Goat entrails and banks

So to limit the probability of being very much mistaken about financial services in 2019, rather than make specific forecasts, we’ll look at the conditions influencing any forecasts.

"The overall economic outlook… is 2019 won't be as good as 2018.”

In financial services in the Asian region (and globally), the major factors will be macroeconomic conditions, regulation, technology and “black swans” – completely unpredictable events.

We can ignore the last because by definition we have no idea what they will be.

But the others allow us to understand the broad environment – albeit the degree of complexity and uncertainty means translating that into fixed perspectives, be they investment decisions or strategies, is always fraught.

The world economy

While for a period before the 2008 financial crisis the financial sector was creating its own weather patterns, in more normal times the fortunes of financial institutions are hostage to the real economy.

For banks, for example, economic growth in communities or larger economies translates to superior earnings. Companies and individuals borrow more and spend more when economies are healthy. They fail less often.

The overall economic outlook, across a basket of credible experts and institutions, is 2019 won’t be as good as 2018. But nor is there an expectation of economic collapse.

However, the financial services sector also does better as a rule when interest rates are falling and the expectation is they – from the US Federal Reserve’s key rate to New Zealand mortgage rates – are more likely to be higher this year than last.

Economies have, in John Maynard Keynes’ memorable phrase, “animal spirits”.

Globally and in our region, the “spontaneous urge” is more about inaction than action. The reasons are manifold: Donald Trump with his trade wars, unpredictable behaviour, irrational policy measures; general elections looming in Australia, India, Indonesia and elsewhere (which always result in a deferral of spending decisions); an inverted yield curve (where longer term interest rates are higher than shorter term ones, historically presaging recessions); and geopolitical uncertainty.

The main front of the trade war is China-US. Both sides have much to lose and both economies are showing signs of fragility. For China, there are pressures on domestic growth which may impede necessary reforms. For the US, Donald Trump’s populist policies, often counter-productive, are the major issue.

Still, growth prospects from India to Australia to New Zealand are far from dire. Forecasters may be nudging them downwards but the greater anxiety is, if a steeper decline does occur, central banks and policy makers have neither the room in monetary policy (lowering interest rates) or fiscal policy (stimulus spending) to do much about it.

According to David Lipton, the first deputy managing director of the IMF, “the next recession is somewhere over the horizon, and we are less prepared to deal with that than we should be… [and] less prepared than in the last [crisis in 2008].

“Given this, countries should be paying attention to keeping their economy on a level trajectory, building buffers and not fighting with each other.”

So an uncertain global political and economic environment coupled with an already maturing economic cycle is not bullish for the financial services sector. Revenue will be hard to come by, bad debts may rise, the cost of funding is on the rise and the spread between rates charged and paid is declining.

As McKinsey notes in its annual review of the global banking industry New rules for an old game: Banks in the changing world of financial intermediation noted “growth for the banking industry continues to be muted - industry revenues grew at 2 per cent per year over the last five years, significantly below banking’s historical annual growth of 5 to 6 per cent”.

Financial technology

The Financial Time’s Alphaville column made a fascinating observation recently: “If technology is everywhere, the tech sector no longer exists. If the tech sector no longer exists, its premium is no longer justified”.

That’s significant for those tech companies trading on very high premiums but nowhere is the observation more germane than in financial services. The financial services sector is now a collection of technology business whether that’s digital banking, machine learning, artificial intelligence, data analysis, whatever.

The challenge in the sector from technology is twofold: new non-bank competition, whether from the Alibabas and Alphabets of the world or startup “fintechs”, and rebuilding existing technology.

It’s unlikely fintechs, despite years of venture capital pitches beginning “we are the Airbnb of banking or the Uber of banking…”, will destroy incumbents. Over the last 18 months the question has become one of how fintechs will partner with incumbents to achieve scale and credibility while preserving their innovation, not how they will take over the world.

For incumbents then, the challenge is how do you choose which fintechs to partner with and how do you partner to maximise innovation and preserve vitality while satisfying regulatory and operational demands? The winners won’t be based on how good the technology is but how good the integration is for customers.

Then there’s the genuine competition from “bigtech” rather than fintech.

In a new podcast on Chinese Bigtech, the Institute of International Finance (IIF) argued China is seeing the rise of a new kind of conglomerate.

“Indeed, the two largest of these Chinese ‘bigtechs’, Alibaba and Tencent, both among the world's largest companies by market capitalisation, are best understood as Google, Facebook, Twitter, Amazon, PayPal, Charles Schwab, Orbitz, Uber, and Spotify rolled into one, with numerous other functions on the side,” the IIF said.

For the moment, this model is most developed in China and has particularly Chinese idiosyncrasies but all those western corporations cited have their own ambitions to seize more of the profit pools typically harvested by the traditional financial services companies.

The fintech sector however continues to be well supported by investment capital and, by sheer weight of numbers, capital and intellect in the sector, it is likely to reshape the financial services sector in some way – either in cahoots with incumbents, new rivals or alone.

According to McKinsey’s recent paper “Synergy and disruption: Ten trends shaping fintech”, the sector will see a fairly normal evolutionary process playing out as greater focus is brought to bear on business fundamentals and incumbents start to respond.

There was always a Catch 22 with fintechs: they set out to disenfranchise the regulated incumbents but, as soon as they looked like they were doing so, regulators (and incumbents) started to demand they be regulated.

Regulation

This brings us to the other major force in the year ahead, regulation. Like economic fundamentals, regulation is all pervasive. Regulators – in Australia for example – may be engaging in turf wars and juggling the inexorable tension between system stability and competition but they will make the rules on capital, competition, remuneration, business mix, leverage and many other basic forces.

Even in fintech. Oliver Wyman’s latest Asia Pacific fintech report “How to Train your Dragon” notes “besides being the main enablers of accelerating access to financial services, policy-makers, governments, and regulators are often tasked with the challenge of facilitating and ensuring fintech develops in a way that minimises the risks to the financial system and society as a whole”.

Reinforcing the idea that tech is no longer a sector because it is ubiquitous, regulation too is one of the most attractive areas for fintech – which tells us investors expect regulatory forces to be significant and hence organisations will have to invest to respond.

According to the RegTech analyst, there was a step change in investment in so-called regtech last year and it is likely to continue.

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“Global regtech investment grew almost five-fold between 2014 and 2018,” the consultancy reported. Investments are getting bigger too.

Outlook

Solid, not exciting with considerable downside potential. As far as forecasts for the financial services sector goes, that’s about it.

There are regional differences: China’s manufacturing is slowing as in the trade war is biting. The New Zealand economy seems to have rolled over. Australia faces the final report from a Royal Commission into misconduct in the sector which will inevitably presage regulatory and policy responses with a general election and probably a change of government in the first quarter.

Developments such as AI, open banking, real time payments, blockchain and cryptocurrencies will all be interesting but unlikely to be seismic in 2019. (Although remember Amara’s Law: "We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.")

On cold, hard numbers the global sector is becoming less profitable.

Critically, barriers to entry are falling and financial institutions’ historic near-monopoly over financial intermediation – borrowing, lending, payments, risk management – is eroding.

According to McKinsey in its report Banks in the changing world of financial intermediation, the “revenue pool associated with intermediation - the vast majority of which is captured by banks - was roughly $US5 trillion in 2017, or approximately 190 basis points (Note as recently as 2011, the average was approximately 230 basis points)”.

This is a story for the next decade, not the next year however.

Andrew Cornell is managing editor of bluenotes