By Philip Dransfield, Partner at credit risk analytics firm, 4most 

Perhaps unsurprisingly, the fallout from the pandemic will continue to present the biggest known risks to lenders for the coming year. Specifically, real losses that have impacted the last year or so will come to light, as well as a call to action to review approaches to loss reporting from the volatility seen in bank provisions. With inflation on the rise globally, there is likely to be a shift in the rebalancing of the economy next year, and now that government supports have largely ended, we should expect to obtain more clarity on the impact of Brexit.

Looking at the banking market, competition, climate change risks and technological change will intensify further, and the right conditions will present opportunities for consolidation. Probably one of the biggest trends for 2022 is the regulatory agenda, which will continue to demand focus and investment.

Effects from the pandemic  Losses emerge IFRS 9	Macro-economic and business environment  Inflation and growth Brexit UK
Banking market Mergers & Acquisitions  Innovation	Regulatory agenda  Basel capital Climate change Consumer duty Operational resilience

Effects of the pandemic: 

Once the dust settles, losses will begin to emerge

According to UK finance industry reporting, mortgage arrears have nudged down in the third quarter this year and the BoE (Bank of England) Credit Conditions survey supports similar stability across other lending to individuals. The ONS reports that unemployment is slightly lower than the previous period. A year ago, the expectation was that very little arrears or job losses would be an issue at the time because of the various interventions and supports. However, now that most of that support has been withdrawn for a period, it is perhaps more surprising and unanticipated.

It may appear, that in respect of actual lending losses, banks and customers have weathered the crisis relatively unscathed. Yet whilst the scale, duration and effectiveness of the support for businesses has been quite remarkable, we can expect a gradual build-up of customers in financial difficulty later in the year, which will ultimately see a prolonged period of higher losses. This view seems to be the broad consensus amongst banks too, as the three-month outlook in the BoE survey continues to be pessimistic.

Drivers of future losses may not be obvious at this point. A potential source of vulnerability for the UK is the ripple effect from government backed lending (COVID loan schemes). How SMEs perform in repaying these loans, will reveal the true state of the UK economy’s engine room. The Government has provided guarantees against nearly £80bn of lending to businesses. Early projections suggested half of this would not be repaid. More recent estimates point to a third. The Credit Conditions survey reports that SME defaults were higher than expected from the last quarter. Whilst it is down to the Government to estimate its liability, the consequences of a high number of failed companies has real potential to seep into the wider economy.

Another key factor is the slow unwind of the suspension of legal processes around repossession and evictions, compounded with significant changes in working patterns. These are likely to be a continuing risk for property investors and lenders, particularly within the commercial sector, and could become an economy-wide problem if a glut of vacancies drives property indices lower and hence, drives a re-assessment of covenants and provisioning.

IFRS 9 2.0 

The International Financial Reporting Standard 9 (IFRS 9), adopted in 2018, which covers reporting of impairment losses, has not fared well during this crisis. Models that had only recently been developed and implemented to comply with the new standard, were being used to estimate the effects of an event of extreme change that had never happened before. The first half of 2020 saw banks report significant losses (by raising provisions in compliance with the standard), only to start releasing them in the second half through to the half-year 2021, as the outlook became less pessimistic. With initial arrears and default outcomes now suggesting customers have fared better than expected, we should expect further releases in reporting over the coming period.

Having used its best judgement, this points to the whole industry introducing a massive amount of volatility that may not have been needed. As a result, it has been suggested that current approaches to meet the standard need revision as it appears that models are useful until they are not. This does not inspire confidence and integrity in this critical accounting estimate. We should expect 2022 (and 2023) to bring renewed activity from banks in terms of revising their models and methods.

Macro-economic and business environment: 

Rising inflation brings risk to asset prices and lending growth

With employment continuing to rise as furlough ended, the current risk to the UK economy comes from inflation. The rise from 0.6% at the end of last year to the current 4.2% is largely driven by higher domestic energy bills and fuel prices. The rate is set to peak at around 5% and even if this proves transitory – a wage-prices spiral is a tail risk because it represents a sizeable hit to living standards; and all before tax rises in April. The good news on unemployment means the BoE can start to raise interest rates from the ‘emergency’ levels put in place at the start of the pandemic. As well as raising debt-service costs modestly, rate rises could lead to a reassessment of asset prices, particularly in residential property where recent growth is hard to explain in terms of the fundamentals.

A clearer picture of post-Brexit UK

While 2021 was officially the first year for the UK being outside of the EU, without full transitional measures in place it has been difficult to comprehend the real impacts. Given the scale of government support to business during the pandemic, changes in spending patterns and less movement in general, the full impact of Brexit is only just emerging.  Some businesses may not prove viable given the increased paperwork involved and the strain on supply chains. The final Brexit relationship also remains unsettled, and the UK has threatened to use Article 16 because of the trade frictions between Great Britain and Northern Ireland, implicit in the current agreement. Discussions about issues like product standards, rules of origin and the Irish border are a process that will continue.

There remains some temporary measures accommodating transition in Financial Services in 2021. In respect of banking, we will carefully watch the extent to which the PRA, FCA and Treasury with new powers to set the rules, remain aligned or diverge with the EU.

Banking market:

Mergers and acquisitions

With many more banks in the market, the need to scale those businesses remains high. Medium sized lenders find themselves in no-mans-land; not big enough to compete with the biggest incumbents, but too big to survive on niche lending. Recent reporting suggests that there are keen interests in merging or acquisitions in this mid-tier of established lenders. Their need is to achieve scale to reduce costs, improve revenues and make tangible inroads against the incumbents’ long-held positions. Several aspects will hamper the potential for any deals right now – including the uncertainty over interest rates creating a divergence in valuations between buyer and seller.  Many of the mid-sized lenders are also recovering from both provision impacts (the extent to which they can release these) and legacy idiosyncrasies, are further separating views from the two camps. If these obstacles are overcome, we may see 2022 bring a round of merger activity.

New lenders will continue to innovate, and some will achieve sustainability

More broadly, lenders continue to pursue digitisation and adoption of technologies that enable them to reshape their business models and cost base. Scale remains a strategic imperative for many lenders, however, it is hard to achieve this safely when going head-to-head with behemoths. Growth requires businesses to innovate. Next year, we will see a ramping up in lending sourced through vehicles like forward flow agreements and partnerships, bringing together different lenders who are good at different elements of the value-chain.

Coming out of the fog of the last few years, we will likely see one or two of the newest lenders reach adolescence and fulfil their potential in 2022. Starling has been reported as emerging well from the pandemic, having participated in the COVID-government schemes that will offer a ready-made customer base to nurture and the acquisition of Fleet Mortgages, showing a clear intention to enter the mortgage sector in addition to current SME and consumer segments. CEO and founder Anne Boden has said that the bank is on track to full-year profitability. We expect more new lenders to reach this milestone in 2022, given the clear expectations of the PRA for non-systemic banks.

Other new lenders continue to look to innovation to acquire customers. Over the last few years, consumer point of sale lending with buy-now-pay-later (BNPL) payment options have grown rapidly amongst non-banks. Today, fintech banks see these opportunities too, because it fits nicely with their advance technology capabilities, customer base and customer-centric focus. However, innovation is sometimes a double-edged sword. Whilst 2022 will likely see continued growth in this segment of lending, it has also been identified by government and regulators.

Consultation led by Treasury and the FCA will bring BNPL and short-term lending into greater focus. This type of credit arrangement has been around for a long time but has been excluded from consumer credit laws and regulations. Its no-interest-bearing nature, and relatively small scale, meant it was not viewed in the same way as other credit. That said, specialist BNPL firms have been so successful and made credit so easy to access that this poses real harm to some customers. This has more potential to effect non-bank lenders more so than banks as any new rules are likely to require improvements to customer information, checks on affordability and helping those in financial difficulty; things that banks should already be doing.

Regulatory agenda:

Basel 3 

In 2022, we will see the implementation of the new IRB Basel rules for the calculation and calibration of risk weights for bank capital come into play. The new rules try to address the failings of what was in place before the financial crisis, which in some ways has contributed to it. The requirements are much more prescriptive, onerous and conservative. In credit risk, banks that were already IRB based on the current rules, had to re-submit their applications for reporting to commence in 2022. However, feedback from the regulator on the first submissions for mortgage assets class models has shown a gap in expectations between banks and regulator. Along with specific changes in mortgage risk weight rules, higher capital reported against mortgage lending in 2022 is anticipated.

Financial risks of climate change 

Throughout 2021, banks have started thinking more seriously about climate change. The ECB and BoE have undertaken industry stress testing exercises across financial services firms to assess the potential impact on their financial state from physical and transition changes. The challenges soon become obvious when projecting out forecasts over fifty years. International efforts to introduce improvements in company disclosures are also creating greater awareness. Producing well-considered climate disclosures provides a basis for comparing company exposures and progress toward net zero emission. For banks in particular, this provides an impetus for them to make clear their own strategy and policy for lending and investment. With the IPCC having issued its latest report, giving a more pessimistic view on the physical science impacts of climate change, this will see greater urgency across nations and companies. During 2022, banks will also take learnings from the initial stress exercises and look at embedding climate change initiatives as part of their core strategy and risk management.

Consumer duty

The FCA is keen to see a higher standard of protection for consumers by firms competing for their business. The intention is for firms to be clear on the outcomes consumers should expect, how they will achieve this and know they can ensure they are doing this effectively. The FCA wants firms to take all reasonable steps to avoid harm, enable good outcomes and act in good faith. The FCA says it continues to see harm done to consumers and wants to see agreed principles that shape the standard of conduct that will permeate the culture and behaviour of firms in the right way. It sees this as a framework for the development of retail markets. The FCA is soon to publish the response from industry on the initial consultation and issue a second round. In 2022, they will refine the policy with a final set of rules and guidance. Some lenders see the FCA as already having the necessary powers and rules in place to achieve the desired outcomes. What this means for firms is quite fundamental and we should expect this to be a big topic of discussion and action in 2022.

Operational resilience

In terms of regulatory change, another key area is meeting the requirements around operational resilience. This requires firms to have identified their primary business services, mapped activities required to provide those services and set tolerance limits to operate these safely, and all by the end of the first quarter of 2022. From then, firms will commence reporting and implementation, including scenario stress testing. The regulations amount to playbook for every lender to manage their material businesses through crisis. Implementation work will go on for three years before final adoption. There is acknowledgement that solutions will need to be proportional to the nature and scale of a business, however, it is firmly on the radar of lenders and will require continued effort to embed as well as review and feedback.

There is a lot to consider in light of the trends and risks we expect to see in 2022. As the pandemic has highlighted, it is impossible to predict which risks and events will occur. There are also other risks not explored here, such as the cessation of LIBOR or postulating ‘what-if’ vaccine efficacy fails and we have further variants and waves of the virus type scenarios. We hope it resonates that in 2022, as with most years, it is the effective management of risk that remains core to successful banking.