Series 5 Episode 8: The year ahead: geopolitics, divergence and the productivity conundrum

Transcript

Tessa Norman: Hi everyone, and welcome to the latest episode of Risk & Regulation Rundown, the podcast where we share our views and insights on hot topics in financial services risk and regulation. My name's Tessa Norman, I'm your regular host, and in this first episode of 2024 I'm joined by two very special guests to share their insights on the agenda for the year ahead. Isabelle Jenkins, PwC UK's financial services industry leader, and Lord Gavin Barwell, a PwC senior advisor and former MP and Chief of Staff to Theresa May. We're going to be talking about the geopolitical, economic, and regulatory drivers which are set to shape financial services this year, and talk about what all of that means for firms and how they should respond. Welcome to the podcast Gavin and Isabelle.

Gavin Barwell: Thank you very much.

Isabelle Jenkins: Good morning.

Tessa: We're going to start off with the bigger picture, because that provides some really important context to what's in store for the financial services industry. As we start 2024, the global picture remains somewhat challenging, with ongoing international conflict and some economic difficulties. This is also being billed as the biggest election year ever. So, of course, the UK and the US are both set to go to the polls. We've also got European Parliament elections coming up in June. So Gavin, can you kick us off by characterising for us the geopolitical and macroeconomic backdrop as we start this year?

Gavin: I think in one word, 'challenging'. I think macroeconomic, the main global forecasters are predicting global growth this year, but a bit slower than last year, the UK probably a bit better than last year, but not that great in terms of the overall macroeconomic outlook. Then I think, geopolitically, as you said, the dominant thing is this is probably the biggest year ever for democracy in the world's history. Something like four billion people across 60 countries having an opportunity to vote, some of them in free and fair elections, some of them in elections that may be not so free and fair. We've also obviously got two major wars ongoing, the Russian invasion of Ukraine and the horrific scenes in Gaza, the humanitarian catastrophe that we've got there. So, it's not an easy geopolitical backdrop, but it's not all gloomy. If you wanted me to give you something positive, I think if you look at US-China relations, they definitely improved a bit towards the end of last year. And given they're the two most important countries in the world, we should take some comfort from that fact.

Tessa: Turning to the UK specifically, we know that the government must hold a general election before January 2025. Latest indications are potentially that will be in the second half of this year. Given the upcoming election, what does that mean for the government's priorities

Gavin: I think there are probably two things that are worth saying. One is there's always a scramble to get stuff done before the election. If you're the Prime Minister, you might not be carrying on as Prime Minister, so you've got your legacy things you want to get done, and then if you're a cabinet minister, or even down to the most junior ministers, they've all got their little projects they've been working on that they want to get delivered before the election. Then when you've got a situation like now, when you've got a government that's behind in the polls, there's a degree of desperation. So what you tend to get is the government trying different stuff to see if it can find some way to budge the polls and get itself back in the game. You saw that a bit in the autumn, and I think you'll probably see some more of that this year.

Tessa: If we do see a change of government brought about by that election, what's that likely to mean for policy? Are there certain areas that you could highlight for us where you expect to see more change, and perhaps are there some areas where you think we're more likely to see continuity?

Gavin: I think, first of all, overarching, I think a Labour government would be a moderate centre-left government, not a Corbynite style left-wing government. I think the way you framed the question is right, actually. I think, in some areas, there could be some quite radical change to government policy, and in other areas things would feel very similar to how they are now. So maybe if I give you a couple of examples in each case. Two big changes, I think a Labour government would have a formal industrial strategy that set out what are the key sectors of the UK economy that it thinks are going to drive growth, and I think financial services would be one of those sectors. Where are the bits of the country that we either have clusters or could develop clusters in each of those sectors? Then, I think another area where there's a clear change would be on net zero, where the Sunak government has back-pedalled a little bit, maybe, in terms of its enthusiasm on that agenda, and I think a Starmer government would bef, full throttle, trying to accelerate the pace of the net zero transition. Then, if you wanted, maybe, a couple of examples of areas where you're not going to see such a big change, I would say the overall fiscal policy, if you think about the tax burden as a whole on the UK economy. I don't think it would be very different under a Labour government than it is today, under the current government. Then, if you think about our relationship with the EU, the mood music would be a lot more positive, but the fundamentals of Boris Johnson's Brexit deal, I don't think a Starmer government would change those, at least in its first term. So big change in some areas, not much change at all in others.

Tessa: Thanks Gavin. That's really helpful context to the sort of environment that financial services firms are operating in. I think there's lots of themes there that we're going to return to. So, Isabelle, if I can bring you in here. We've heard a lot about challenges, and some uncertainty. How are you seeing clients respond to that, and what does all of this mean for their strategic planning, as they look to the year ahead?

Isabelle: Well, I'll come back to Gavin's word, 'challenging'. Obviously, we've seen a significant increase in interest rates over the last few years. Whilst that is positive for some products that are relying on a net interest margin, it has a significant impact on the cost of funding for all financial services organisations, and obviously wider. So what we're seeing with financial services organisations is this need in the short to medium-term to a) be able to deliver on their strategy, but in a period of great uncertainty. So what we're seeing people really focusing on is doubling down on efficiency, productivity, getting their house in order to be able to operate over the next few months.

Tessa: As well as some of the geopolitical and macroeconomic factors that we've talked about, there's also a number of regulatory and market drivers of change that firms are navigating. What do you see as the key drivers going into the year ahead?

Isabelle: Yes, absolutely Tessa, and that's hard because it's a really big agenda. Financial services organisations have got a lot on their plate. I'd start with technology, and that's both new technology, but actually how do you keep your old technology operating? Regulatory expectations, which continue to evolve. We've got the Edinburgh Reforms. Then as Gavin was saying, what would be potential changes if there was a change in government? We've got ESG, and how firms are responding to that, both in terms of net zero, but in terms of sustainable finance. Consumer duty is a really big focus for organisations. Then also there's this point about divergence of regulations across the multiple territories that big global financial services organisations are operating in.

Tessa: It would be great to explore some of those in some more detail. Let's take technology first. How are you seeing firms embrace that, both in terms of some of the opportunities, and also the challenges and risks as well?

Isabelle: Again, I'd almost categorise it into those two areas. So 1) how do you embrace the opportunities of new technology? I'm surprised in this podcast we've got this far without saying the words 'AI'. What are organisations doing? They're looking to get their houses in order. They need to make themselves efficient. They need to be combining this great customer experience with an efficient process, but then is effective, and has a level of control in it. So, how can new technology help them to do that? It's looking at the impact of crypto currencies, crypto tokenisation of assets. There are some new technologies that give financial services a really great opportunity to really develop and improve their businesses, but they're coming from a position where, for a lot of them, they have a legacy architecture that is still quite hard to operate, still requires a lot of investment. It's interesting, because when you reach out to regulation, then you've got the regulators tackling both aspects of this. So, of course we've got lots of conversations about what will happen about regulation over crypto? How will regulators expect organisations to implement and control AI? We've still got the fact that firms need to get the foundations right. So operational resilience remains absolutely crucial. Again, we also see regulators being focused on systemic and longer-term risks associated with technology, and particularly the use of third parties. In December '23 we saw Bank of England, PRA, FCA, set out a proposed regulatory framework for critical third parties. Those rules are likely to be finalised later this year. The EU is making similar moves with the Digital Operational Resilience Act, DORA.

Tessa: Thanks Isabelle. Gavin, of course, governments as well as industry and regulators are exploring some of these new technologies, and what they might mean. How are we seeing governments respond?

Gavin: They're struggling, is the first thing to say, because this technology is evolving so rapidly. The politicians and the civil servants that advise them are not experts in it, and it's very hard for them to keep up-to-date with the pace of change. I think the other thing I would say is that they can't make up their minds what the balance is here, between risk and opportunity. So, if I think of some of the people that I used to work with, that ran the UK's National Risk Register, they will look at AI and think, 'This could be the biggest risk on our register.' If you think of some of the nightmare scenarios of either you lose control of a super intelligent machine, or hostile countries using AI to develop more dangerous cyber weapons, or biological or chemical weapons, down to the most immediate risks, which I think are around disinformation, essentially. But then on the other side of the coin, potentially huge economic upsides, in terms of productivity. Just before Christmas, a Canadian team used AI to develop a new antibiotic that looks like it works against all of the drug-resistant superbugs. So simultaneously some of the things that have been at the top of the government risk register for years, AI might actually help us deal with.

So, I think they're struggling with how do you deal with something that could simultaneously be salvation from a lot of the things we're worried about, and is itself a huge risk.

Tessa: That's really fascinating, just the scale of some of those questions, for both governments and for industry as well. I think technology's a really interesting area, Isabella, as you've alluded to, where divergence is becoming increasingly important, and firms with an international footprint have really got to closely monitor how policies and frameworks are emerging in different jurisdictions. How are we seeing divergence impact firms?

Isabelle: We're hearing really growing concerns, particularly amongst globally active firms, about the increasing divergence between UK, EU, and US requirements. We think this is going to be a strong theme this year. Many jurisdictions are reviewing their rules at the same time. Given the time since the financial crisis, that's natural. We've all got to the stage where we're all looking, and with the advent of new technologies, and particularly the impact AI is going to have, but it's tough on firms, particularly those that are acting on a global basis. Again, how can they manage the risk to their business from this divergence, and how do you cope with that without adding yet more complexity to your business? The other area where divergence is set to play an important role this year is around wholesale market reform. The UK's progressing a broad wholesale market reform agenda as part of the Edinburgh Reforms. As a result, we'll see that firms will need to make operational changes to internal processes, their systems, their reporting, their controls, their compliance frameworks. It has quite a wide impact. For firms that are operating in multiple jurisdictions, they're going to have to look at the reforms being made. As I said, UK, EU, and US at the same time.

Tessa: Gavin, is there anything further that you'd add to that? How do firms manage some of those risks, particularly thinking about that geopolitical context that you talked about at the start of our conversation.

Gavin: Yes, when we started we talked about the immediate geopolitical challenge for 2024, but I think if you take a step back, and you look at the longer-term trends, what you're seeing is the emergence of a messy, multi-polar world. I think about my lifetime. I turned 50 fairly recently. I haven't entirely come to terms with it yet. If I think about my life, when I was a kid, when I was growing up, I lived in a bi-polar world of the Cold War, US, Soviet Union, and then for most of my adult life, I've lived in a uni-polar world, with the US really as the sole superpower, and willing and able to be a sort of global police officer, and that world has now gone, partly because of the rise of China, partly because the US doesn't want to play that role anymore. I think some of the media commentary assumes we're going to go back into a bi-polar world of US versus China, and I think that misses a really important point, which is that, behind China, we have India, we have Brazil, we have Saudi Arabia, we have Indonesia. So actually, the world that my kids are going to grow up in is an increasingly complicated, multi-polar world, where, yes, US and China, and probably in a regulatory sense the EU as well, are the biggest players on the block, but there are others out there that are strong enough in their own particular neighbourhood to be able to go their own way.

That's just going to make it, not just for financial services but for any business that's trying to operate globally, it's not going to be as simple a world to do that in as they had this kind of golden period in the 1990s and early 2000s, when it felt like most countries were heading to be liberal democracies, and open market economies, and you might have a fairly uniform operating environment across the whole world. It doesn't feel like that's the way the world's going at the moment.

Tessa: Post-Brexit, there's been quite a strong narrative from the UK government about the international competitiveness agenda, and we've talked about the Edinburgh Reforms as a key part of that. Do you think that's likely to be a continuing focus, potentially beyond a change in government?

Gavin: Yes, I think so. I think so, because the Labour party is basically not, as I said earlier, proposing any fundamental change to Boris Jonhson's Brexit. It's not saying we're going to go back into the single market. So the UK is, kind of, faced with this dilemma, which is that the benefit of Brexit that the advocates of Brexit put forward was that we would have regulatory autonomy. We'd be able to go our own way. If you don't make any use of that benefit at all, but you have imposed a bunch of costs on yourself by not being in the single market, then the whole thing doesn't make sense. So there's quite an imperative to do it, but, on the other side of the coin, there are two resistances, which is sometimes business says, 'Well, yes, but actually it would be easier for us if it was all just the same,' and sometimes consumers say, 'Well, I don't want to have chlorinated chicken sold in my supermarkets,' or, 'I don't want the government to abolish the rule saying there's a maximum number of hours I can be made to work a week.' So that's where governments have been struggling, that they-, if you're going to make Brexit work, you need to use this regulatory autonomy, but there are various kinds of blockers to it. I think a Labour government would definitely proceed with the Edinburgh Reforms. It might make a few tweaks here or there, but it's been very clear that it sees, as part of its 'Making Brexit work' plan, it wants to make use of those freedoms. I don't think that agenda's going to go away with a change of government.

Tessa: You mentioned consumer protection there, and I think there's been a really interesting tension in financial services, between international competitiveness, on the one hand, and consumer protection, and we've actually seen quite a strong interventionist agenda on the consumer side over the past year or so. Isabelle, how do you see that playing out over the year head? Consumer duty was introduced in July 2023, but there's a number of other initiatives that are still progressing as well. What do firms need to think about this year?

Isabelle: You're right, Tessa. We have seen this increasingly interventionist consumer protection agenda, both from the government and from regulators. Gavin was talking about this divergence, and this divergence on a global scale, and this is an area where the UK's really forging ahead. Again, recently we've seen the FCA announce that they're going to do some reviews into motor finance. This is something that they're very passionate about. In fact, when the regulator talks about consumer duty, they talk about how firms' work on consumer duty will never be done. So, it isn't a, 'Here's the standard, meet the standard, and you can focus on something else.' It's about how you evolve it. Thematically, how are you protecting the consumer? Consumer duty is a flagship initiative for the FCA, and firms should expect continued FCA supervisory scrutiny, and an ongoing pressure for continual review and improvement of outcomes. Some firms have experienced challenges with fully embedding the duty across their whole business. This is something which is very easy to think of the impact in a retail business, but, actually, it has implications to asset management, and even into wholesale banking. So, that breadth of the implementation is something that firms are looking at, and should be a focus for this year, and then we're going to have two deadlines in July 2024. First is implementing the duty for closed books, and then the first will be the annual board assessment.

Closed books is going to be particularly challenging, particularly for larger firms, because they're going to have a significant volume of products that will be on different IT platforms. Very often organisations have bought closed books, but they're still operating multiple different platforms, and across legacy brands. The difficulty, compared to open products, of getting the data, and particularly if they've got to reach out to customers to get it, is going to be really challenging. That means more operational issues for firms, and they're going to have to think about how they're going to address this before July.

The first annual board report, again, firms haven't just got to do the report, but they've got to do that they've done the robust challenge and review before the July deadline. They're going to have to build the time in to allow them to do that. The FCA wants to see firms adopt a future-focused and continual improvement mindset. Again, this will never be done. This is a principle that firms need to keep developing. So, reports need to include a clear action plan on how they're going to improve outcomes, and continue to involve the firm's compliance with the duty.

Tessa: Brilliant, thank you very much Isabelle. As well as the consumer duty and those upcoming deadlines, there's other initiatives, such as access to cash, which are going to continue to evolve this year. So more to come for firms as well.

Isabelle: You're right. In addition to consumer duty, we'll see the FCA publishing the findings of its review of the treatment of politically exposed persons, we'll see them finalising reviews around, as you said, reasonable access to cash, and actually a review of how firms treat vulnerable customers as well. \We've got all this coming in the next year.

Tessa: If we can turn, now, to the final driver of change which we mentioned earlier on, which is ESG, so quite a big topic to finish with. Gavin, it would be great to get your perspective, first of all, on the political positioning on this, and how that might be evolving? We had the latest COP meeting towards the end of last year, and we're starting to see some shifting political positions, as you alluded to earlier. What's your sense of where policy direction's headed on climate issues?

Gavin: That's a big question. I think, internationally, there is a growing consensus on the need for action, you saw that at COP, but governments are not going fast enough to keep 1.5 degrees of warming in sight. Politics are getting more difficult in most countries. There was a period where you, if you take the UK as an example, we had a kind of cross-party consensus around climate change, and that's beginning to fracture. You see that to a degree in the EU, as well. You see it in spades in the US. So what do I think is going to happen? I think, overall, the pace of movement towards net zero over the next ten years will accelerate, but it will be bumpy along the way. Let me break that down and explain why I think that. I think there are two key drivers. One is most governments and major companies are now committed to this, and the costs of the technologies are coming down. So that is an important driver. The other is that the impacts are getting more and more visible. Actually, the thing that I think a lot of people haven't clocked is that the impacts that we're seeing at the current degree of warming are worse than the models predicted they were going to be. I think what is going to happen is that, over the next ten years, more and more of us are going to see things happening around us that are clear evidence of climate change.

As that happens, voters will panic, and they'll demand their politicians go faster, but, and this is the beauty of politics, voters are allowed to be hypocrites. So when the politicians respond with things they don't like, they'll say, 'I didn't want you to do that though.' That's why you'll get bumps along the road. If you think about the row over the ULEZ expansion here in the UK, or you think about the row in Germany over boilers, or the Gilets Jaunes protests in France, I think they all paint a pretty consistent picture, which is that governments don't U-turn and give up on the whole thing, but they often have to ditch an unpopular policy and find a different way of achieving the overall aim. The final thing I would say is it's probably at its most difficult in the US. That's where the debate has become the most polarised, and I think it's particularly difficult for financial services firms in sectors that are regulated at a state level. If you're regulated at a federal level then, to a degree, you can ignore the political noise, and you can listen to what the administration is saying to you about what needs to happen, although there could be an administration later this year. At state level, you may well find blue states are demanding you do one thing and red states are demanding you do something else, and, 'If you don't comply, you're not going to have our business.' So, some businesses are finding that particularly difficult. I suspect the US will go on being an outlier in terms of the degree of polarisation about this issue.

Tessa: So a bumpy political trajectory, differences between different jurisdictions and different states, and also challenges around accurately predicting the model, and what's going to happen. That all sounds like quite a challenge for firms.

Isabelle: Yes, exactly. As Gavin has explained really well, this issue about divergence is a major challenge for financial services organisations. When you're looking at net zero, sustainable finance, and then looking across their lending book, about the impact of ESG, and the longer-term plans of how they're going to manage that, this divergence-, as Gavin said, down to the state level. Particularly if you're an asset manager, and you've got global strategies, it's very difficult to manage that. It's really challenging for financial services organisations. Where they've set strategies, and they've set plans, and they've already started to action them, to then find that, actually, they're getting pushed back, and it's causing them issues in terms of the delivery of their services in different territories, it's really hard to do. Nonetheless, we've got this wave of incoming ESG regulation, and again, we come back to this point about divergence, that we've got different standards, different regulations, different requirements coming at organisations. In the UK and elsewhere, we've got CSRD, from a European perspective, and then we'll have a UK version. We've got the ISSB standards.

On net zero transformation, the TPT framework is a real catalyst for FS firms to think about the role they can play in the transition to net zero, and how they can manage risks from that. That's a very positive thing, and a nice framework for organisations to start looking at. Many firms are considering how they meet both their stakeholder commitments and their regulatory requirements, and then how they align the ESG strategies with their business strategy. Really, there's a point where it just has to be embedded, it is part of the core business strategy. For insurers, climate disruption continues to be a concern, and Gavin was talking about-, we're seeing those implications of climate change. We can see a real time impact, actually, for insurers and on their business. That is likely to lead to changes for underwriting, for claims processing, and for pricing. Insurers are going to need to refine their risk assessment models to cope with yet more erratic climate events, and the increasing impact that those have on strategy and operations.

Gavin: That's really difficult. If you think about how insurance works, you look at past behaviour as a predictor of the future. What climate change is basically telling you is, 'Well, past behaviour is not a predictor of the future.' It's not easy.

Isabelle: Exactly, and that whole point about your pricing models, and then the impact, yes, just some of the claims we see, that weren't expected-, it's a challenging marketplace. The final thing I would say actually picks up on the S of ESG. We're going to see the FCA and the PRA publishing their policy statements on a regulatory framework for diversity and inclusion in the second half of this year. That is about fostering an inclusive environment, that's not just a moral obligation but it's actually a strategic necessity, and, actually, about how doing that is actually going to improve your businesses, and the business benefits you get from doing it.

Tessa: Thank you both. That's been such a fascinating discussion of what's clearly going to be a really packed agenda for the year ahead. If we think about the common themes that we've talked about, so divergence being one, that real uncertainty and challenge about predicting, and some of those new areas, so from diversity and inclusion to some of the new technology, such as AI, for a final thought to leave our listeners with, given all that we've talked about, what's the one issue that you think firms really need to put a bit higher up their strategic agenda this year? Isabelle, I'll come to you first.

Isabelle: For me it comes back to this point that we talked about at the beginning, which was about complexity. So for organisations to navigate through the next year, they need to get their houses in order. So, for me it's about productivity, and it's really about the broader aspects of productivity, about how, actually, looking at front to back processes, how you can make changes that will both make the customer experience better, it will make the process more efficient, and get cost out, but actually you'll also have a better control process, because you just take all that complexity out.

Tessa: Gavin?

Gavin: I'm a little bit biased, but for me I think, certainly for firms that are operating across more than one jurisdiction, it's understanding geopolitical risk, which is something that, probably, ten, fifteen years ago, firms didn't have to pay much attention to. I suppose the main thing that I would want to say to people is I don't think what you're experiencing at the moment is a blip, an unlucky accident that a few of these things have come at the same time. I think that is the way the world is now, and it's likely to remain that way for the foreseeable future, and therefore understanding this much more complex operating environment is critical to businesses' success.

Tessa: Thank you both so much. So much food for thought to leave our listeners with there, both about the challenges, but lots of opportunities as well. To our listeners, I really hope you've enjoyed this conversation as much as we have, and thank you very much for listening. As always, please subscribe to future episodes, and please rate and review this series as it helps other listeners to find us. If you'd like to hear more from us on risk and regulation, please look out for our regular publications on our website, and we'll link to that in the show notes. We'll be back next month with our next episode.