By Simon Dodds, at Shearman & Sterling

For most major financial institutions, the key challenges of 2020 were expected to include US/China relations, Brexit and cyber security. A global pandemic was not high on the risk agenda. COVID-19 has changed that and in the short-term has forced banks to radically adapt their working practices. The general consensus is that banks are in a better position to weather the storm than during the 2008 financial crisis, in part as a result of financial regulation introduced in the intervening years. Nonetheless, COVID-19 still looks set to pose significant challenges for the banking sector, including the potential for depressed revenues, widespread loan defaults, rising rates of unemployment and the possibility of a prolonged economic downturn. COVID-19 will likely act as an accelerator, prompting economic and societal changes that were already evident to occur more quickly. COVID-19 will likely hasten the decline of certain sectors that have  relied on physical interaction  whilst encouraging the rise of on-line alternatives.  With so much still unknown about the virus, planning is difficult. The impact of lockdowns on society and the wider economy means banks are likely to reconsider key aspects of their medium and long term business and management strategies.  This is a time of increased risk for financial institutions, but also of opportunity.

This article considers five areas impacted by the pandemic that are of relevance for financial institutions and highlights the potential changes to financial institutions’ longer-term strategies as a result of COVID-19.  These are all areas that would benefit from strategic review at senior management level.

1. Business strategy

COVID-19 has triggered a period of unprecedented uncertainty, which presents both challenges and opportunities for financial institutions. 2^nd quarter results indicate that banks have, thus far, benefitted from sharp growth in trading revenues, the result of extremely volatile trading markets, although this is unlikely to last. Financial institutions are confronting significant levels of covenant breaches and are already increasing bad debt provisions, again clear from 2^nd quarter results.  This in itself poses problems for banks, as high loan loss provisioning leads to lower earnings, with financial pressure likely to increase as an economic downturn further negatively impacts revenue.  Governments have encouraged banks to grant forbearance for defaults and have mandated loan payment moratoria, but the time is rapidly approaching when repayments will need to resume. In the UK, it has been reported that banks are producing an industry code of conduct for the enforcement of government-backed COVID-19 loans, which is expected to entail a lighter-touch and more consistent approach to loan enforcement action across the banking sector.  Facing pressure on revenues that will likely last at least for the medium term and maybe longer, financial institutions will be driven, inevitably, to consider cost reductions.  This may lead to redundancies.  It may potentially lead to a reconsideration of growth strategies, a paring back of certain business lines and an exit from unprofitable geographies.  Weaker banks will need to keep an eye on their capital positions.  Access to the capital markets may not be easy given volatile markets, leaving some financial institutions with the prospect of seeking government aid.

The situation is not entirely gloomy.  COVID-19 has a host of negative impacts, but it also presents opportunities, at least for stronger financial institutions.  Financial institutions should strive to understand the changes to society prompted or accelerated by COVID-19.  In banking, COVID-19 will increase the trend away from branch banking and accelerate the importance of web based applications for banking.  The decline of activities within the hospitality and transportation sectors and on the High Street will likely accelerate;  online providers (of groceries and deliveries; of conference calls and fast internet; and of other types of online services) will have opportunities to prosper and there will be opportunities for the stronger and most agile banks.   The 2008 financial crisis provided a spur to innovation in the FinTech arena and the COVID-19 crisis may, similarly, act as an accelerator prompting faster change.  FinTechs in the UK have expressed frustration at having only a limited participation in the roll out of the government’s various pandemic-related loan schemes, but FinTechs have been active in other ways seeking to help SMEs navigate the crisis.  Bank collaboration with FinTech companies, which has historically been disappointing, may increase, as banks seek to capitalise on the explosion in digitalization seen since the outbreak of the pandemic. For example, Lloyds Banking Group recently announced a partnership with PayTech Form 3 to speed up and enhance the digital customer experience.  The asset and wealth management sector is facing significant challenges in the wake of COVID-19, which may create space for investment banks to enter or re-enter the market.  Bank M&A activity is also predicted to rise as investors seek a “flight to quality”, leaving smaller financial institutions vulnerable to takeovers.

Regulation

Regulators are attempting to keep abreast of, and to an extent guide, bank business strategies.  In doing so, regulators are walking a fine line seeking to balance different priorities that are, or may be, in conflict.  On the one hand, regulators are concerned to ensure that the bank sector remains stable and individual financial institutions remain solvent.  On the other hand, regulators seek to support government policies that are aimed at protecting the wider economy and avoiding a deluge of bankruptcies.  Supervisors have sought re-worked business plans and financial and capital projections from financial institutions. The European Central Bank is gently encouraging bank M&A activity in the Eurozone, stating that it would not automatically impose higher capital requirements on banks that merge. European and Member State regulators have issued consistent guidance on banks’ treatment of customers and have warned against dividend payments and share buybacks.  The ECB recently extended, from October 2020 to January 2021, its recommendation that the largest Eurozone banks refrain from paying dividends and from share buy backs. The ECB also requested these Eurozone banks to “exercise extreme moderation on variable remuneration”. In response to a request from the UK Prudential Regulation Authority, the UK’s largest banks suspended dividends and buybacks on ordinary shares until the end of 2020 and cancelled outstanding 2019 dividends. The PRA also encouraged banks to refrain from paying cash bonuses to senior staff, including material risk takers.  At the other end of the spectrum, the ECB expects EU banks to keep a more vigilant eye on recovery plans and to adjust them as necessary to reflect emerging events.

A potential difficulty for the largest financial institutions will be navigating conflicting cross-border regulatory requirements.  This continues to be an impediment to cross-border M&A activity in the Eurozone, notwithstanding the ECB’s encouragement.  More generally, the tension evident in the different priorities of regulators needs careful management by financial institutions.  Senior management will, of course, be focussed on their own institution’s continuing financial performance and will be determined to ensure their capital and liquidity positions are strong.  Equally, senior managers will be prepared to play a role supporting government imperatives to preserve the wider economy.  Managing these conflicts requires senior management to take a holistic view.  Open communication and transparency with all relevant regulators, important in normal circumstances, assumes critical importance during the current COVID-19 pandemic.  This includes taking account of each regulator’s needs, maintaining communication channels and communicating in a timely manner.

2. Corporate governance and organizational structures

The strength and effectiveness of firms’ organizational structures will be crucial in enabling financial institutions to plan and implement business strategies and emerge successfully from the crisis.  Many financial institutions will have had in place, pre-pandemic, effective structures, but the pandemic has already tested them and will continue to do so.  Even the best run financial institutions will have learnt lessons from the way in which they have operated during the crisis.  Some things will have worked well; some things less well.  Some senior individuals will have risen to the challenges posed by the crisis; others may have performed less well when stretched by the crisis.  Firms should, of course, have in place a transparent corporate structure led by a strong board. Clear reporting lines should be established with carefully planned decision-making processes and provision for managing disagreements and overlapping responsibilities. Strong personal relationships and effective internal communication are key to overcoming the novel stresses thrown up by the pandemic.

A clear business strategy, communicated by the board, is crucial, but financial institutions will need to be agile in their response to evolving circumstances. Effective responses are likely to require decision-making by special committees, made up of the heads of key functions (e.g. business heads, Risk, Legal and HR) who will meet (usually remotely) regularly throughout the crisis. Access to reliable and up-to-date information is vital to making the right decisions. Key data points for financial institutions will relate to liquidity and capital levels, open trading positions, exposures to counterparties and an understanding of borrower and counterparty creditworthiness.

Risk management is one area that may need specific attention as a result of COVID-19. The nature of the pandemic is challenging banks’ ability to assess strategy, as many existing bank risk models struggle to accommodate the rapidly developing circumstances surrounding the pandemic.  Model risk management, the practice of reviewing the relevance and accuracy of financial institutions’ modelling tools, is of increasing importance.  Potential shortcomings in banks’ existing modelling capabilities include the inaccuracy of rating models due to their failure to rapidly update scores; a misleadingly high number of early-warning-system indicators leading to a loss of predictive power; and overreaction to stressed prices and credit in model-based market risk approaches.

Leadership

A defining characteristic of the firms that emerge successfully from the pandemic will be strong leadership exhibited by the senior management team. Maintaining at least a semblance of calm and control is vital for preserving the confidence of staff internally as well as external stakeholders. It will be important to take decisive action and deliver clear messages on the decisions made. Even where there is little material information to report, ongoing communication with stakeholders will do much to assuage anxiety. These aspects of good leadership are not new, but are all the more important in the context of COVID-19.

Areas where leadership may need to adapt to the challenges of the pandemic include the use of furlough schemes and working from home arrangements. At the start of the pandemic, banks had to decide whether to make use of furlough schemes. In the UK, the government’s furlough scheme is now gradually being withdrawn, meaning banks will now have to decide how to treat those employees whose functions were deemed non-essential. The government’s bid to get the country back to work may mean a return to the office may be on the horizon for many (in addition to those key workers at financial institutions who have continued to work from office locations for the duration of lockdown). Reports indicate that many members of senior management at financial institutions have been pleasantly surprised by the strength of working from home arrangements and are in no hurry to return to the office. But this will not be the case for all members of staff, some of whom may be struggling to manage small children, cramped living conditions or isolation alongside work commitments. Senior managers will need to reassure staff while also being transparent about the firm’s financial situation and the possibility of redundancies.  Future office space requirements are likely to become a significant longer-term issue for financial institutions.

3. Transparency and Diversity

Clear communication with investors will be indispensable to counteract the uncertainty generated by COVID-19. Disclosure requirements in most Western economies mandate a certain level of transparency for publicly listed companies. Regulators expect financial institutions to inform investors of their intentions to take advantage of COVID-related regulatory forbearance initiatives, such as the delays to the reporting requirements of Securities Financing Transactions. Firms should keep their regulator up to date with their regulatory implementation plans.

Other existing “hot topics” are likely to be amplified by the socio-political tensions emerging in the pandemic. The Black Lives Matter movement has reignited debates on discrimination, including at financial institutions which historically have poor diversity credentials.  Reports that those from certain social and ethnic groups, including working class black and Asian communities, are likely to be disproportionately affected by the pandemic may further accelerate existing efforts to promote diversity within financial institutions. The greater vulnerability to COVID-19 of the BAME community should also be considered by firms as they plan for a return to office working.  The pandemic has also reinforced investor sentiment for “purpose” in investment, seeking returns other than pure financial gain. Environmental, social and governance considerations have gained significant traction in recent years, but the tangible effect of COVID-19 on the economy foreshadows the potentially catastrophic impact that other non-financial crises, such as climate change, may have on the financial sector. The fallout from the pandemic may spur more investors to pursue investments that prioritize broader environmental and social goals.

Diversity has been a key issue for financial institutions for many years.  Likewise, ESG has been an important topic that has assumed a greater place on the agenda for all financial institutions.  In both cases, the pandemic is operating as an accelerator, magnifying their importance and demanding that all financial institutions (and indeed all companies) address them urgently.  These are topics that senior management will need to focus on and find ways to meet the concerns of their various stakeholders, investors, employees, regulators, governments and society.

Key takeaways

In light of the above, we might expect to see at least some of the following changes to financial institutions’ longer-term strategies as a result of COVID-19:

• A lighter-touch approach to loan default enforcement where defaults occur under COVID-19 government-backed loan schemes;
• A focus on the opportunities presented by COVID-19. This might include diversification into new sectors, for instance asset and wealth management, and greater collaboration with FinTechs; it might also include bank M&A activity
• A more agile and holistic approach to financial regulatory compliance, taking account of rapidly changing, and sometimes conflicting, guidance issued by regulators globally;
• Greater focus on the establishment of crisis management committees and related crisis and risk management structures and plans;
• Increased transparency and flow of information internally and externally to staff, stakeholders and regulators;
• Greater flexibility in working arrangements; and
• Heightened focus on diversity, corporate governance issues and ESG considerations.