Future of Financial Services

Paul Kovacs: What are the key trends and competitive pressures that you see developing now and over the next five years for financial institutions in Canada?

Fred Gorbet: Let’s consider retail financial services, and what I like to refer to as the “Seven C’s.”

1) Convergence

Most financial firms are chasing after wealth management; in the process, they all begin to look and act alike. This may be less pronounced in P&C insurance than in life insurance and banking, but we are certainly seeing more insurance brokers and agents offering asset management services to clients.

2) Competition

As it increases – particularly in the “commoditized” areas of financial services like consumer credit and basic insurance and investment products – margins tend to decrease.

3) Customer-driven nature of financial services

Consumers are much more informed and demanding than they used to be. Success in winning and retaining customers depends increasingly on adding value.

4) Cooperation

To offer customers the “best in class” of the services they demand, financial firms will increasingly need to form strategic partnerships.

5) Consolidation

Efficiency has become so imperative that many financial firms have little choice but to seek greater economies by becoming larger.

6) Capital

Having adequate capital is a necessary condition for success, but it may not be sufficient. Firms also need to deploy capital effectively; to do this, they must devote increasing attention to enterprise-wide risk management and appropriate ‘risk-adjusted’ returns on equity.

7) Conduct

Recent experience shows it is critically important for financial firms to focus on ethics and reputation risk. This need goes way beyond effective corporate governance, as it has everything to do with the culture of an organization.

Over the next five years, the success (or otherwise) of retail financial firms will depend to a considerable extent on how well they negotiate their way through these “Seven C’s.”

Jim Harries: In view of the challenges facing providers of financial services, the job of regulating financial firms must also be getting tougher. What challenges, in particular, are financial regulators facing in the medium term?

Fred Gorbet: Plenty of challenges. For starters, implementation of the Basel II capital standards, as well as new “fair value” accounting rules. Both are expected to come into place over the next couple of years; both will have implications for current solvency tests used by regulators.

In addition, risk and uncertainty in the economic environment are placing a greater onus on regulators to do stress testing and scenario planning for the financial firms they regulate.

How should this be done? In some cases, the answers are fairly clear. As you know, the Dynamic Capital Adequacy Test (DCAT) is an insurance-related stress test. Some are concerned that the way in which DCATs are developed and presented does not make them effective tools for boards to really understand the risk profile of the business. And, of course, there is currently no DCAT-equivalent for the Canadian banking sector.

Regulators also need to ensure the firms they regulate are governed effectively. If effective corporate governance is lacking, it becomes more difficult for regulators to assess accurately and respond to a wide range of risks – including risks affecting the reputations of individual financial institutions, as well as those affecting the confidence of consumers, who depend on these institutions for their financial security.

Traditionally, financial regulators have trusted that their supervisory actions are actually ameliorating risk. This is becoming a tougher challenge in today’s more complex financial environment. Given the development of sophisticated, market-based instruments to transfer risk, how confident are regulators that risks are actually being ameliorated rather than transferred to other institutions? The U.S. banking system, for example, has a record-high exposure to mortgages despite the extensive mortgage securitization in that country. Why? Because banks have invested in mortgage-backed securities as part of their asset portfolios. Another example is the use of credit derivatives. One institution can reduce credit risk through selling part of it to others. But the credit risk is not lessened by this act, only redistributed. The lack of timely information on derivatives means it is not always clear where in the system risks are residing. Going forward, the ability of regulators to understand how complex financial products are affecting total risk, and who bears it, will be critical.

Jim Harries: What about Canada’s financial guarantee funds? [Here defined as organizations such as PACICC, Assuris, CDIC and others, which are obligated to protect policyholders, depositors, and other financial consumers in the event that a member firm becomes insolvent.] How should the financial guarantee funds be preparing for the challenges ahead?

Fred Gorbet: The financial guarantee funds are potentially in a tough spot if serious trouble occurs. From what I’ve seen, PACICC has done a good job preparing itself to respond to insolvency risk within the P&C insurance sector. That is – and should be – your prime concern. But I believe guarantee funds need to focus on two important issues now.

The first results from convergence. As conglomerates form to facilitate convergence, the probability increases that one of these conglomerates, perhaps a large one, might fail. Should this occur, we would have a situation in which all the guarantee funds could potentially be involved with the regulators in a pre-failure situation and with the liquidator post-failure. Which fund gets what claim on which assets is likely to raise some difficult issues. I believe that some advance planning to develop mutual understandings of roles in such a situation would be helpful to the consumers that the funds are protecting.

The second issue is what happens if there is a systemic failure. If this were to happen in the deposit-taking sector, for example, there is a government financial backstop to CDIC that can help it ride out the storm. But if it were to occur in another financial area, including insurance, the problem could exceed the financial resources of any single guarantee fund.

These issues illustrate why it is critical for the guarantee funds to stay close to the regulators and to one another. In this respect, I applaud the work the guarantee funds have done to form an association to think about how to deal with these issues. Discussion and agreement on how to handle a larger cross-pillar, cross-jurisdictional failure of a financial conglomerate is an excellent exercise in crisis management and preparation.

Paul Kovacs: What do you see as the main external challenges facing the financial services sector over the next five years?

Fred Gorbet: My main concern is the high degree of imbalance that has developed in the U.S. economy over the last five years or so. The imbalances we see in the United States right now are not sustainable, so it is inevitable that adjustment will take place. Let me elaborate.

The United States currently consumes and invests 6% more than it produces. The U.S. economy absorbs 80% of the net flow of international capital – an inflow of approximately US$2 billion per day. The U.S. current account deficit has deteriorated steadily for more than a decade and now exceeds 6% of GDP. The fiscal position of the U.S. government has also worsened sharply in the last five years, and the federal budget deficit now pushes 4% of GDP. Basically, the United States has become a net “dissaver,” relying on other countries with current account surpluses to cover the imbalance through capital inflows. And when we look at how this consumption is being financed, a lar
ge part of it has come from an increasingly leveraged housing market – where homeowners have taken money out of home equity, adding to their mortgage debt to maintain high levels of consumption. In fact, the last five years have seen net dissaving by U.S. households.

Paul Kovacs: If substantial U.S. economic adjustment is inevitable, what might this look like?

Fred Gorbet: If the United States can’t take appropriate action to address their twin deficits – the current account deficit and the federal government’s budget deficit – then the risk of “policy drift” puts the Federal Reserve in an increasingly tough spot. The question becomes: ‘What will the new Fed Chairman Ben Bernanke do?’ In such circumstances, there is a strong likelihood of the Fed tightening policy on its own. This could mean significant hikes in interest rates. And the housing and mortgage-lending sectors would be among the hardest hit. As I mentioned, the U.S. banking system currently has record exposure to the mortgage market – with mortgage-related assets currently making up more than 60% of total earning assets. Twenty years ago, this ratio for U.S. banks was just under 30%. That’s a big and worrisome shift within a relatively short period of time.

If U.S. monetary policy becomes tighter and interest rates rise further, Canada will not be immune. Higher interest rates reduce the market value of the predominantly fixed-income investment portfolios held by most P&C insurers. And should interest rates become more volatile, history shows that this tends to increase insolvency risk for insurers.

Paul Kovacs: Thank you, Fred. Clearly, the period ahead looks to be challenging and exciting for those of us in the financial services industry.