The outlook for banks is brightening as margins improve thanks to rising interest rates, but 2023 will not be a year of plain sailing.
A deep recession would increase loan losses. Conversely, if banks navigate the economic shoals successfully and profits rise, they could face a public backlash and a clamour for windfall taxes as have been introduced in some countries already.
Every part of the economy is grappling with uncertainty heading into 2023. No one knows how the war in Ukraine will play out and what the impact will be on energy prices, inflation and monetary policy. But it is fair to say that banks are better placed than most other sectors.
For a decade or more after the Great Financial Crisis, money was next to free. Cheap funding was a boon for the economy, but with deposit rates near zero, banks’ net interest margins were squeezed. With interest rates now well off the floor and set to rise further as central banks seek to quell inflation, net interest margins are widening. Profit looks set to be stronger in 2023.
Of course, credit losses will rise if the economy slumps, house prices tumble and unemployment rises. But the best guess is that the hit to earnings should be manageable. Indeed, a bigger risk might be that banks are ultimately seen to be doing too well. At a time of an unprecedented squeeze on living standards because of high inflation, banks could find themselves the target of public resentment, just as energy firms were in 2022.
In such a scenario, the banking industry could suffer fresh damage to a reputation that is still recovering from the financial crisis. And cash-strapped governments could be tempted to placate public opinion by taxing what it deems to be windfall profits (forgetting that earnings were unusually low while interest rates were near zero). The Government in Spain introduced a windfall tax on larger banks at the end of 2022.
In the UK, the short-lived Truss Government proposed a similar levy on banks. But the Chancellor of the Exchequer Jeremy Hunt has for now actually reduced an existing surcharge on bank profits from 8% to 3%, although this still means that banks will continue to pay a higher rate of tax on their profits than other companies.
Looking past business cycle challenges, two themes are likely to dominate the coming year in financial services.
First, the continuation of efforts by banks to integrate innovative services developed by fintechs more closely into the everyday lives of their customers.
When the UK initiated Open Banking (OB) in 2017, many fintechs saw an opportunity to disrupt traditional banking by harvesting and applying the reams of customer data that OB suddenly made available to them. Five years on, the emphasis increasingly is on partnerships, with fintechs providing white-label solutions that banks can offer to their clients.
If the OB focus hitherto has been on making more use of information on customers’ transaction records, 2023 could see even greater interest in facilitating payments. We would also expect banks and fintechs to gradually expand their OB collaboration to a broader range of financial services, including investments and pensions, though this may only really get going once an Open Finance framework is developed.
The second theme is regulation. In December the Chancellor announced the ‘Edinburgh Reforms’ for financial services. The announcement covered a wide range of reforms the government is pursuing to improve competitiveness and growth. Detail will emerge over time, but the announcement can be seen as emblematic of a shift in mindset since the financial crisis, focusing now on making the most of the role that financial services can play in the economy.
This year will also see the first deadline for the implementation of the FCA’s new Consumer Duty. The Duty is a significant shift in regulatory approach which expects financial service firms to focus on demonstrating that they deliver good outcomes for their customers. A huge amount of activity has been underway across the industry to get ready. The Duty presents a challenge for firms, with higher standards and greater scrutiny, especially as customers struggle with the cost of living. There are also uncertainties over how the new standards will play out in practice. At the same time, it is an opportunity for firms that are delivering good outcomes to show that they are doing so, and pull ahead of rivals.
As every good sailor knows, the weather is unpredictable and can change suddenly. But the forecast right now is for the banking industry to enjoy a better 2023 than most other sectors of the economy. Lenders can look forward to strong profits, while customers should benefit from continued innovation in the delivery of financial services and even greater focus on making sure they receive good outcomes.