FINANCIAL SERVICES: An Introduction to UK-wide

Financial Services: Contentious Regulatory in UK-wide

FINANCIAL SERVICES: An Introduction by Fox Williams LLP 

Introduction 

2020 has been an unprecedented year for financial services in terms of the ongoing disruption to firms arising out of the global pandemic. The ongoing disruption to the markets is likely to mean that the financial services industry faces an uncertain future and will have to address a number of regulatory challenges in addition to maintaining their “business as usual”. Against this backdrop we expect both contentious and advisory practices to be busy throughout 2021.

The economic effects of Brexit (and any potential future EU relationship) will also develop much more fully over the coming twelve months. These changes bring opportunity: we expect financial services businesses with strong digital distribution platforms to prosper, in relative terms, as more consumers purchase financial products online.

Cross-Market Themes 

The COVID-19 pandemic has provoked a substantial regulatory response from the Financial Conduct Authority (“FCA”), the Prudential Regulatory Authority (“PRA”), The Bank of England (“BoE”) and the UK government.

For example, the FCA’s rules on the treatment of borrowers on mortgage holidays dovetail with the PRA’s guidance on the capital treatment of such loans. Regulators have postponed several initiatives, such as the FCA’s market study on general insurance pricing practices, to allow regulated firms to focus on operational resilience. It remains to be seen how the COVID-19 pandemic will play out over the coming year and what further initiatives regulators can develop to meet it.

But COVID-19 has not derailed every prior regulatory initiative: notwithstanding COVID-19 disruption, LIBOR is expected to be phased out by end-2021 for GBP-denominated contracts. It is to be replaced with the preferred SONIA reference rate. As LIBOR is referenced by approximately 400 trillion dollars of contracts, it is a huge undertaking.

The financial services sector must also contend with Brexit. It is unclear whether the UK will strike a deal before the end of the transition period on 1 January 2021. Possible scenarios are too numerous to detail here, but none of the plausible ones looks appealing.

UK and International Banking 

The deposit-taking sector both in terms of retail and wholesale banking activity is intimately involved in the financial response to COVID-19: the Coronavirus Business Interruption Loan Scheme and Coronavirus Large Business Interruption Loan Scheme are backed with an 80% government guarantee, leaving the banks on the hook for the remaining 20%. Whilst this scheme has been a key feature of the UK’s response to mitigate the economic impacts of COVID-19 the implications to the sector if large scale default on these loans occurs could be substantial. This will be an area of focus for the banks from a capital perspective in 2021 and for the regulators from a market stability perspective.

It seems that much of the UK government and related regulatory response was predicated on a V-shaped recovery. Since some of this may have simply stored up problems for the future, it remains to be seen how this response will perform if the recovery disappoints. Regulators have proceeded to protect common equity tier 1 capital adequacy ratios. The BoE’s Financial Policy Committee has cut the counter-cyclical capital buffer from +2% to 0% of risk-weighted assets. The PRA has also extended regulatory forbearance on the calculation of market risk weighted assets in the face of extraordinary stock market volatility in March 2020. The PRA provided guidance on the modelling assumptions to be used in calculating Expected Credit Losses under IFRS 9 to mitigate the risk of a modelling-driven credit crunch. Whether these steps are sufficient may become clearer in the year ahead.

Banks will also face the challenge of implementing CRD V over the coming year. CRD V refers to the principal EU legislation amending the prudential regime for banks (and certain investment firms) enacted in 2019. Member States, including the UK, are expected to implement and apply these measures from 29 December 2020. The legislation implements 1) certain Basel III standards agreed in December 2010 and 2) certain EU-specific standards developed in response to a review of a performance of the CRD IV legislation.

Investment firms 

Despite the global pandemic many investment firms have maintained very high levels of commercial activity as a result of the highly volatile markets. We expect a degree of market volatility to continue with the result that investment firms will be active (and a need for advice on their activities).

Investment firms have been making headlines in 2020 for liquidity mismatches since the collapse of Woodford Investment Management. In January 2020, the FCA wrote a Dear CEO letter to the asset management industry indicating the areas where it considers the industry fails to meet standards, highlighting liquidity mismatches. In March 2020, the FCA gave a speech on liquidity mismatches in open-ended funds, where it spoke to its ongoing work in this area. The FCA is currently consulting on proposals to reduce the scope for liquidity mismatches in open-ended property funds in the light of several episodes of suspension of redemptions over the past few years, both in the aftermath of the Brexit vote and during the COVID-19 crisis. It expects to publish final rules in 2021.

Insurance 

We expect litigation to be one of the dominant legal themes in the insurance space, both COVID-19 related and otherwise.

The general insurance industry is caught up in COVID-19 litigation. The FCA is driving an unprecedented and high-profile test case in relation to the proper scope of business interruption insurance for pandemic claims. This case and its outcome represent a significant risk and threat to insurers (who may find they have exposures far greater than they ever considered) or leave businesses unprotected. The outcome of this case may result in further significant challenges for the FCA and the UK government, rather than bring the clarity and certainty hoped for. By the time of publication, we expect the Court to have delivered its judgment at first instance and may well have accelerated to an early hearing before the Supreme Court. Whatever the outcome the impact to insurers and insured clients is substantial.

The life insurance industry is also involved in precedent-making litigation arising out of the Prudential and Rothesay Life appeal. This appeal concerns a surprising first instance decision to refuse to approve a Part VII transfer of a book of annuities from Prudential to Rothesay Life. If the appeal fails, it will have potentially profound implications for the law on Part VII transfers and impact parties involved in the transfer and restructuring of insurance businesses.

Fintech 

The Fintech sector continues to be highly active and some firms are finding that the pandemic is an opportunity to develop virtual business models which do not require offices and physical infrastructure to engage with their clients.

This represents a potential bright spot in the financial services landscape: online sales of financial products are booming, in markets from mass-market wealth management to pet insurance. Challenger firms are building differentiated brands around modern technology stacks while incumbents struggle to catch up. We expect this trend to continue.

We do however also expect to see a greater level of enforcement activity across the Fintech sector. Early entrants to the markets are now having significant customer impacts (particularly where there may be issues with their business models) and this is attracting more regulatory attention. Notable business failures in the P2P lending space and the mini-bond scandals in 2020 are likely to indicate that similar issues will arise in 2021 and require further attention.

The Regulatory Cycle 

Notwithstanding the challenges in the global economy the major regulatory institutions in Europe are continuing to press ahead with a number of key regulatory developments. Notwithstanding the impact of Brexit these issues will need to be addressed by firms in the UK who will be impacted by them.

The European Insurance and Occupational Pension Authority (“EIOPA”) is reviewing the Solvency II prudential regime for insurers. EIOPA is expected to deliver its opinion to the European Commission at the end of December 2020. EIOPA states that Solvency II is working well and characterises its approach as one of “evolution rather than revolution”. Nevertheless, its consultation document does propose the introduction of macroprudential tools, recovery and resolution tools and insurance guarantee scheme tools into the Solvency II regime.

The European Securities and Markets Authority (“ESMA”) is reviewing the impact of the Markets in Financial Instruments Directive II upon European financial markets; it has delivered several reports to the European Commission, with further deliverables expected over the next year. And in August 2020, ESMA wrote to the European Commission with feedback on areas for improvement to be addressed in the forthcoming review of the Alternative Investment Fund Managers Directive.

Conclusion 

In an environment of high uncertainty, one thing appears likely: the coming year will be one of extraordinary commercial and legal significance for the financial services industry.

With certain exceptions, the attitude of regulators during the COVID-19 crisis has been accommodating. Their focus has been on operational resilience. We think that regulated firms can expect this attitude to continue, although the longer the pandemic’s impact continues the greater the expectations the regulators will have of all firms operating in this challenging environment. Senior Management, Risk, Compliance and Legal functions will therefore need to be prepared for a challenging 2021.