Challenges of the financial sector

“May you live in interesting times” is the backhanded compliment of an old Chinese curse. The financial sector has certainly lived through interesting times lately . . . not so much because of the COVID pandemic, which certainly doesn’t help, but rather the economic environment it has been struggling with over the last decade and a half.

Jolts to the sector have been widespread and nonstop. Without trying to list them all, this blog post aims to come up with some reflections about the challenges and opportunities it now faces.

The financial sector as a whole, and in particular banking, is now going through a thoroughgoing transformation. Its business model has been strained to breaking point by three global trends. Firstly, the low-interest scenario, a result of the need to kickstart economic growth at all costs. Secondly, an increase in regulatory pressure due to the 2008 downturn. Last but not least, the cutthroat environment of new players harnessing the new technologies to break into a market that was hitherto practically a closed shop.

The low interest rate environment (LIRE), a knock-on effect of low economic growth, poses a risk to the profitability of financial institutions. Although, in the short term, low interest rates might spur demand, cut operational risks and lower financing costs, the interest curve nonetheless plays against net interest margins, hitting hardest the deposit-intensive businesses as well as the smaller and lower-capitalization firms.

The increasing regulatory pressure, brought in to reduce the financial system’s systemic risk after the latest crises, has indeed helped to make institutions more resilient; the downside is the upward cost leverage, hitting profitability anew, plus fiercer competition from other players.

The net result of the two abovementioned factors is an irruption of new players into the market (Fintech and Bigtech). Armed with the latest technological advances and inspired by a contrary business model, they represent a clear threat to traditional institutions, especially in products and services where entrance barriers are lower and regulatory loads are less onerous (means of payment, consumer credit, etc.)

The natural response

In response to this scenario, financial institutions have rolled out different strategies.

First of all there has been a growing trend to concentration of the institutions by way of mergers and acquisitions. When margins are trimmed, volume comes into its own. Synergies enable operational and structural costs to be cut.

The second notable trend is towards a reduction in costs. Demography and a market comprising increasingly digitalized clients are two factors that have favored this endeavor, cutting the costs of commercial networks and speeding up the transformation to purely digital products.

These strategies, it might be argued, are natural responses. Nonetheless they have fallen short of their mark, proving unable to cope fully with the onslaught of new players. The main institutions have therefore bowed to the need of undertaking a thoroughgoing transformation, enabling them to joust against the new lances of Fintechs and, above all, Bigtechs.

Transformation

This digital transformation comes in various shapes and sizes. In a nutshell, it is a question of recognizing the need of refocusing design, rolling out and marketing financial products to meet clients’ needs and expectations.

Apart from the cultural change, another key role in this strategy is played by modification of business processes and technology.

Ferreting out clients’ needs and expectations no longer depends on a commercial network hard by the bank but rather on very complex platforms and ecosystems that glean all possible client information (big data) and then analyze it (machine learning) with the aim of personalizing the range, client experience and relationships.

These ecosystems and platforms are no longer hosted in massive, proprietary datacenters but rather cloud systems, enabling clients to tap into calculation-, storage- and communication-power that would otherwise have been well beyond their economies of scale using inhouse resources.

These processes seek maximum automation (machine learning, cognitive techniques, RPA, etc), enhancing quality while also cutting operational costs.

Technological challenges

The downside of the promised world of new technology and its transformation capacity is the new challenges it poses, transformed challenges .

In the first place the importance of privacy is really brought out by this big data scenario. Besides the regulatory aspects, client confidence is an asset that is based, among other factors, on a proper management of their data and a guarantee that this data is to be used only for legitimate and justified purposes.

Secondly, big data and artificial-intelligence techniques have to be applied correctly to ensure a real benefit for clients, guaranteeing algorithm fairness and explicability.

A necessary but not sufficient condition here is to guarantee cybersecurity. Institutions’ exposure zone is increasing in line with the digital transformation process, increasing risks. This calls for new risk-management strategies and tools.

Author: Roberto López Navarro