smaller banks will be looking at an alternative, such as using a major provider as an agent to handle payments. They will save money by discontinuing investment in their legacy systems and also have a future-proof solution by outsourcing the problem to someone else. A larger bank has the critical mass in terms of volume and, although there will still be the pressure on its margins, getting a greater market share will compensate for reduced margins because it effectively reduces costs per item.
In terms of the PSD, although there is some speculation that it will not be implemented within the timeframe given, there is no doubt that it will be implemented – maybe quicker in some countries than others – because it is mandatory. The UK, for example, is very serious about the PSD and will put it before Parliament early this year, which shows that there is a political will to implement the directive. Early adopters will push it through and then other countries will follow. There are some interpretation differences country-to-country, but the basic underlying concept is that there will be reduced revenues and increased transparency in pricing. This means that banks are going to have to re-examine their business model.
Will SEPA Drive Automated Clearing House Consolidation?
For SEPA to work there has got to be a common standard that all countries can support and understand. At the moment there is some interest in consolidating the number of automated clearing houses (ACHs) in Europe, but until now there has been no major move in that direction, mainly because each country believes that its ACH should be the one left standing. For example, the Germans believe that theirs should be the main ACH, but the French don’t agree because they think their system is better. The same is true with the Spanish. The two big economies, Germany and France, have to come together to agree a common standard because if they do then they will be able to drive the project forward. The situation would be further helped if the UK, as the third largest economy, joined them and pushed for a common platform.
Instead of ACH consolidation, it is likely that there will be more bilateral arrangements, i.e. avoid clearing systems all together. For example, if the big three major players in the Netherlands did bilateral clearing that would probably account for 80% to 90% of the transaction volume that presently goes through the ACH. If these banks then did the same with other major banks in the rest of Europe, the ACHs’ volumes would drop dramatically and make them uncompetitive. Therefore, if there is no movement in terms of ACH consolidation, major banks will probably move towards bilateral agreements.
This move will drive consolidation within the payments industry as a whole because only the major players will have the bilateral arrangements, which would force the smaller banks to either go through a more expensive ACH or go to a major player that who would be able to transact through bilateral arrangements.
The Payments Landscape in 2009
The payments landscape will not change dramatically in 2009. This year will see a continuance of the ‘wait and see’ approach, with some beginning to talk about alternatives. Obviously the PSD and SDD will be implemented, which will force a few people to start looking at alternatives. However there won’t be a big investment in infrastructure, only a sense of the need to do something or at least start to look at doing something.
This lag will probably continue into 2010. If a couple of financial institutions say that they are going to outsource their payments to another institution, then the ball will start rolling. But at the moment no one is keen to be the first mover in this. Banks tend to be conservative and wait for someone else to do it first; once someone else has made the move then the floodgates could open. It will be the first movers that will determine what happens and how quickly.