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.
- Business strategy
COVID-19 has triggered a period of unprecedented uncertainty, which presents both challenges and opportunities for financial institutions. 2nd 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 2nd 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.
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.
- 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.
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.
- 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.
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.
What to Know Before You Expand Across Borders
By Sean King, Director of International Tax at McGuire Sponsel
The American retail giant, Target Corporation, has a market cap of $64 billion and access to seemingly limitless resources and advisors. So, when the company engaged in its first global expansion, how could anything possibly go wrong?
Less than two years after opening its first Canadian store in 2013, Target shut down all133 Canadian locations and terminated more than 17,000 Canadian employees.
Expansion of an operation to another country can create unique challenges that may impact the financial viability of the entire enterprise. If Target Corporation can colossally fail in its expansion to Canada, how might Mom ‘N’ Pop LLC fare when expanding into Switzerland, Singapore, or Australia?
Successful global expansion requires an understanding of multilayered taxes, regulatory hurdles, employment laws, and cultural nuances. Fortunately, with the right guidance, global expansion can be both possible and profitable for businesses of any size.
Any company with global ambitions must first consider whether the company’s expansion outside of the U.S. will give rise to a taxable presence in the local country. In the cross-border context, a “permanent establishment” can be created in a local country when the enterprise reaches a certain level of activity, which is problematic because it exposes the U.S. multinational to taxation in the foreign country.
Foreign entity incorporation
To avoid permanent establishment risk, many U.S. multinationals choose to operate overseas through a formal corporate subsidiary, which reduces the company’s foreign income tax exposure, though it may result in an additional level of foreign income tax on the subsidiary’s earnings. In most jurisdictions, multinationals can operate their business in the foreign country as a branch, a pass through (e.g., partnership,) or a corporation.
As a branch, the U.S. multinational does not create a subsidiary in the foreign country. It holds assets, employees, and bank accounts under its own name. With a pass through, the U.S. multinational creates a separate entity in the foreign country that is treated as a partnership under the tax law of the foreign country but not necessarily as a partnership under U.S. tax law.
U.S. multinationals can also create corporate subsidiaries in the foreign country treated as corporations under the tax law of both the foreign country and the U.S., with possibly two levels of income taxation in the foreign country plus U.S. income taxation of earnings repatriated to the U.S. as dividends.
Under U.S. entity classification rules, certain types of entities can “check the box” to elect their classification to be taxed as a corporation with two levels of tax, a partnership with pass-through taxation, or even be disregarded for U.S. federal income tax purposes. The check the box election allows U.S. multinationals to engage in more effective global tax planning.
Toll charges, transfer pricing and treaties
When establishing a foreign corporate subsidiary, the U.S. multinational will likely need to transfer certain assets to the new entity to make it fully operational. However, in many cases, the U.S. multinational cannot perform the transfer without recognizing taxable income. In the international context, the IRS imposes certain outbound “toll charges” on the transfer of appreciated property to a foreign entity, which are usually provided for in IRC Section 367 and subject to various exceptions and nuances.
Instead, the U.S. multinational may prefer to license intellectual property to the foreign subsidiary for a fee rather than transfer the property outright. However, licensing requires the company and foreign subsidiary to adhere to transfer pricing rules, as dictated by IRC Section 482. The U.S. multinational and the foreign subsidiary must interact in an arms-length manner regarding pricing and economic terms. Furthermore, any such arrangement may attract withholding taxes when royalties are paid across a border.
Are you GILTI?
Certain U.S. multinationals opt to focus on deferring the income recognition at the U.S. level. In doing so, they simply leave overseas profits overseas and delay repatriating any of the earnings to the U.S.
Despite the general merits of this form of planning, U.S. multinationals will be subject to certain IRS anti-deferral mechanisms, commonly known as “Subpart F” and GILTI. Essentially, U.S. shareholders of certain foreign corporations are forced to recognize their pro rata share of certain types of income generated by these foreign entities at the time the income is earned instead of waiting until the foreign entity formally repatriates the income to the U.S.
The end goal
Essentially, all effective international tax planning boils down to treasury management. Effective and early tax planning can properly allow a company to better achieve its initial goal: profitability.
If global expansion is on the horizon for your company, consult a licensed professional for advice concerning your specific situation.
Pandemic risks eclipse treasury priorities as businesses diversify investments to mitigate impact
The Covid-19 pandemic has shunted aside existing challenges to sit atop treasurers’ priority lists, according to “The resilient treasury: Optimising strategy in the face of covid-19”, a survey run by the Economist Intelligence Unit (EIU) and sponsored by Deutsche Bank.
The results show that treasurers are looking to diversify their investments in a bid to mitigate the pandemic impacts, including heightened liquidity, foreign-exchange and interest-rate risk. As many as 55% plan to increase investments in long-term instruments, with 48% increasing investments in bank deposits, another 48% in local investment products, and 47% in money-market funds.
“The Covid-19 pandemic has drastically altered business plans in 2020. It has placed a certain level of strain on treasury processes, but the challenge it presents has been managed by traditional treasury skills. It is clear that pandemic risk will be on the treasury checklist for years to come, but it is one of many risks the department faces and will continue to manage,” says Melanie Noronha, the EIU editor of the report.
Despite Covid-19 looming large, other challenges wait in the wings. Notably, the replacement of the London Interbank Offered Rate was identified by 38% of respondents as the main challenge of their function.
Technology, meanwhile, continues to be a pressing issue, with treasury teams becoming increasingly reliant on IT solutions. Here, data quality is rising up the list of concerns. Already highlighted as very or somewhat concerning in 2019 by 69% of respondents, the figure rose to 78% in 2020. Acquiring the necessary skill sets to realise the full benefits of this data and technology is also a continuing priority – with some progress registered from last year. In 2020, 30% of respondents say they have all the skills they need to manage technological change, up from 22% in 2018.
“Treasury’s focus on technology is not only helping teams operate more efficiently in a remote-working environment, it has long played – and continues to play – a key role in realising their long-term priorities,” notes Ole Matthiessen, Head of Cash Management, Corporate Bank, Deutsche Bank. The survey shows that
Release 1 | 2 managing relationships with banks and suppliers (highlighted by 32% of respondents) and collaborating with other functions of the business (also 32%) remain top of the agenda – and seamless digital systems will help give treasurers the bandwidth and insight to be more effective partners for both internal and external stakeholders.
Based on a global survey of 300 treasury executives, conducted between April and May, the survey explores stakeholders’ attitudes among corporate treasurers towards the drivers of strategic change in the treasury function – from the pandemic through to regulation and technology – and their priorities for the next five years.
Digital collaboration: Shaping the Future of Finance
By Ryan Lester, Senior Director of Customer Experience Technologies at LogMeIn
With heightened economic uncertainty and increased customer expectation becoming the norm in the banking industry, it is understandable that the sector is struggling to keep afloat. Due to its precarious nature, banking institutions are trying their best to ensure they remain relevant in the competitive landscape and guarantee that their customers continue to be a priority.
When it comes to the first half of this year, the pandemic has shown how easy it is for industries to fail. Customers and companies alike had to get used to the new normal, as physical locations started to close. The banking industry felt this first hand, as banks were made to restructure how their business ran, with restricted opening hours and a wider push to motivate people to use online banking.
While some had already embraced digital options prior to the pandemic, this proved to be a stark contrast to the elderly population, who frequently visited branches to access their finances. Moving forward, banks have to adopt new methods to ensure customers get the most out of our their accounts, without their experience suffering.
Heightened Customer Expectations
When the pandemic reached its peak, people were encouraged to use online banking, as telephone contact was under strain with long waiting times and pressure mounting on contact centre agents. According to Fidelity National Information Services (FIS), which works with 50 of the world’s largest banks, there was a 200% jump in new mobile banking registrations in early April, while mobile banking traffic rose 85%.
With branches remaining closed, customers were continuously being urged to limit the amount of calls they made to the most urgent cases and consider whether they could solve their answers through mobile online banking or checking the company website. Although already being adopted in pockets of the industry, this was a real catalyst that spurred banks to up their game on digital channels and with self-service tools.
Banks are challenged with precariously balancing customer needs with the cost of personalised support. With the demographic of customers changing over the last few years, customers are becoming increasingly younger and more comfortable with technology. Influenced by the “Amazon Effect”, their expectations have raised to an all-time high, placing record strain on the sector
Customer experience isn’t just about support anymore, it’s about serving your customer at every point in the journey. Companies have an opportunity to elevate the experience they provide by moving beyond one-and-done interactions to create continuous engagements with their customers. It is starting to become a primary competitive differentiator in the market and one that doesn’t have a lot of variation. Deploying AI chatbot technology will be able to strategically help banks improve customer experience and raise the level of support that agents provide.
Digital collaboration: Working around the Clock
The benefits of adopting digital channels and self-service tools are second to none. By implementing chatbots, fuelled by conversational AI, banks will be able to help serve a wide range of customer queries and ensure they are protected from fraud and scams.
Conversational AI is exactly what it sounds like: a computer programme that engages in a conversation with a human. When it comes to service delivery, conversational AI can be deployed across multiple channels to engage with customers in ways that effectively address evolving customer needs. At a time defined by COVID-19, self-service tools such a conversational chatbots can work around the clock to solve customer queries in a concise and timely way. Of course, self-service tools won’t completely replace human agents in the banking industry, but they will help companies re-distribute customer traffic and workflows in ways that enhance customer experience. Self-service tools fuelled by conversational AI can also improve employee experience because service employees can handle fewer, but higher-level service tasks that chatbots might escalate to them.
Adopting new tools to help facilitate consistent and concise answers and help maintain customer experience is on the forefront of many industry minds. Banks such as the Natwest Group have seen this first-hand and are testament to the benefits that a good digital experience can provide. Simon Johnson, Capability Consultant, Digital at NatWest Group highlights NatWest’s use of digital tools during lockdown, “Over the last few months, we’ve learnt how to use digital tools to help our employees remotely. From a banking perspective, there have been a lot of changes including base rates, waive fees and the best ways of contacting our vulnerable customers, ensuring we keep them protected from frauds and scams.
“By introducing our Bold360 chatbot interface, Ella, we’ve been able to get relevant information out quickly, apply the best practice and ensure that our customer journeys are being developed correctly. Due to the volume of questions, some of our customers were finding themselves waiting longer than usual. So digital channels become essential to helping reduce the wait time. Using Bold360, we were able to mitigate issues and answer questions in a more timely way through our chatbot.
“Moving forward, as we open more digital services, we are analysing our data to see if customer will return back to their usual way of banking, now that they’ve seen what a good digital experience can provide. Either way, with Ella, we are ready.”
Chatbots and Humans: The Best Option for Customer Service
Over the last year, banking institutions have recognised the power that digital collaboration can have to their success. Delivering exceptional customer service and support is key for any business wanting to stay competitive in today’s market and banks are especially challenged with precariously balancing customer needs with the cost of personalised support. Leveraging the right technology, such as AI-powered chatbots, will enable the banking industry to provide better support and a more robust customer experience in the long term. Other institutions must follow suit, or risk becoming obsolete.
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