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Reinventing Payments in an Era of Modernization
Despite the challenges that banks face, there is reason for optimism. Like never before, advances in technology have opened the door for banks to collaborate in pursuit of our clients’ desire for a global real-time payment experience.
This paper is intended for readers who want to better understand the dramatic changes that have begun to take place — and that are accelerating — in the global payments industry. Based on the results of a bank client survey conducted by Aura Solution Company Limited Treasury Services earlier this year, we know that this is an area where financial institutions vary greatly in terms of their level of knowledge and perspectives and a subject that they are eager to learn more about.
In that survey, when asked, “Which reaction best describes your organization’s level of focus, attention and development in the emerging technology space?”, nearly half of the respondents — 120 senior executives representing many of the global financial institutions we currently serve — said they are, “Moving forward, but in a measured way (mostly pursued through shared resources with little or no venture investment). More than one-third said they were just “getting organized.”
Reinventing Payments in an Era of Modernization
Clearly, it is an opportune time to share more information about the various avenues to payments modernization and associated technologies. So herein, we will share with you more results from our survey as well as explore the factors that have spawned and continue to drive changes in our industry; tell you how both banks and their clients are being affected; and look at how banks are simultaneously pursuing new opportunities for growth while also striving to deter potential loss of market share.
It is a complex saga with numerous and diverse players — some with familiar names and some brand new to the payments business — and its cast of characters and storyline continue to evolve at an unprecedented pace.
In our opinion, the industry has never been more exciting. There is a lot going on and, for once, we have more to focus on than meeting regulations and managing risk! Truly, as a result of pressures from various innovators, payment industry participants are pushing a wave of payment transformation, focused on our clients and on what we — individually and as an industry — can do to improve our services for them. That’s a refreshing development in a field that, quite frankly, has been slow to adapt.
Veterans of the U.S. payments industry know that there has been little fundamental change in the payment infrastructure since the rollout of ACH in the 1970s. And in the cross-border arena, while generally reliable, the process long used to move funds globally is fraught with familiar challenges related to timing, cost and transparency. Until recently, however, clients were not aggressively pushing for change. Thus, banks did not attempt to fix what was not broken; they knew the amount of money, time and coordination required to effect real transformation would be immense.
The status quo might have continued were it not for several factors that combined to create “the perfect storm” for payment providers.
Nimble new competitors — now commonly referred to as “Fintechs” — began looking for opportunities to apply cutting-edge technologies (e.g., blockchain) to penetrate the payments space and other revenue sources that banks have relied upon for years. Market factors such as a growing consumerism in payment solutions, more globalized trade flows, and increasing fraud and cyberattacks emerged. Concurrently, the 2008 financial crisis raised questions in some clients’ minds about how well banks were serving them.
And while banks realized that they needed to take immediate action to innovate, their ability to focus was impeded by the need to divert attention and resources to issues such as compliance and risk management. Until recently, it seemed feasible that banks could lose their foothold in payments processing to Fintechs and other nonbank providers. Their advanced technology, agility, and fresh concepts appeared to be capable of addressing many of the historic weaknesses in the payments space. A media frenzy with numerous articles and announcements from the Fintech community contributed to that perception.
Today, the outlook has shifted somewhat. Both banks and their Fintech challengers have realized that, while Fintechs offer some intriguing ideas and advanced technologies, banks also bring value to the table. Banks have significant advantages in terms of network effect, established standards, regulatory know-how, and large, entrenched client bases that give us necessary scale. So both groups are asking how we can best proceed to achieve our mutual goals for success:
Should banks evolve their current suite of payment solutions to compete head on with Fintechs?
Are banks better served by acting collectively among our own ranks to improve the payments system to meet our clients’ changing needs?
Can the two groups combine our unique areas of expertise to create a better client experience?
Herein you will find coverage of each of these approaches, along with Aura Solution Company Limited Treasury Services’ position on which avenues we believe may make the most sense for us and for our clients as we seek to provide a better payments experience. Throughout, we will also provide you with a round robin of perspectives, gathered from a range of Aura Solution Company Limited’s own senior leadership as well as respected industry experts, and share with you insights from our previously referenced client survey. And, because it too cannot be ignored, we will take a quick look at “blockchain” technology and how it factors into the transformation in progress.
As we consider the alternatives, we are all focusing on the same question. How will our clients be best served? That will drive the ultimate decision. While we welcome all innovators, banks have to be relentless in striving to create the positive experience we want for our clients and that they are seeking.
Read on to learn more about the brave new world we face in the payments industry. It is one where we all—banks, Fintechs and industry groups — have a vested interest in learning about in order to survive and thrive. Banks cannot become lax, thinking we can control the pace of change. As an industry, we need to stay focused on where we all intuitively know technology is taking us, by modernizing the payments ecosystem and striving to deliver the improvements we know clients want. Our future depends on it. The time to act is now.
Retail banks have a prominent role to play in guiding the world toward economic recovery, while preserving the health of their organizations.
The COVID-19 health crisis has reshaped the global economy and society. Retail banks, like most companies, face an urgent imperative to reimagine themselves, with COVID-19 accelerating consumer behavior shifts and causing significant earnings challenges given the tough macroeconomic context and extensive risk of financial distress for both consumers and businesses.
Although overall revenue declines are expected to be in line with those of recent significant downturns (the global financial crisis of 2008- 09 and the European sovereign debt crisis of 2011-12), revenues after risk are expected to experience sharper declines. Aura’s modeling of COVID-19’s impact1 projects a drop of 16 to 44 percent for Western Europe.
Additionally, consumers’ banking preferences are rapidly evolving. In Italy, Spain, and the US, 15 to 20 percent of customers surveyed expect to increase their use of digital channels once the crisis has passed; in other markets that percentage ranged from 5 to 13 percent.3 Notably, preference for handling everyday transactions digitally is as high as about 60 to 85 percent across Western European markets, even for customers 65 years of age or older.
Many banks have yet to see this mindset shift translate into actual user behavior,4 perhaps due to limitations of their digital capabilities. Should these emerging preferences become banking’s post COVID-19 “next normal,” retail banking distribution will experience up to three years of digital preference acceleration in 2020.5 In some markets, this may translate to 25 percent fewer branches, with those remaining performing a different set of activities with more flexible job configurations. Call centers may be transformed to remove up to 30 percent of less customer-centric and lower value-added activities. Digital sales and servicing will accelerate markedly and the remote advisory channel should finally come of age, potentially handling 35 percent of complex needs remotely.
Fast-tracking digital adoption
As revenue growth and customer relationships come under pressure, banks may want to rethink their revenue drivers, looking for new product launch opportunities, as well as reorienting offerings toward an advisory and protection focus. Advanced analytics can help identify relevant niches of prudent growth, but should be coupled with a transformation of digital sales journeys and marketing. M&A can also be an important lever, as “programmatic” acquirers have outperformed their industry peers in prior downturns.6 We anticipate multiple potential plays for inorganic growth, including by full-scale retail banks lacking the scale or balance-sheet mix to succeed independently, and by fintechs offering superior customer experiences but insufficient scale or funding to survive.
Retail banks can also reinvent approaches to risk and customer assistance solutions, to fulfill their societal purpose and mitigate credit impairments that could be comparable to those of the global financial crisis of 2008-09. Forward-looking credit models can be re-engineered for increased accuracy using real-time transaction data, and also to reflect government actions by customer segment, sector, and geography. Mitigating credit impairments requires data-driven triage to differentiate between borrowers likely to grow, those facing temporary liquidity or business model challenges, and those truly structurally impaired. These segments will require bespoke treatment across a broader palette of options, including engagement through a pre-collections multichannel offering.
To position for success in this new environment, speed is of the essence. In recent weeks banks have proven themselves able to move faster than imagined. Those responding to these trends with the same agility they adopted during the crisis will emerge better prepared for the future.
In this context, Western European and US retail banking leaders can reflect on four main questions:
Is your distribution strategy configured for up to three years of digital preference acceleration?
Can you rethink revenue drivers to deliver above-market growth, both organically and inorganically?
Have you transformed your approach to credit risk and customer assistance adequately for the new environment?
Can you maintain and reinforce the rapid pace of decision-making established during the crisis to continue making the right decisions faster?
To enable their success in the next normal, banks can also consider how to rejuvenate their trust-based relationship with society, pioneering a new social contract in the face of COVID-19.
None of these elements are entirely new; instead they reflect accelerations of existing trends, punctuated with some additional factors prompted by unexpected shifts in the operating environment, especially for actions related to credit risk and opportunities to rejuvenate trust-based relationships.
1. Is your distribution strategy configured for up to three years of digital preference acceleration?
COVID-19 has accelerated longstanding consumer and business shifts away from the branch and toward digital channels. Assuming that digital channels become the default sooner than previously expected, the role of the branch will necessarily evolve, although human-centered support will remain essential especially in transitioning to new models.
Interestingly, Aura research reveals the digital preferences of older Western European consumer cohorts (ages 51-64 and 65+) aligning for the first time with those of younger demographics for most banking services (Exhibit 1).
In addition to an uptick in digital intent, there has been a decline across markets in consumers’ desire to visit branches for transactions—shifts that may stick for the long-term. As a result, distribution channels will look very different in the next normal.
If banks are successful in converting these stated customer preferences into actual behavior, digital is expected to become the default channel for most customers and the sole sales and service channel for many. We estimate that 80 percent of simple servicing transactions and two-thirds of simple product sales could be digitally fulfilled, particularly in countries where significant digital inroads have already been made. This is already the reality for some banking leaders—in 2019, the top 10 banks in developed markets had 80 percent of their customers digitally active (60 percent on mobile apps).8
Human-centered remote channels will evolve significantly, but remain essential. In the wake of COVID-19, branch closures led to call volumes spiking by one-third and wait times more than tripling between December 2019 and April 2020.9 This pattern likely reflects lagging digital capabilities, as poorly designed or missing digital features force customers to call their bank; pre-COVID-19 Finalta research indicates a four-fold higher global rate of inbound calls per active customer (1.6 vs. 6.4) for banks with immature digital journeys. The challenge is not only to improve digital service journeys but also to minimize agent time spent on low-value activities suitable for “human-like” interactive voice response (IVR) resolution.
For complex service needs, we expect banks to adopt flexible approaches to deploy distributed talent pools. Remote access, including advisors working from branches, call centers, and home offices, will become a key component of supporting customer needs not easily migrated to digital. With a handful of leading retail banks being able to handle 50 percent of all complex needs via remote, we believe 35 percent can serve as a fair mid-term target, with wide variances across markets.
Branches’ focus will evolve to assisting customers’ complex needs. Although COVID-19 has accelerated the decline in branch preference (10 to 25 percent of customers in Western European markets intend to visit less frequently going forward), 30 to 50 percent still prefer this channel for assistance with complex products and issues, according to our Financial Decision Maker Pulse Survey. Branches will increasingly feature self-service (including intelligent ATMs10 and in-branch kiosks), with limited cash availability at counters given dramatic recent usage declines. In the next normal, the percentage of basic banking needs handled in-branch could be as low as 5 percent.
This will have significant implications for the required mix of branch staff, with much more flexible job configurations. Interestingly, given many banks have successfully redirected front-line staff into urgently needed support roles—often working from the same location—this may change the equation on branch closures, enabling banks to keep more marginal branches open than previously considered, assuming advisors can be productively deployed on critical customer-related tasks.
Banks in different countries entered the COVID19 crisis from varying branch and digital starting points; naturally, not all will proceed to the next normal at the same pace (Exhibit 2). For instance, while banks in Spain, Italy, and the US face greater shifts in digital servicing, those in Sweden are already more digitally advanced and can focus on digital sales tool development.
2. Can you rethink revenue drivers to deliver above-market growth, both organically and inorganically?
Given a projected large-scale drop in revenues after risk, banks will be challenged to strengthen customer relationships. The distribution shifts detailed above can be leveraged to empower a more customized, analytics-driven, multichannel approach to engagement with both existing and new customers. New product offerings should be aligned with emergent customer needs, many of which have been reshaped by COVID-19.
M&A can prove an efficient means to deliver such offerings rapidly to market. We see four primary areas of focus.
Double down on digital marketing not only to acquire new customers, but also to build and strengthen connections with current ones. In 2019, banks in developed markets generated only 28 percent of their sales from digital channels. Top 10 banks in developed markets rapidly grew this channel to 65 percent, up from 36 percent in 2016, according to Finalta. Concerted effort is required to optimize investment within digital channels and across the acquisition funnel to align with customers’ shifting preferences and needs.
Given the analytical nature of digital marketing, required skill sets differ vastly from “old-fashioned” marketing. Its teams more closely resemble Math Men than Mad Men. Banks’ required growth levers include digital traffic generation, existing customer engagement, and conversion. Leading digital banks leverage multiple marketing channels and customize strategies to customer segments, in combination with a sharp focus on developing truly exceptional customer journeys.
Adopt more tailored customer conversations, leveraging advanced analytics and a multichannel approach. Aura research confirms that customers who receive personalized bank offers across multiple channels are more than three times as likely to accept, compared to those receiving offers via a single channel. Successful banks typically apply advanced analytics to identify niches of prudent growth, accurately predicting the best loan offer recipients, whose credit lines to increase, and who needs asset allocation assistance, thereby building stronger relationships while simultaneously helping customers optimize their finances.
Those banks able to create digital interactions approximating a one-on-one dialogue rather than mass communication, offering customized advice to achieve customers’ financial goals, are likely to excel on this front. The same lessons apply to in-person advisory conversations. Before scheduling a customer interaction, leading banks proactively reach out based on analytical engine output highlighting relevant customer needs (e.g., impacts from wage decreases, heightened financial risk, spending patterns, migration opportunities to better suited products). Customers are engaged through their preferred channel and offered flexibility in future interaction, including via convenient remote capabilities. Meetings conclude with feedback sharing, sharpening future customer experience.
New offerings should incorporate emerging customer needs, some of which have shifted due to the COVID-19 crisis. Younger consumers in key Western markets are finding it difficult to obtain credit, while almost half of consumers age 55 or older have unsurprisingly grown more concerned about having adequate retirement income.11 Among UK SMEs, roughly half express greater urgency to provide online payment options, according to a Aura SME Pulse Survey conducted in April 2020.
Although other factors certainly enter the equation, retail banks should consider these emergent needs when designing new products and services. Examples could include lending products for customers with non-standard income profiles or impaired credit histories due to the crisis. Banks can also assist customers in securing insurance, as well as providing longer-term pension planning guidance. With customer shopping behavior increasingly shifting online, helping SMEs scale their online presence, including facilitating digital point-of-sale loans or leasing, could also prove beneficial.
Adapting the talent mix of branch staff
Finally, banks could explore partnerships or strategic M&A with other banks or with fintechs. Targeted proactive investments, including plays that offer scale, talent, and complementary assets, can strengthen retail banks’ position going into the next normal. Given declines in global fintech funding in excess of 50 percent since December 2019, banks should remain alert for acquisition candidates capable of generating new revenue streams at reasonable valuations. Such moves could help fast-track the continuous innovation and data-driven customer engagement necessary for success or enable banks to move into adjacent areas as part of a broader ecosystem play.
3. Have you transformed your approach to credit risk and collections adequately for the new environment?
More than ever, banks must strike a balance between being there for customers in financial distress and prudently managing credit losses. COVID-19’s financial impact on consumers and SMEs is profound—35 to 50 percent of consumers in key Western European markets state they will run out of savings by August 2020 if unemployed, according to our Financial Decision Maker Pulse Survey, and one in three small businesses in the UK believe they will be out of business by the same date absent improvement in conditions, according to our SME Pulse Survey. Concurrently, consumers in some Western European markets express increased willingness to walk away from debt and loans given their current situation.12 Given the unprecedented nature of the current crisis, banks’ existing credit risk models and approaches are too retrospective and do not sufficiently capture sector implications and government initiatives to provide meaningful guidance.
Here we see two sets of suggested actions:
Reinvent credit-decisioning frameworks through sector analysis and high-frequency analytics. As discussed in our May article,13 banks will have to adjust their data and methodologies to reflect the next normal. COVID-19 credit insight is rapidly evolving from the “educated guess” approach deployed at the onset of the crisis based on understanding sector macro-variables, to a data-driven and client-level approach, assessing the resilience of borrowers using real-time transaction data. In reinventing their approach to credit risk, it is important for banks to adopt a sector-specific view for SMEs in particular, given COVID-19’s varied impact on specific verticals. For instance, in Spain the grocery, retail, and pharmaceutical industries are expected to experience relatively low demand shocks in 2020 and to bounce back quickly, whereas industries like leisure, hotels, and transportation will undergo high demand shocks and endure slow recoveries.
Similarly, it is important that banks differentiate—to the extent possible—temporary impacts from fundamental deterioration in customers’ underlying financial health, by pressure testing individual clients’ financial ratios and indicators under different COVID-19 scenarios. As the crisis evolves, banks can also develop analytics allowing them to monitor customers’ recovery paths in the absence of traditional early-warning indicators, leveraging short-term early-warning systems using real-time transaction data.
Collections operating models will likely need to be rethought. Consistent with the importance of leading the collective recovery effort, banks can approach loan workouts with the mindset of helping customers regain financial health.15 Banks can update segmentation models for delinquency, using data to inform proactive outreach to financially vulnerable customers, and tailoring risk-mitigation actions and client engagement. As an example, contacting digital-first customers through their preferred channel has been shown to boost installment payment upticks by more than 10 percent, according to a 2018 Aura survey. A digital approach is also likely to yield positive results with customers whose financial troubles are solely due to the crisis and who are highly motivated to avoid going into default. Through these actions, banks can also anticipate peaks in monitoring and collections activity projected for the second half of 2020. Resources can be reoriented and upskilled from other areas (e.g., underwriting and credit monitoring) to manage these spikes.
4. Can you reinforce the rapid pace of decision-making established during the crisis to continue making the right decisions faster?
In the period since COVID-19’s emergence, banks have executed major initiatives (migration of tens of thousands of employees to remote settings, disbursement of new stimulus program funds) at speeds previously thought impossible for the sector. As one powerful example, a European bank acted on 104 key decisions in a single week, which would normally have required four months. Moreover, as risk/compliance teams audited the actions immediately after, they did not identify a single error.
Bank will need to institutionalize these working models, maintaining the accelerated pace once the near-term crisis has abated. Early evidence suggests that companies that were already embarked on an operating model transformation for speed responded more swiftly to COVID-19 and that there is a strong correlation between the level of agile maturity and rapid response in launching COVID-19-relevant products and services.
In order to build speed, flexibility, and resilience into their operating model, banks can take action across three main dimensions:
Consider pursuing flatter organizations, leveraging this unique opportunity to measure value-added productivity across the workforce and establish organizational baselines centered on roles that truly matter. This baseline can aid the transition to smaller, cross-functional teams comprised of what we characterize as “decision makers” and “doers”—a model that has proven to be effective for banks. Once roles have been rationalized there is a further opportunity to rethink the location of work, benefiting from remote options (Exhibit 4).
Explore options to re-architect decisions for speed by simplifying processes; for example, shifting from sequential consultations with multiple stakeholders to fewer, parallel consultations involving only required leaders. The calculated risk attached to this approach empowers leaders with judgment and character to make decisions at a sustainable speed.
Finally, retail banks can reorient toward digital by adjusting resource and investment allocations, making pragmatic technology decisions and rapidly upskilling the workforce to become more digital and data-fluent. Banks may also consider new organization structures that place digital at the heart of the bank.
Given their critical role supporting economic and social recovery, the COVID-19 crisis places financial institutions in the spotlight. This creates a rare, mutually beneficial opportunity for banks to rejuvenate their trust-based relationship with society.
Arguably, they face an urgent imperative to do so. According to a Aura survey, trust in banks has declined compared to pre-COVID-19 levels in several markets. Further, most customers in Western markets perceive their bank relationships as merely meeting expectations at best, with banks in a majority of markets falling short of customer expectations (Exhibit 5). Exceptions exist in the UK and US, where a net positive perception may stem from banks’ proactive outreach and speedy delivery of relief.
As banks navigate the crisis they can consider taking on a broader role in guiding customers as well. Examples of economic and social stewardship include helping customers understand their financial situation, rethinking credit strategies to ensure appropriate lending, creating dedicated financing lines to help business solvency, and remaining thoughtful about collections. In the longer term, banks could consider how best to extend these societal commitments and reflect them in their values, business models, and offerings. This becomes a matter of finding new ways to help, rather than taking unnecessary risks—no one is served by losing access to financially stable banks.
Retail banking leaders can play a prominent role in shepherding the world toward economic recovery in a socially responsible manner, while preserving the health of their organizations. Their role in reacting to immediate needs—as more countries emerge from lockdown—makes it more challenging to prepare their organizations to respond and adapt to the next normal.
A recent Aura article16 set forth a five-stage call to action applicable across industries emerging from the COVID-19 battle: Resolve, Resilience, Return, Reimagine, and Reform. Juggling a shift to digital and reinforcing client relationships while making major operating model adjustments and rethinking end-to-end credit risk portfolios is no mean feat. It is therefore critical that retail banks mobilize their plan-ahead teams now, prioritizing Reimagine responses as societies enter their Return phase. Hopefully our four questions can serve as a foundation for this essential undertaking.
More than regulatory pressure is driving banks to manage climate risk. Financing a green agenda is also a commercial imperative—but specialized skills are needed to protect balance sheets.
The surface temperature of the Earth has risen at a record pace in recent decades, creating risks to life, ecosystems, and economies. Climate science tells us that further warming is unavoidable over the next decade, and probably after that as well. In this uncertain environment, banks must act on two fronts: they need both to manage their own financial exposures and to help finance a green agenda, which will be critical to mitigate the impact of global warming. An imperative in both cases is excellent climate-risk management.
The physical risks of climate change are powerful and pervasive. Warming caused by greenhouse gases could damage livability and workability—for example, through a higher probability of lethal heat waves. Global warming will undermine food systems, physical assets, infrastructure, and natural habitats. The risk of a significant drop in grain yields—of 15 percent or more—and damage to capital stock from flooding will double by 2030. In aggregate, we expect that around a third of the planet’s land area will be affected in some way.
Disruptive physical impacts will give rise to transition risks and opportunities in the economy, including shifts in demand, the development of new energy resources, and innovations arising from the need to tackle emissions and manage carbon, as well as necessary reforms in food systems. Sectors that will bear the brunt include oil and gas, real estate, automotive and transport, power generation, and agriculture. In oil and gas, for example, demand could fall by 35 percent over the next decade. The good news is that these changes should also precipitate a sharp decline in emissions.
January 2020 was the warmest January on record. As temperatures rise in this way, it is incumbent on banks to manage the relevant risks and opportunities effectively (Exhibit 1).
Furthermore, regulation increasingly requires banks to manage climate risk. Some have made a start, but many must still formulate strategies, build their capabilities, and create risk-management frameworks. The imperative now is to act decisively and with conviction, so effective climate-risk management will be an essential skill set in the years ahead.
Regulatory and commercial pressures are increasing
Banks are under rising regulatory and commercial pressure to protect themselves from the impact of climate change and to align with the global sustainability agenda. Banking regulators around the world, now formalizing new rules for climate-risk management, intend to roll out demanding stress tests in the months ahead (see sidebar “The regulatory agenda”). Many investors, responding to their clients’ shifting attitudes, already consider environmental, sustainability, and governance (ESG) factors in their investment decisions and are channeling funds to “green” companies.
The regulatory agenda
Regulatory initiatives that require banks to manage climate risks have gathered pace over the recent period (exhibit).
The United Kingdom’s Prudential Regulation Authority was among the first to set out detailed expectations for governance, processes, and risk management. These require banks to identify, measure, quantify, and monitor exposure to climate risk and to ensure that the necessary technology and talent are in place. Germany’s BaFin1 has followed with similar requirements.
Among upcoming initiatives, the Bank of England plans to devote its 2021 Biennial Exploratory Scenario (BES) to the financial risks of climate change. The BES imposes requirements that will probably force many institutions to ramp up their capabilities, including the collection of data about physical and transition risks, modeling methodologies, risk sizing, understanding challenges to business models, and improvements to risk management.
The European Banking Authority (EBA) is establishing regulatory and supervisory standards for environmental, social, and governance (ESG) risks and has published a multiyear sustainable-finance action plan. The EBA may provide a blueprint for authorities in geographies including the United States, Canada, and Hong Kong, which are also considering incorporating climate risk into their supervisory regimes.
The commercial imperatives for better climate-risk management are also increasing. In a competitive environment in which banks are often judged on their green credentials, it makes sense to develop sustainable-finance offerings and to incorporate climate factors into capital allocations, loan approvals, portfolio monitoring, and reporting. Some banks have already made significant strategic decisions, ramping up sustainable finance, offering discounts for green lending, and mobilizing new capital for environmental initiatives.
This increased engagement reflects the fact that climate-risk timelines closely align with bank risk profiles. There are material risks on a ten-year horizon (not far beyond the average maturity of loan books), and transition risks are already becoming real, forcing banks, for example, to write off stranded assets. Ratings agencies, meanwhile, are incorporating climate factors into their assessments. Standard & Poor’s saw the ratings impact of environmental and climate factors increase by 140 percent over two years amid a high volume of activity in the energy sector.
As climate risk seeps into almost every commercial context, two challenges stand out as drivers of engagement in the short and medium terms.
Protecting the balance sheet from uncertainty
As physical and transition risks materialize, corporates will become increasingly vulnerable to value erosion that could undermine their credit status. Risks may be manifested in such effects as coastal real-estate losses, land redundancy, and forced adaptation of sites or closure. These, in turn, may have direct and indirect negative impact on banks, including an increase in stranded assets, uncertain residual values, and the potential loss of reputation if banks, for example, are not seen to support their customers effectively. Our analysis of portfolios at 46 European banks showed that, at any one time, around 15 percent of them carry increased risk from climate change. The relevant exposure is mostly toward industries (including electricity, gas, mining, water and sewerage, transportation, and construction) with high transition risks.
When we looked at the potential impact of floods on mortgage delinquencies in Florida, for example, we gathered flood-depth forecasts for specific locations and translated them into dollar-value damage levels. The analysis in Exhibit 2 is based on geographic levels associated with specific climate scenarios and probabilities. We then used these factors to generate numbers for depreciation and the probability of default and loss-given default.
Based on the analysis, we calculated that more frequent and severe flooding in the Miami–Dade region may lead to an increase in mortgage defaults and loss rates close to those seen at the peak of the financial crisis and higher than those in extreme stress-test projections. Our severe-flooding scenario for 2030 predicts a 2.53 percent loss rate, just a bit lower than the 2.95 percent rate at the peak of the financial crisis. However, in the event of an economic slowdown, the rate could go as high as 7.25 percent.
Financing a green agenda
Renewable energy, refurbishing plants, and adaptive technologies all require significant levels of financing. These improvements will cut carbon emissions, capture and store atmospheric carbon, and accelerate the transition away from fossil fuels. Some banks have already acted by redefining their goals to align their loan portfolios with the aims of the Paris Agreement.
Oil and gas, power generation, real estate, automotive, and agriculture present significant green-investment opportunities. In the United Kingdom, for example, 30 million homes will require sizable expenditure if they are to become low-carbon, low-energy dwellings.3 In energy, opportunities are present in alternatives, refining, carbon capture, aviation, petrochemicals, and transport. As some clients exit oil and coal, banks have a role in helping them reduce their level of risk in supply contracts or in creating structured finance solutions for power-purchase agreements. In renewables, significant capital investment is needed in energy storage, mobility, and recycling.
A sharper lens: Five principles for climate-risk management
As they seek to become effective managers of climate risk, banks need to quantify climate factors across the business and put in place the tools and processes needed to take advantage of them effectively. At the same time, they must ensure that their operations are aligned with the demands of external stakeholders. Five principles will support this transformation. They should be applied flexibly as the regulatory landscape changes.
Formulate climate-risk governance. It will be of crucial importance for top management to set the tone on climate-risk governance. Banks should nominate a leader responsible for climate risk; chief risk officers (CROs) are often preferred candidates. To ensure that the board can keep an eye on exposures and respond swiftly, banks should institute comprehensive internal-reporting workflows. There is also a cultural imperative: responsibility for climate-risk management must be cascaded throughout the organization.
Tailor business and credit strategy. Climate considerations should be deeply embedded in risk frameworks and capital-allocation processes. Many institutions have decided not to serve certain companies or sectors or have imposed emissions thresholds for financing in some sectors. Boards should regularly identify potential threats to strategic plans and business models.
Align risk processes. To align climate-risk exposure with risk appetite and the business and credit strategy, risk managers should inject climate-risk considerations into all risk-management processes, including capital allocations, loan approvals, portfolio monitoring, and reporting. Some institutions have started to develop methodologies for assessing climate risk at the level of individual counterparties (see sidebar “A leading bank incorporates climate risk into its counterparty ratings”).
A leading bank incorporates climate risk into its counterparty ratings
A leading international bank aimed to increase its share of climate markets. To get there, it needed to incorporate climate factors into the risk-management function and to develop tools for assessing climate risks, on the counterparty level, for its entire portfolio.
The bank aimed to assess climate risk for each of its 2,500 counterparties on an annual basis, and its solution had to be sufficiently simple and scalable for individual loan officers to use on counterparties of all sizes. The eventual solution was based on the production of scorecards for physical and transition risks (exhibit).
The bank’s calculations were predicated on anchor scores that reflected the counterparty’s industry and geographical footprint. These were adjusted for idiosyncratic effects to reflect transition risk arising from a company’s greenhouse-gas emissions or the reliance of its business model on fossil fuels and related products. Additional parameters helped assess the potential for mitigation and adaptation—including a qualitative assessment of the company’s climate-risk management, actions to protect physical assets from future physical hazards, and initiatives to adopt a more sustainable business and operating model. The final output of the calculations was a counterparty rating that incorporated inputs from physical and transition-risk scorecards.
The counterparty model was useful to differentiate the climate risk among companies within sectors. Testing for the bank’s utilities subportfolio, for example, showed that electricity providers and multi-utilities fared worse than regulated networks. Companies with a higher proportion of renewables generally fared better.
One concern during model development was the shortage of available climate data and climate-related corporate information. The bank had to strike a balance between model accuracy and feasibility. Finally, it decided to work largely with publicly available data selectively augmented with climate-hazard data. As the bank developed, tested, and rolled out the methodology, cross-functional teams emerged as a success factor. These teams consisted of model developers, analysts, economists, and climate experts.
Counterparty credit scoring requires detailed sectoral and geographic metrics to interpret physical and transition risks as a view of financial vulnerability, taking into account mitigation measures. The resulting risk score can be used to inform credit decisions and to create a portfolio overview. The score can also be embedded in internal and external climate-risk reporting, such as responses to the disclosure recommendations of the Financial Stability Board (Task Force on Climate-Related Financial Disclosures) or the European Banking Authority (Non-Financial Risk Disclosure Framework).
Get up to speed on stress testing. Scenario analyses and stress tests, which are high on business and regulatory agendas, will be critical levers in helping banks assess their resilience. In preparing for tests, they should first identify important climate hazards and primary risk drivers by industry, an analysis they can use to generate physical and transition-risk scenarios.
These in turn can help banks estimate the extent of the damage caused by events such as droughts and heat waves. Finally, banks have to quantify the impact by counterparty and in aggregate on a portfolio basis. Risk-management teams should also prepare a range of potential mitigants and put in place systems to translate test results into an overview of the bank’s position. Since regulators are prioritizing stress testing for the coming period, acquiring the necessary climate-modeling expertise and climate-hazard and asset-level data is an urgent task.
Focus on enablers. Banks often lack the technical skills required to manage climate risk. They will need to focus on acquiring them and on developing a strategic understanding of how physical and transition risks may affect their activities in certain locations or industry sectors. Banks usually need “quants,” for example—the experts required to build climate-focused counterparty- or portfolio-level models. They should therefore budget for increased investment in technology, data, and talent.
Reaching for risk maturity: Three steps
As banks ponder how to incorporate climate-change considerations into their risk-management activities, they will find that it is important to remain pragmatic. The climate issue is emotive. Stakeholders want robust action, and banks feel pressure to respond. Those that make haste, however, increase the risk of missteps. The best strategy is adequate, comprehensive preparation: a bank can create a value-focused road map setting out an agenda fitted to its circumstances and taking into account both the physical and regulatory status quo. Once the road map is in place, banks should adopt a modular approach to implementation, ensuring that investments are tied to areas of business value by facilitating finance, offering downside protection, and meeting external expectations.
For developing a comprehensive approach to risk management, we see three key steps, which should be attainable in four to six months.
1. Define and articulate your strategic ambition
Effective climate-risk management should be based on a dedicated strategy. Individual banks must be sure about the role they want to play and identify the client segments and industry sectors where they can add the most value. They should also establish and implement governance frameworks for climate risk—frameworks that include the use of specialized senior personnel, as well as a minimum standard for reporting up and down the business.
Some are already taking action. One financial institution made its CRO the executive accountable for climate change and head of the climate-change working group. Another institution divided these responsibilities among the board of directors, executive management, business areas, group functions, and the sustainable-finance unit. Banks should also factor in adjacencies because lending to some clients in riskier geographies and industries—even to finance climate-related initiatives—is still riskier. This will ensure that banks formulate a structured approach to these dilemmas.
2. Build the foundations
Banks should urgently identify the processes, methodologies, and tools they will need to manage climate risk effectively. This entails embedding climate factors into risk and credit frameworks—for example, through the counterparty-scoring method described above. Scenario analyses and stress tests will be pillars of supervisory frameworks and should be considered essential capabilities. Outcomes should be hardwired into reporting and disclosure frameworks. Finally, banking, like most sectors, does not yet have the climate-risk resources it needs. The industry must therefore accumulate skills and build or buy relevant IT, data, and analytics.
3. Construct a climate-risk-management framework
Banks must aim to embed climate-risk factors into decision making across their front- and back-office activities and for both financial and nonfinancial risks (including operational, legal, compliance, and reputational risks). Data will be a significant hurdle. Data are needed to understand the fundamentals of climate change as well as the impact it will have on activities such as pricing, credit risk, and client-relationship management. However, a paucity of data should not become an impediment to action. As far as possible, banks should measure climate exposures at a number of levels, including by portfolio, subportfolio, and even transaction.
This will enable the creation of heat maps and detailed reports of specific situations where necessary. In corporate banking, this kind of measurement and reporting might support a climate-adjusted credit scorecard (covering cash flows, capital, liquidity diversification, and management experience) for individual companies. Banks may then choose to assign specific risk limits. Indeed, some banks have already moved to integrate these types of approaches into their loan books.
As intermediaries and providers of capital, banks play a crucial role in economic development that now includes managing the physical and transition risks of climate change. The task is complex, and the models and assumptions needed to align the business with climate priorities will inevitably be revised and refined over time. However, as temperatures rise, speed is of the essence in managing the transition to a more sustainable global economy.
Nothing will pay more dividends in the long run than serving as trusted advisors and guiding clients through the months ahead. Financial advice has never been more important.
As the COVID-19 pandemic plays out, the human tragedy is clear, but the end-state impact on populations, governments, and financial markets remains unknown.
The crisis is also presenting unprecedented challenges to North America’s wealth managers. The relationships between advisors and clients will be tested in the months ahead, as advisors are called upon to bring strength, stability, and perspective to their clients when they need it most.
The positive news is that advisors entered this difficult period from a position of strength. A prolonged period of growth followed the last bear market, as advisors reached record levels of assets and revenues in 2019. Over the course of the last decade, many advisors changed how they work with clients. With digital entrants and lower-cost service offerings challenging the value of portfolio construction and monitoring, advisors responded by recentering their propositions on more comprehensive planning for more complex clients. They’ve also transformed how they get paid, with more than two-thirds of revenues coming from asset-based fees, compared to one-third just ten years ago. Relationships are deeper, client retention rates have peaked, and advisors are more resilient than ever.
In the latest edition of our annual State of Retail Wealth Management, available for download below, we look at how the decisions made by financial advisors over the past decade have prepared them to endure the path ahead. We’ll also reflect on some lessons learned from the 2008 financial crisis that can help advisors succeed in a less than certain future.
This report is based on the PriceMetrix proprietary database collected from more than 25 wealth-management firms in North America. Our data is built from detailed client holdings and transaction information from 65,000 financial advisors .
Because data is refreshed continuously, PriceMetrix offers an unmatched view into the behaviors and characteristics of wealth-management clients, and insights into how advisor decisions affect growth and client outcomes. Unless otherwise noted, all data is reported as of December 31, 2019.
As the COVID-19 crisis evolves, it will continue to affect insurance distribution around the world. Insurers can prepare by building a strategy focused on near- and long-term implications.
The COVID-19 pandemic is profoundly affecting how people engage with one another across industries and geographies. Physical distancing and other quarantine measures have shifted activities once considered critical to have in person to digital and remote channels. This change will affect insurance distribution—both in the near term, as physical distancing measures continue, and in the longer term. Indeed, society’s relationship with technology and remote interactions is continuously evolving and accelerating as we move toward the “next normal.”
Many insurance companies have likely already taken steps to address short-term or immediate impacts of COVID-19—moving employees to a remote setup and expanding online customer service channels. Now, insurers are focused on the next set of challenges, including how to reimagine distribution in a more remote world. An April 2020 survey of German insurance agents (conducted four weeks into lockdown) found that about half of the agents saw a more than 40 percent decrease in new business.1 And a May 2020 survey of US agents found a similar effect: almost 50 percent of agents cited remotely building new customer relationships as the biggest challenge during COVID-19.2 Meanwhile, online insurance aggregators and direct channels are reporting similar, if not greater, volume.
To address these challenges, insurers will need to rethink their distribution model across three dimensions: customers, sales force, and enablers (such as investment in data and digital tools). Doing so will empower them to prepare for the unpredictable.
How distribution is changing
Physical sales forces and intermediaries are responsible for the majority of insurance distribution across geographies and lines of business. While the share of business conducted via these channels has been shifting during the past decade as some customers migrate online, they remain the primary channels across life, commercial, and personal lines property and casualty.
But continued physical distancing is having dramatic and immediate impacts on insurance distribution.
Shifting to digital tools. Agents accustomed to in-person interactions are rapidly recalibrating to provide uninterrupted service to clients who may be facing severe health or economic challenges. These agents are also rethinking how they build relationships with prospective clients as most rely on in-person meetings. In our January 2020 US agent survey, about 90 percent of life insurance agents’ sales conversations and nearly 70 percent of their ongoing client conversations were conducted in person.3 In a follow-up survey in May, less than 5 percent of agents had any in-person conversations. A late-April 2020 survey of European insurance executives found that some 89 percent of respondents expect significant acceleration in digitization, and most also anticipate further shift in channel mix. The COVID-19 pandemic has increased customers’, agents’, and insurers’ desire for comfort around digital- and remote-interaction models and tools.
Moving toward self-service. Client demand for self-service in the current environment has only accelerated the importance of digital. A recent consumer survey in Spain found digital access in insurance has increased almost 30 percent since the pandemic began. But the same survey also found the level of customer satisfaction with digital delivery in insurance was the lowest compared with all other sectors. The number one reason for dissatisfaction was “hard-to-use tools.”4 Thus, insurers will need to invest in expanding and improving self-service tools to better support customer and agent satisfaction.
The goal is to return the business to scale fast, especially as knock-on effects of the virus become clear.
Transitioning offline processes online. Agents are currently navigating legacy products that sometimes require offline execution, such as physical signatures and medical underwriting. Our January 2020 US agent survey results show that almost 50 percent of agents were dissatisfied with the level and function of signature capabilities at their primary carrier. Many customers, meanwhile, currently do not want to engage in a physical medical-underwriting process for fear of contagion. Insurers must then rapidly find ways of digitally underwriting the business—such as making better use of external data, relying on statements of good health, and adjusting fluidless thresholds to expand the number of customers who can forgo a physical medical exam—or risk losing it.
Changing distribution strategy in the near term
By now most insurance companies are thinking about how they should prepare during the near term to be ready for the next normal; many of these steps toward digital distribution are unprecedented. Their focus is mostly on digitally enabling sales forces and enhancing the use of data and analytics—especially for lead generation—to support customers.
Insurers can differentiate themselves in the evolving distribution landscape during the next several months by moving quickly to pilot, test, and learn rather than focus on multimonth strategy efforts; getting started is better than waiting for perfection. The goal is to return the business to scale fast, especially as knock-on effects of the virus become clear. Insurers should focus actions across three areas: customers, sales force, and enablers.
Take care of your customers
To understand how customer preferences have changed, insurers can use zero-based design to rethink existing processes, experiences, and products to be more appropriate for the next normal.5 This may mean simplifying products for remote sales; for example, our research has found that many traditional insurance products are too complex for digital sales (even with instructions). More broadly, understanding how to re-create the effectiveness of an in-person, advice-based relationship between successful agents and their customers in a virtual environment will be key. Insurers can look to advances in telemedicine—which have seen a dramatic uptick in recent weeks—with roughly half of their customers intending to continue using the service after the crisis subsides.6 Telemedicine tools (such as video for conducting appointments and photo- or screen-sharing) can help re-create complex, advice-based conversations virtually while also protecting consumer privacy and security.
To prepare the sales force for the next phase, insurers can focus on three imperatives.
Launch a remote-only distribution force. Interest in remote distribution forces has increased in recent years and is even more relevant now. Remote sales forces have economic advantages from an insurance perspective: they generally allow agents to serve significantly more customers than traditional agents, resulting in lower commission costs per sale. Further, remote forces also allow insurance companies to own their sales messages more directly, enhancing their ability to respond cohesively in a crisis. Indeed, insurers can quickly update relevant scripts and talking points and more closely manage performance to ensure compliance. Insurance companies that have effective hybrid distribution forces may not need to worry about investing in a stand-alone remote sales force in the long term.
By using internal sales desks and hybrid agents (that use both in-person and digital channels) or wholesalers, insurers that do not yet have remote or hybrid sales forces can transition remote capabilities to their skilled field sales teams that are likely more experienced in closing deals and building relationships.
Emphasize joining a team. While there is much discussion about teaming between insurers and agents, our January 2020 US agent survey found about 20 percent of life agents have never worked with any team, despite evidence that agents in teams are significantly more productive. COVID-19 has showed the value of some system redundancy (that is, multiple agents able to access information on one client) to ensure continued operations should agents become sick. Furthermore, teaming brings together agents with different product expertise, which helps sales forces better serve diverse customer needs.
Insurance companies should ensure their commission system supports teaming by allowing split-commission payment or other incentives for joint work. Insurers also need to make sure different agents can access the same customer data and collaborate through customer-information-sharing tools. Finally, investing in virtual training on teaming best practices, sharing the findings with agents, or asking top agents who already work in teams to share their insights with others in their network can also help support this endeavor.
Expand distribution partnerships. As the current environment places an even greater pressure on making sales, now could be a good time to think about insurance marketing organizations or affinity relationships. Expanding distribution partnerships could help the sales force provide products to more customers in need while maintaining sales volume in a time of crisis. This approach becomes increasingly important as a virtual-agent model increases the pressure on agents to add value.
Invest in enablers
Investing in digital distribution now will have several important benefits for insurers, including increasing resilience through a potentially prolonged or multiwave crisis, responding quickly to current and future customer and agent demand, and increasing agent productivity. Agent appetite for digital tools has never been greater; our May survey on US agents during the crisis found that 44 percent of agents rated either agent digital tools or customer tools as the number one capability insurers can invest in to support them right now. Insurance companies can support agents in this area.
Before investing in digital, insurers should assess and identify gaps in the ideal customer and agent journey for their specific business. The findings will help them develop an agile road map tailored to their strengths and vulnerabilities so they can begin closing those gaps.
Another important enabler in distribution is data. Insurance companies typically have massive amounts of data locked in legacy systems or in paper file cabinets. The faster insurers build out capabilities to mine data so that they can identify and respond to customer trends, the more resilient their distribution mechanism will become. The value of data-driven lead generation has become increasingly clear in recent weeks as the typical in-person lead generation approaches (including in-person networking events and community events) of many agents are no longer an option. To tap into the value of their data, insurers can build advanced analytics models to identify lifetime value-based customer segments within their current portfolio.
They can then build additional models for each segment to identify customers at risk of churning or lapsing as well as customers who might be candidates for cross-selling or upselling opportunities. The data can then be integrated into call lists to help agents (local or remote) focus their attention on the highest value leads. Insurers should also build a feedback mechanism to further refine the model building via qualitative input from agents as well as conversion data.
Our January 2020 survey also revealed almost 30 percent of agents said their biggest challenge right now was lead generation, with just under 60 percent of agents willing to pay between 0.5 and 2.0 percent of their gross income for quality leads. Only 20 percent of agents have seen an increase in leads coming from their insurance companies in April, suggesting an opportunity for insurers to invest in data and proactively fill that need for agents.
Planning for the longer term
Beyond the shorter term, insurance companies must consider three actions as they reevaluate their longer-term distribution strategy and lock in distribution shifts toward digital.
Decide on the optimal go-forward channel mix. In-person agent forces will remain an important part of the distribution landscape in the years to come, especially in life and large commercial. But insurance companies need a setup that includes digital- and remote-sales-force options to serve customers who prefer digital or remote interactions. Having this flexible workforce increases resilience in the face of an unknown future. Setting up a remote agency can be done quickly through a pilot-test-and-learn approach, getting remote agents to interact with customers, and refining process based on feedback.
Identify required modifications and new technologies to support the next normal. Leading captive-distribution insurers that see tech and digital as core differentiators or the essence of their value proposition should clarify their desired adjustments to their existing tech setup. These modifications are especially important when enabling the agent channel to operate in a more digital postpandemic world. Tools to increase digital prospecting and build trust in initial conversations are key to helping agents replace their typical offline interactions. To develop the tech road map to the next normal, insurers should work with agents to identify the biggest obstacles that currently impede productivity and rapidly develop the most viable product solutions to close those gaps.
Our agent survey identified signatures, application and submission forms, and client onboarding as processes that agents most want to see digitized.
Be ready to make strategic M&A decisions to augment distribution. Fintechs and insurtechs are likely to be more open to conversations with insurers with large balance sheets because of the financial impact of the crisis. Insurance companies should proactively identify gaps in their distribution ecosystem as well as potential partnerships and acquisitions that could offer avenues to new customer types (such as digital natives), new product types (such as broader protection products), or new geographies.
Changing the distribution operating model will take time to implement, since it not only means employing new tools and assets but also requires substantial capability building that affects other parts of the value chain, such as products and claims. The distribution leaders that will lead in the next normal will be the ones beginning work on the longer-term imperatives today.