piecing the jigsaw: the future of financial...

Piecing the jigsaw: The future of financial services*Spring 2005

PricewaterhouseCoopers • Piecing the jigsaw: The future of financial services

IntroductionPiecing the jigsaw: The future of financial services

Crystal ball gazing is never a good start for developing an organisation’s strategy but a certain degree oflooking into the future to identify new trends is a must for companies who want to remain leading institutionsof tomorrow. Being able to track and understand the potential impact of current and future changes in ourenvironment is a key requisite to maintaining a competitive advantage.

At PricewaterhouseCoopers, as well as helping financial services organisations deal with the myriad of hereand now issues, we also look ahead to what the future may bring so that we can advise our clients on howbest to manage for change in a highly competitive environment.

Piecing the jigsaw is a paper focusing on the future of the financial services industry over the next threeyears and considers the drivers, risks and opportunities, as well as the impact and responses for existingand potential players in the industry.

The study identifies five principal drivers that will affect all financial institutions: Politics, Demographics,The Economic Cycle, Regulation and Reporting and Technology.

To support the development of this study we set up a number of expert communities within the globalnetwork of PricewaterhouseCoopers, covering the different financial services sectors and differentgeographies to consider the implications of the drivers on the industry. The findings were furthersupplemented by significant desk research, and we worked with the Economist Intelligence Unit to help pull all of the findings together into this report.

I am confident that you will find this paper insightful and if you would like to discuss any of the issues raisedin more detail please speak with your usual contact at PricewaterhouseCoopers.

Jeremy ScottChairman, Global Financial Services Leadership Team

Contents


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Executive summary 4

1. Demographics 14

2. The economic cycle 20

3. Politics 26

4. Regulation and reporting 34

5. Technology 38

Conclusion 44

Contacts 46

‘Understanding a customer’s needsand meeting them capably, in the longterm, is all that stands between usand some new form of competitor.’The quote, from the head of strategicplanning at an Australian bank, datesfrom 19961. The sentiment is anythingbut dated.

This report, on the drivers of changein the financial services industry overthe next two to four years, argues thatmany of the imperatives for successidentified in our original 1990sresearch have, if anything, becomemore salient with the passage of time. From the importance of trust to the need for life-cycle wealthmanagement, from the value oftechnology to the significance ofbranding, the blueprint for thecustomer-centric institution outlinedthen is largely valid today.

As institutions seek to achieve growthand improve the customer experiencewhile relentlessly managing thechallenges of costs and compliance,we believe that the shape of theindustry will change. Scale willbecome less important than a focuson core competencies. Institutionswill simplify their offerings andorganisations around the activitiesand markets in which they excel andexit the areas in which they don’t.

Distinctions between banks, insurers and asset managers willcome to mean less as organisationsincreasingly position themselves inniches that cut across sectors, from

a focus on information-processingservices to expertise in a set ofemerging markets, from the value of a proprietary branch network to the sophistication of in-house risk models. The financial servicesindustry of tomorrow will look like a jigsaw, with individual sectors,functions and institutions interlockingmore and overlapping less than theydo today.

This report identifies five principal forces –

1. Demographics

2. The economic cycle

3. Politics

4. Regulation and reporting

5. Technology

These will continue to affect allfinancial institutions over the comingyears. Some, such as regulatorychange, are already having asignificant impact on the industryand demand immediate attention.Arguably the most powerful force ofall affecting the industry – populationageing – will have huge and far-reaching consequences but doesnot yet require a revolutionaryresponse. But the successfulinstitutions of the future willunderstand, adapt to and exploit allof the following drivers of change.

Executive summary


1 Tomorrow’s Leading Retail Bank, Economist Intelligence Unit and PricewaterhouseCoopers, 1996.

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The greying of populations in the world’sdeveloped markets is set to strain publiclyfunded pensions and healthcare systemsto the limit. Policymakers in manycountries have so far been tentative, andoccasionally self-defeating, in grasping thenettle of pensions reform, but the need forindividuals to save more and to worklonger in order to provide for their ownretirement is inescapable.

As in other sectors, such trends willnaturally impact upon financial servicesproviders in their capacity as employers.Unlike most other sectors, the industry will focus primarily on the businessopportunities brought by populationageing. Inflows of retirement-related fundsinto capital markets will increaseappreciably over the next few years. For working-age savers, products offeringthe promise of faster capital growth thantraditional investment products will grow in popularity.

For workers who are close to retirementand for retirees themselves, stable andpredictable income is critical. In the US,Fidelity and Merrill Lynch have designedcash management accounts for retirees

that will pull in income not only frominvestments at the brokerage firms, butalso from monthly social security andpension benefits. As the share of elderly in the population rises, smart financialservices providers will also increasinglyfocus on wealth transfer-related productssuch as trusts, life insurance and annuities.

Population ageing is not just a developedworld phenomenon, of course, butemerging market demographics aredefined primarily by population growth andrising affluence. Forecasters predict thatdemand for financial services in China andIndia, the twin Asian behemoths, will beboosted by rapid rates of growth in GDP,personal disposable income and the stockof domestic savings. The continuinggrowth potential for consumer financeproducts in these emerging markets andothers is striking.

As more and more customers in developedand emerging markets come to use,depend on and directly manage financialproducts – either in areas where the stateused to be the main provider or in areaswhere institutional investors controlledinvestment decisions – the consumerculture will become increasingly powerful.Recent scandals involving financialinstitutions have made education andprotection of consumers of financialproducts a live political issue. At the sametime, customer loyalty is declining. Pricetransparency is increasing thanks toInternet-based information and serviceproviders, as is the ease with whichcustomers can switch accounts andproducts. Acquiring, retaining andsatisfying customers in this environmentwill become ever harder.

The industry response

• Many financial institutions will spend the rest of this decade positioning themselves to meetthe demand for long-term savings products and for life-cycle wealth management services.Those organisations that offer life-cycle wealth management services and predict changesin consumer preferences through the cycle will be most successful, at least in developedmarkets. Branding, product mix, customer service and performance metrics must allsupport the goal of building a long-lasting and multi-faceted relationship with the customer.

• All institutions must build a high-performance culture centred around the customer. Staffincentives linked to customer satisfaction and service levels will become more prevalent.Timely and insightful metrics on customer attitudes will become a greater priority.Successful institutions will think about the customer experience first and their internalprocesses second.

1. Demographics

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Following a heady 2004, when the worldeconomy recorded its fastest growth fortwo decades, the financial servicesindustry can expect leaner times over the medium term in developed markets.Economic forecasters expect the next fewyears to be characterised by a gradualdeceleration in output and demandgrowth, with the slowdown being mostmarked in the US. Japan’s mini-revival is widely forecast to lose momentum andthe performance of the euro zone is likelyto remain disappointing. A number ofdownside risks, from a dollar crash to a hard landing in China, could make theprognosis gloomier still.

Growth will still be relatively robust byhistoric standards but financial institutionswill have to overcome a number ofchallenges to make money over the next

few years. The pace of borrowing in manydeveloped markets will slow as worriesover debt levels continue to rise. Stockmarkets are not pricing in a significantincrease in corporate earnings in themedium term and investment yields arelikely to remain low. Competition anddisintermediation caused by the arrival ofnew entrants will further erode margins,particularly in the retail sector.

In their search for growth, expansion byfinancial institutions into new markets islikely. China and India catch most eyes,although other less-vaunted markets, such as the Middle East and Indonesia,may also come to the fore over the medium term. But the challenges ofsuccessful and sustainable entry intoemerging markets, from emergent

domestic competition to the regulatoryand compliance issues of operating inmultiple territories, will encourage mostinstitutions to adopt an incrementalapproach to geographic expansion.

On the product side, institutions will keeptheir eyes peeled for innovative sources ofrevenue. The continued rise in alternativeinvestments available to individuals –private equity, for instance, or structuredproducts offering guaranteed returns –will reflect the demands of a growing classof investor hungry for greater yields thanthose afforded by conventional investmentproducts. The pressure to innovate willagain be balanced by the need to offertransparent products that are both easy forconsumers to understand and acceptableto regulators.


• Rising competitive pressures will force institutions to differentiate themselves moreaggressively, whether through their product mix, their market focus, or their brandingproposition. Restructuring will focus on entrenching existing areas of strength, notdeveloping entirely new ones. Conglomerate strategies will wear less well thancompetency-led ones – even if managers are keen, shareholders won’t be.

• Cost-efficiency will remain key. Expect a further acceleration in the outsourcing of non-corefunctions and greater emphasis on performance improvement as institutions seek toincrease the efficiency of back-office processes. Expect compensation packages to bemore closely tied to performance too.


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The responsibilities and ethics of thefinancial services industry are alreadyunder close political scrutiny and there areseveral reasons to believe that the level ofscrutiny will intensify. Governments willlook to the private sector to help put theirpensions and healthcare systems on asustainable footing. The rising affluence ofconsumers in emerging markets will focuspolicymakers’ attention on the standardsof care that the industry applies ineducating and protecting its customers.

The industry’s buffeting in recent years atthe hands of politicians, regulators and,most visibly of all, Eliot Spitzer, New York’svigorous attorney-general, is likely tocontinue. Financial institutions must beproactive and forward-looking in theirresponse. Conformity with industrypractice is no defence againstinvestigation and censure.

Over the last two years much attention has been paid by regulators and otherstakeholders to transactions involvingwhat is termed ‘financial engineering’,comprising either accounting or taxationarbitrage or both. Whilst there is no agreeddefinition of what financial engineering is, it is clear that some financial engineering is now regarded by some stakeholders,and especially government institutions, as unacceptable. Until greater clarity in this area can be achieved between all thestakeholders involved, financial institutionswill need to ensure that transactions theyenter into or design for their customers areconsidered carefully in the light of the

views being expressed by regulators andother parties. It may be that some elementsof business will no longer be appropriate.

Other political forces will be at work overthe coming months and years. One will be continued geopolitical risk, much of itrelated to the so-called war on terror.Political risk will pose a direct threat to theassets, people and loan portfolios offinancial institutions in less stable parts ofthe world. It will also have a wider impacton the industry through high-profilepolitical initiatives to crack down onmoney-laundering activity – estimated bythe IMF to account for flows of moneyworth 24-25% of world economic output.

The tension between protectionist andliberalising sentiment within and acrosscountries will be another critical politicaldriver. The forces of competition will begiven freer rein within borders, whetherthrough industry deregulation in emergingmarkets, such as China and India, or

consolidation in developed markets suchas Japan, Germany and the US. A pick-upin M&A activity is likely to continue as aresult, particularly in banking, althoughacquisition strategies will tend to beincremental rather than transformative.Private equity firms will gain particularmomentum in regions where the scope foreconomic restructuring is greatest, such ascontinental Europe.

Constraints on cross-border liberalisationwill remain high, given stumbling progressin global trade negotiations, politicalsensitivities over foreign acquisitions andthe cultural barriers (not least in a nominallyunited Europe) to successful integration.Here too, however, the prevailing trend istowards greater openness – witness theweb of free-trade agreements undernegotiation in Asia and Latin America, the scheduled further expansion of the EU to include Romania and Bulgaria and(occasionally faltering) steps towardscapital-market integration in Europe.


• Organisations should expect their products, pricing and policies to be judged through theeyes of the customer. Leading institutions will solicit and act on customer feedback at allpoints of the business, from product launch to product sunsetting. The office of theombudsman will rise in importance within retail banks. The simplicity and transparency of products will be a key ingredient of success.

• As institutions continue to internationalise, whether through increased offshoring activity orexpansion into new markets, political risk will preoccupy the industry further. An informedview on developments in China and India, as well as neighbouring countries, will beessential to boardroom discussion. Executives from both of these countries will appear onglobal boards with increasing frequency.

3. Politics

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The people angle

Threading through the issues confronting the CEOs of financial institutions is theperennial challenge of managing people effectively and, more broadly, of ensuringthat the right talent is in the right place at the right time. According to a recent PwCsurvey of more than 1,300 CEOs across industry, over half believe that the loss ofkey talent is a major threat to future business success. The fight for skilled staff isn’thelped by forecasts that the number of jobs to be filled globally will grow by 14% in the next ten years, yet the global workforce is set to expand by just 8% in the same period.

People challenges manifest themselves in other ways too – from the pull ofemployees to work longer as a result of poor financial planning for retirement,through to the push of businesses to manage costs more effectively and therefore to seek alternative HR solutions, including offshoring, outsourcing and thedevelopment of shared service centres.

Paying greater attention to how institutions manage people is also key to how theymanage business risk. An effective control framework can only be achieved if acoherent management team is in place and if clearly defined reporting structures arein place throughout the organisation.

The reality of penetrating new markets, moving employees into more cost-effectivegeographical locations and new employment patterns (multiple careers, longercareers, continuous learning, remote working and the like) will require employers tothink in more imaginative ways about the following questions, among others:

• How to recruit talent – where will employees be based, at what stage of educationwill they be recruited, what will the competitors offer, and what will employees want?

• How to reward – with a more diverse workforce, and with a (potentially) longercareer, what is the appropriate reward mix at different stages of an economic cycle(from the company’s perspective) and at different stages in an individual’s career?

• How to manage performance – how do organisations recognise and reward goodperformance, and how is poor performance identified and dealt with?

• How to manage people and HR risks – what processes are in place to makeinformed decisions on people and HR risks, and how is the effectiveness of theseprocesses reviewed?

3. Politics continued

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Financial services firms in developedmarkets can expect a growing volume ofregulation – for starters, consider Basel II,IFRS, the USA Patriot Act, or the 42components of the EU’s Financial ServicesAction Plan (FSAP) exercise – and morerigour in applying them. The intensity of regulatory scrutiny will be milder in emerging markets, but here too the trend will be towards a heavier compliance burden.

New regulations bring new risks, mostdrastically closure and loss of income inthe event of a severe failure of compliance. Other risks include higher compliancecosts, potential loss of reputation fromnon-compliance, product offeringscramped by changing and uncertainregulatory frameworks, and potentiallymore volatile earnings resulting from fair-value accounting. Among other effects,these risks will have a dampening impacton the speed of M&A deals as would-bebuyers spend more time on due diligence.On the plus side, liberalisation will opennew markets, regulations will fuel new

businesses like environmental liabilitiesinsurance, and institutions with strongreputations for ethical behaviour mayderive competitive advantage as a result.

A tighter focus on capital management,through Basel II and the planned SolvencyII initiative, will encourage corporaterestructuring and disposal of non-coreactivities. The focus on governance will

foster enhanced risk management,improved management processes andmore risk-aware performance cultures.The introduction of International FinancialReporting Standards, which came intoeffect for Europe’s listed companies in2005, will further reinforce the trendtowards prudential capital and goodgovernance by ensuring greatertransparency around institutions’ finances.


• Institutions will either abandon low-return businesses altogether or seek to improvemargins through automation and process improvement. Greater visibility surrounding thetrue profitability of individual lines of business will hand more power to the ratings agencies, and to investors, to judge institutions’ real value. Product performance will be monitoredmore closely, leading to more frequent changes in pricing and guarantees.

• Enterprise-wide risk management systems will mature and proliferate. Management willreceive timelier, more accurate information on the performance of individual lines ofbusiness. Employees will be incentivised and assessed against measures of good governance.

• A truly global footprint entails a hugely complex compliance challenge. Ensuring thatmultiple regulatory requirements are met has the potential to worsen the customerexperience, but failing to meet these requirements has the potential to sink the business. For most institutions, international expansion will be focused on a few key markets.


New technology continues to deliver morecapability at lower cost. Improvements incompression technology, the spread ofconsumer broadband and the impendingshift to Internet Protocol (IP)communications networks will give the financial services industry theinfrastructure it needs to deliver on the promise of e-finance.

On World Bank estimates, e-financepenetration among Internet users willincrease from between 40% and 50% inmajor markets such as the US, Japan andthe UK in 2005 to 90% by 2010, withpenetration rates in emerging marketsrising from less than 20% in 2005 to 60%-70% by 2010. Institutions that do not offeran efficient multi-channel distributionstrategy will not be competitive.

In an environment of decreasing customerloyalty and increasing customersophistication, technology is both problemand solution. Electronic distribution willcontinue to enable easier pricecomparisons and changes of financialprovider. But technologies for enhancingCRM and improving customer experiencewill assume much greater importance as

financial services firms seek to build newcustomer relationships in fast-changingmass-market segments such as pension products.

Risk management has implications fortechnology strategy, too. The use ofpredictive models will continue to expandfast throughout the financial servicesindustry over the coming years, fromrefining insurers’ estimates of losses, toreducing card issuers’ acceptance of riskycustomers and honing the tradingstrategies of investment banks and hedge funds.

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• Upgrading technology to track risk exposure accurately and swiftly across the whole firmwill be crucial. Allocating capital to maximise returns relative to risks, real-time knowledgeof the firm’s total risk exposure, and an effective, transparent dialogue with regulators,rating agencies and the capital markets will represent the minimum standards for the well-governed financial services firm.

• CRM will move away from its conventional focus on assembling historical data on thecustomer towards anticipating how customer needs will evolve throughout the life cycle.Institutions will invest much more in predictive approaches to customer data. Downstream,technology will be used to mass-customise products, services and distribution.

• Security will be a significant differentiator for financial institutions. The reputational andoperational risks from breaches in security are growing, and franchises and brands cansuffer immense damage from unauthorised release of data, or leaks from their own or anoutsourced database.

5. Technology

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What do all these drivers add up to? The successful financial institution of thefuture will be characterised by a pervasivecustomer-centric culture and three broadhallmarks: a focus on its areas ofcompetitive advantage; adaptation toforces of fragmentation; and theflexibility to exploit new opportunities.

Focus does not mean the end ofconvergence or consolidation. Instead of seeking to dominate in every segmentand territory in which they operate, manyinstitutions will temper their ambitions,looking to expand regionally instead ofglobally or focusing on particular customersegments. Size will still be important tomany institutions, not least as a means ofdeterring potential predators, but there willbe an emphasis on simplification, both ofprocesses and platforms inside theorganisation and of the service offering tothe customer. The upshot will be the rise ofcompetency-led enterprises, institutionsthat develop and excel in particular areas.

Fragmentation is the natural corollary ofthis competency-led approach. Ratherthan seeking to build a broad footprintacross all markets and sectors, institutions

will outsource more functions andprocesses, decentralise distribution andsell off more businesses that are not corecompetencies. There will be plenty ofacquisition activity but of a highly targetedvariety. Sellers will dismantle and divestnon-core or underperforming parts of theirbusiness; buyers will acquire businessesthat fit neatly with their focus and can beintegrated quickly. Following the paths setby many other industries, the managementof alliances, suppliers and distributors willbecome a critical skill as organisationsdefine their areas of expertise more tightlyand co-operate more closely with others todeliver value to the end-customer.

As well as honing their strengths,tomorrow’s leading institutions will alsohave the flexibility to seize opportunities.In recent years, many organisations haveperformed well because the economy andthe markets have performed well, buoyingconsumer debt and inflating investmentfees. Flatter markets, heavier regulationand fiercer competition mean thatinstitutions will have to think laterally andmove nimbly to define and defend marketniches. From pensions to structuredproducts, from China to India, there are

plenty of areas of high potential. But seizing them will take greaterentrepreneurialism than institutions have been prone to show in the past.

Not all of these forces are in perfectalignment. Flexible organisations will bepulled towards non-traditional revenueopportunities that may not fit their currentfocus. Nevertheless, the organisations that can balance these imperatives bestwill be the most successful. Those thatcannot – the institutions that attempt to doeverything and the ones that fail to evolveat all – are headed for failure.

The institution of the future

There is no single, pre-determined route tosuccess over the coming years. An insurerin China will face different challenges andadopt differing solutions from an assetmanager in the United States. Yet as theleaders of today’s financial institutionsthink about the shape of tomorrow’sleading players, their strategies shouldembrace five key principles:

1 Identify and articulate what yourinstitution does best. Conglomeratestrategies will lose their remaining lustre. A well-defined corporate identity, in theminds of customers, investors, regulatorsand staff, will be critical. That identity mightbe founded on traditional differentiators,such as particular customer segments orchosen markets. Or it might reflect lessconventional ones, such as the distinctionbetween distribution and manufacturing,differences in levels of risk appetite or skillsin information processing. Whatever aninstitution’s core activity, it should be at theheart of its strategy.

2 Simplify the offering to customers ...Whatever its core activity, trust will be an organisation’s most precious asset.Fiercer regulatory scrutiny and a wideningconsumer base means that complexity is out and simplicity is in. Products should be transparent and easy to understand; risks should be clearly defined and explicitlyunderstood; and product performanceshould be reported on regularly andobjectively. The interface with the customershould be designed to be user-friendly above all else. Customer satisfaction metrics will sit at the heart of managementdecision-making processes.

Five action points for the CEO

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3 … and simplify the enterprise itself.As an institution’s corporate identity and product offering simplify, so will theorganisation itself. Technology platformsshould be consolidated and integrated, aided by continued outsourcing to third-party providers. Risks should be assessedand managed on an enterprise-wide basis.Performance data should give a panoramicview of the institution. Cost efficiencies will arise as a result. More importantly, silos will fade and teams will collaboratemore effectively across the organisation.There will be little room for hierarchies,whether based on products or functions, in tomorrow’s leading institution.

4 Hone market positioning in line withdemographic trends. Whether seeking to take advantage of the growth potential of the emergent middle class in developingmarkets, or targeting fast-expanding sub-populations within countries throughethnic products and services, or pursuinglife-cycle strategies aimed at tomorrow’spensioners, successful institutions will put demographic trends at the heart of their business plans. To drive growtheffectively, institutions should identify a core of high-potential customers and build their offering accordingly.

5 Don’t forget the most importantingredient – people. The industry landscapemay change but the importance of people is permanent. No institution can thrivewithout high-quality employees at all levels of the organisation. What is changeable is the skills base of those employees. The next few years will see two pronouncedand convergent trends in employeecapabilities – towards better data analysisand towards enhanced customer-facingskills. We believe that institutions shouldthink very carefully before outsourcing theircustomer-contact activities.

• The greying of populations in the world’s developed markets will thrust the burden of pensions and healthcare provision increasingly onto theprivate sector;

• The rising affluence of customers in the developing world will stimulatedemand for financial products;

• Migration patterns and growth rates of ethnic minorities within populationswill encourage the development of products and services aimed at particularethnic and religious groups; and

• These factors will reinforce the power of the consumer and the need forfinancial services institutions to concentrate more of their energy oncustomer service and branding.

1. Demographics


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The tectonic plates of demography shiftslowly. The trends we describe in thischapter are largely long-term in nature:their most dramatic effects lie beyond the two to four year time horizon of thisreport. But they will have a considerableimpact over the shorter term too: on policy,on savings behaviour and on the industry’soffering, as governments, individuals andfinancial institutions face up to the prospectof older populations and longer retirements.

The problem of population ageing is notrestricted to the developed world, but it isfar more acute there. Today in the developedworld, 15% of the population is elderly (65and above). By 2030, according to UNprojections, the share will be closing in on25% and by 2050, it will be approaching30%. What’s more, the elderly themselvesare getting older. The number of peopleaged 80 years and over is increasing at nearly twice the rate of that of those over 65.

Some countries and regions are in bettershape than others. According to IMFestimates, the dependency ratio – the ratioof working-age adults (aged 15 to 64) toelderly – will fall by 2050 to 1.5 to 1 inJapan, to 1.4 to 1 in France, and to 1.2 to 1in Germany. In at least one country, Italy, it may sink beneath 1 to 1, meaning thatmore people will be collecting benefitsthan paying taxes. The United States,

by contrast, is blessed with a relativelyhigh fertility rate, although it too mustabsorb the imminent shock of theretirement of the baby boomer generation.

The potential fiscal impact of populationageing is enormous, as governments areforced to spend more on pensions, healthcare, and long-term residential care.Policymakers in many countries havestarted to edge nervously towards pensionand healthcare reform and a greater role forthe private sector and personal provision inboth areas, as they seek to keep costsunder control, but progress has often beenlimited, and occasionally self-defeating.

In Germany and France, for example, the pension reforms of 2001 and 2003respectively are designed to scale backpay-as-you-go benefits promises andexpand access to funded privatealternatives. However, much more willneed to be done to increase the labour-force participation rate, raise retirementages and grow privately funded pensionsfrom where they stand today.

That will mean more emphasis onoccupational pensions, althoughcompanies will continue to shift fromdefined-benefit schemes to defined-contribution schemes to reduce their ownliabilities. But more fundamentally, it willmean that individuals in developed

markets will be expected to take moreresponsibility for their retirement, by savingmore and by taking greater control ofinvestment allocation.

Changing individuals’ mindsets will taketime, of course. In the UK, often held up asone of the most advanced countries interms of pensions reform, the total assetsof private pension funds were equivalent to an estimated 90% of GDP in 2003, the third highest proportion in the worldafter the Netherlands and Switzerland. But the national savings rate remains low,and hasn’t been helped by the withdrawalof tax credits on tax-exempt savingsvehicles and government plans to taxprivate pensions pots that breach athreshold of £1.5m ($2.7m).

In the United States, most workers havesaved little for retirement. According to arecent Employee Benefit ResearchInstitute survey, only 21% of householdshave accumulated more than US$100,000in retirement savings and 35% say theyhave accumulated nothing at all.

But the latter percentage will start to dropin the coming years and many financialservices providers are already workinghard to position themselves to takeadvantage of the expanding retiree market.In the US, Fidelity and Merrill Lynch havedesigned cash management accounts for

Population ageing, pensions and healthcare

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retirees that will pull in income not onlyfrom investments at the brokerage firms,but also from monthly social security andpension benefits.

How will older populations and greaterprivate pension funding affect investmentstrategies? Changes in savings behaviourwill take time to emerge, of course, butsome clues are already to hand from theUS, where the baby boomer generation is approaching retirement. A 2003 surveyof affluent baby boomers2 found that 43%of respondents – compared with only 26%in 1993 – said that their single greatesteconomic concern was having adequateresources in retirement. The usage ofindividual retirement accounts (IRAs)among this group as a primary investmentvehicle had risen strongly (up to 40% in2003 from 17% in 1993), while reliance onmoney market accounts went down to14% from 23% in 1993. Mutual funds andlife insurance products are also significantvehicles, reinforcing the view that the flowof retirement-related funds into capitalmarkets will increase appreciably over thenext few years.

In tandem, alternative investments are setto rise in importance as increasing numbersof long-term savers seek to diversify theirportfolios and realise higher returns thanconventional investment products. Amongthe other likely beneficiaries will be property,whose cycle tends to lag the economiccycle, so that its correlation with the equitymarkets is relatively low. Hedge funds andprivate equity will move into a new, moremature phase over the next two to fouryears. Many hedge funds will strugglewhile markets remain listless, as regulators

scrutinise them more closely and as greaterinflows of capital hamper their agility, but those that survive will move further intothe mainstream of investment thinking.Similarly, a report by Goldman Sachs andRussell Investment Group indicated thatthe strategic allocation of private equityinvestments in 2003 was 3.6% of a pensionfund’s total assets in the UK and 4.2% incontinental Europe. Both proportions areset to rise in the coming years as privateequity activity gathers momentum.

Investment patterns change later in life, of course: research suggests that peoplebecome likelier to reduce their exposure to risk as they get closer to, and enter,retirement, when consumption becomesmore important than saving (see box). The pressure on financial servicesinstitutions to provide products withguaranteed returns will rise as a result,although the risks in this area will need tobe carefully managed. Increasing longevityis putting pressure on pension funds thatoffered guaranteed pay-outs to retireesbased on unrealistic forecasts ofinvestment returns and mortality rates. In some countries, this has given rise to accusations of mis-selling or ofinappropriate investment advice, resultingin legal action and the requirement to paycompensation that has pushed someinstitutions into insolvency.

Later still in retirement, wealth transferrises up the financial agenda, as thoughtsmove to bequests and inheritances.According to a report from CerulliAssociates, a research firm, more thanUS$20trn will move from US babyboomers to their heirs and to charities

between 2001 and 2046, if the estate taxexpires as planned in 2010. As the share of elderly in the population rises, smartfinancial services providers willincreasingly focus on wealth transfer-related products such as trusts, lifeinsurance and annuities.

As for changes to healthcare provision, thedemographic shift is likely to signal bothgreater customer interest in long-term careinsurance and a realignment of pricing for acustomer base that will be increasingly oldand increasingly susceptible to medicalintervention. The debate over the ethics ofpredictive genetic testing as the basis forinsurance pricing and cover will also heatup as technology advances in this area.

One of the primary solutions to populationageing is to grow the working-agepopulation through increased levels ofimmigration. Although this area will remainpolitically inflammatory for the foreseeablefuture, managed inflows of working-age

2 AXA Nest Egg Study, a 2003 poll of 701 US baby boomers born from 1946 to 1964, with annual household incomes of $75,000 and above.

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people are an obvious response toincreased dependency ratios. That willreinforce an existing trend of risinginternational migration, largely fuelled by cheaper, easier travel between thedeveloped and developing worlds. UNprojections for net migration from 2000 to 2050 put the USA (1.1m annual netmigrants), Germany (211,000), Canada(173,000), the UK (136,000) and Australia(83,000) as the biggest net gainers. China, Mexico, India, the Philippines andIndonesia will be the biggest net exportersof people.

As the size of the ethnic minorities withincountries’ borders grows, aided in somecases by higher fertility rates, theeconomic case for financial servicesinstitutions to create products aimed at those groups will also strengthen. The population of Hispanics in the US, for example, reached 39.9m in July 2003, a phenomenal growth rate of 13% over theprevious three years. Over the same period,the number of US residents who reportedbeing Asian grew by 12.5% to 13.5m.

In the UK, the size of the local Islamicpopulation has already persuaded HSBCto issue the country’s first occupationalpension fund compatible with Islamic law.The HSBC Life Amanah Pension Fundavoids shares in certain industries,including production or distribution ofalcohol, pork products, tobacco andconventional financial services. Otherproducts, such as Islamic mortgages,Islamic life insurance and Islamic bonds,are also growing fast in Europe and the US.

Source: IMF World Economic Outlook, September 2004

The longer view: Asset meltdown in 2030?

As the burden of providing for pensions and healthcare switches away from the state and towards the individual, the incentives for people of working age to save will increase.But what will happen when today’s workforce becomes tomorrow’s elderly? Some haveargued that an increase in retirement-related investments over the medium term will giveway over the longer term to an asset meltdown as retirees withdraw and consume theircapital and sell their stocks to a smaller pool of buyers, forcing stock prices to fall.

A review of the literature on this topic in the IMF’s September 2004 World EconomicOutlook finds the theory has some substance. Real post-war stock prices in the UnitedStates have been positively associated with the relative size of the population to be agedbetween 40 and 64 years of age, when demand for stocks and other financial assets is atits peak. As the number of people in this age group shrinks, runs the argument, so stockprices will decline.

A note of caution is in order, however. The period over which the relationship betweenshare prices and demographics has been observed is comparatively short. Changes inpolicy, such as raising the retirement age or encouraging greater participation ratesamong women, have the potential to ease the imbalance between the working-age andpensioner populations. Economic theory would also suggest a higher premium forholding equities in old age, when the risks associated with a downturn in stock prices anderosion of savings is greater. There may well be pressure on equity prices when the retireepopulation expands, in other words, but the rewards for the braver older investor couldbe higher.

1800

1500

1200

900

600

300

0

60 Demographic and real stock prices

Real stock price

Populationaged 40-64

Population Real stock price

55

50

45

40

30

35

251910 25 40 55 70 85 2000 15 30 50

Demographic change and equity markets

18


While the developed world confronts theproblems of population ageing, emergingmarket demographics are defined primarilyby population growth and rising affluence.China and India dominate attention by dintof their sheer size.

China has a population of 1.3bn and theoverall market size of the economy is likelyto exceed US$2.3trn (at market exchangerates) by 2009. Although GDP per head willremain low, at US$1,790 in 2009, that stillrepresents a significant improvementcompared with US$1,120 in 2003.

Demand for financial services in China willbe boosted both by rapid overall rates ofGDP growth and by even faster growth inthe stock of domestic savings, as reformsaimed at improving the efficiency of theeconomy reduce job security and raise thecost of welfare provision, and as China toowrestles with the long-term challenges ofpopulation ageing. The growing stock ofsavings will increase demand for a greatervariety of investment vehicles in addition tothe plain-vanilla bank deposit accountsthat have traditionally formed the home formost of China’s household wealth.

China’s insurance market will beparticularly dynamic. Recent research fromSwiss Re forecast that non-life insurancepremiums collected in emerging markets

are expected to double from US$123bn in 2003 to around US$250bn by 2014, at constant prices. Life premiums willincrease even faster, from US$188bn toUS$450bn over the same period.

India remains, as a whole, a very poorcountry – GDP per head is little more thanUS$600 a year – and financial activity iscorrespondingly undeveloped. Lending as a percentage of GDP totalled just60.3% in 2004, compared with more than170% in China. Yet this low base suggestsroom for strong growth as the economyaccelerates. According to the EconomistIntelligence Unit, personal disposableincome will grow at an average annual rateof almost 15% in 2005-09.

India and China are not the only populousemerging markets worth watching.Indonesia may finally start to fulfil itspotential under its newly elected president.Brazilian income levels are set to recovergradually after precipitous falls earlier inthe decade. Memories of Russia’s 1998financial crisis have proved short: Russia istipped by the Economist Intelligence Unitto suck in significant amounts of ForeignDirect Investment (FDI) over the course ofthe next five years. In each of these markets,and others beyond, rising wealth levelsand relatively low penetration rates spellpotential for financial services providers.

The emerging affluent of the developing world

Personal disposable income (US$bn)

Country 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Brazil 332 283 257 289 360 440 461 488 525 558

China 568 626 701 782 858 937 1029 1133 1241 1,357

India 333 333 358 431 530 645 746 836 921 1,011

Indonesia 99 94 116 129 133 142 150 165 178 192

Russian Federation 136 170 201 263 332 403 462 512 577 628

Source: Economist Intelligence Unit

19


In both developed and emerging markets,these demographic trends will reinforceanother critical theme of the next two to fouryears: a more robust consumer culture. Thedevelopment of this culture will be drivenby a number of interconnected factors:

• More people in more countries willcome to depend on more financialproducts to realise their goals at allstages of their lives. As the stategradually reduces its role in areas such as pensions and healthcare in developed markets, and as morepeople in emerging markets are givenaccess to credit, customers will wieldgreater choice in how they run their finances.

• Broad trends of deregulation andmoderating economic growth willincrease competition to acquire andretain customers. As standard retailproducts commoditise, a recentPricewaterhouseCoopers survey shows that financial services providersincreasingly differentiate themselves

by the quality of their customer serviceand the power of their brand. It followsthat institutions will need to focus moreof their efforts on recruiting, retainingand incentivising their front-office staff.

• Customer loyalty is declining. Pricetransparency is increasing thanks toInternet-based information and serviceproviders, as is the ease with whichcustomers can switch accounts and products.

• Consumer protection concerns aretrending upwards, as new customerscome online among the lower socialclasses in developed markets and the emergent middle classes indeveloping markets. Recent scandalsinvolving financial institutions havemade education and protection ofconsumers of financial products a livepolitical issue.

• Rising privacy concerns, driven by the increasing popularity of electronicdistribution channels and the data

storage requirements of enhanced riskmanagement systems, will furtherreinforce this trend towards greaterprotection of consumer rights.

What does this strengthening consumerculture mean for financial servicesinstitutions? Two things, at least. One is an increased focus on building a high-performance culture centred around the customer. That will mean balancing a continued focus on cost savings, as providers seek to remain competitive on price, against the need to provide top-quality service. Incentives for staff that areexplicitly linked to customer satisfactionand service levels are likely to becomemore prevalent. Timely and insightfulmetrics on customer attitudes will becomea greater priority. These imperatives willapply to outsourcing service providers aswell as the financial institutions themselves,as third parties continue to take on morecomplex and valuable processes.

The second consequence of the risingpower of consumers will be the growingimportance of branding, an area where the industry arguably falls down bycomparison with others. Recent researchby NOP World in the UK found that thefinancial services industry suffers fromrelatively low levels of advocacy, theprocess whereby customers advocateparticular products and influence others to use them. Changing this will be hard,say marketers – unlike cars and mobilephones, few people see the details of their financial products as a fun topic of conversation or as adding lustre to their public persona. But being able to command a brand premium in amarketplace where competitive pressuresare rising and where differences in productofferings are often imperceptible, will be agoal for many over the next few years.

The rising power of the consumer

Source: PricewaterhouseCoopers/Economist Intelligence Unit Survey – November 2004 ‘From aspiration to achievement:Improving performance in the financial services industry’

Transactions and processing

Compliance

Sales, branding and marketing

Customer service

Product development

Human resources

Quality performance of actual products and services

IT management

Finance and accounting

Procurement

Risk management

Speed and quality of management decision-making

Other, please specify

24.18% (44)

8.97% (16)

46.7% (85)

49.45% (90)

28.02% (51)

12.64% (23)

37.91% (69)

9.89% (18)

8.79% (16)

1.1% (2)

24.18% (44)

15.38% (28)

3.85% (7)

0 20 40 60 80 100%

Which areas of your business are the key sources of competitive advantagefor your organisation in the marketplace? Please choose up to three areas.

• The financial services industry can expect leaner times over the mediumterm as the world economy’s growth rate slows;

• Tougher competition and squeezed profitability will encourage focus onalternative investment products and new geographical markets as sourcesof growth;

• Cost efficiency will be a priority, leading to an acceleration in levels ofoutsourcing and offshoring;

• Disintermediation by new entrants will pose a particular threat in the morecommoditised retail market; and

• Continued capital shortages will restrict insurers’ freedom of movement.



21


The world economy grew in real terms by 5.1% in 2004 (at purchasing powerexchange rates), the fastest pace ofgrowth for more than 20 years. That headyrate of expansion is not expected to last.On Economist Intelligence Unit forecasts,global economic growth will fall to 4.2% in 2005 and dip further thereafter.

Importantly, this projected slowdown doesnot represent a poor global economicperformance in absolute terms – the rate ofgrowth expected in 2005 and 2006 is robustin comparison with the rate achieved duringmuch of the 1990s. But after several yearswhen the global economy has improved,the next few years are likely to becharacterised by a gradual deceleration in output and demand growth.

The softening is expected to be marked inthe US, with growth falling from 2004’s

cyclical peak of 4.4% growth. High levelsof debt are likely to weigh on consumers as interest rates rise. The ending of taxincentives for business investment will eat into capital expenditure. High oil priceswill also take their toll. Consequently, weexpect the pace of economic expansionduring 2005 and 2006 to be considerablymore modest than this year.

Japan’s mini-revival is forecast to fade asthe export stimulus fades. World importdemand is now moderating, as the US andChina slow, and Japanese exporters willincreasingly find it difficult to maintain therecent strong growth in sales volumesduring 2005 and 2006.

The picture in the euro zone is somewhatbrighter, but performance will remaindisappointing. The appreciation of the euroover the past two years, coupled with a

slowdown in global import demand,suggests that trade will become less of a growth driver over the next two years.Moreover, although consumer demand willimprove, consumers are likely to remaincautious in the face of rising pension andhealthcare costs.

Emerging markets will continue to be thesource of the most dynamic growth in theglobal economy, but they too face tougherconditions. Rising US interest rates arereducing international liquidity, puttingpressure on emerging economies thathave large financing needs. The financingsituation for emerging-market economieshas been unusually favourable over the pasttwo years, as real negative interest rateshave encouraged investors to seek outinvestments in overseas markets. Ascapital flows back to developed markets,weaknesses could emerge in some markets.

The world economy: Moderating growth

World summary

(%) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Real GDP growthWorlda 4.6 2.3 2.8 3.9 5.1 4.2 3.9 4.1 4.1 4.2

Regional growth summary

North America 3.8 0.8 2.0 3.0 4.4 3.3 2.9 3.0 3.0 3.0

Western Europe 3.9 1.7 1.3 1.2 2.5 2.0 2.1 2.3 2.3 2.3

Transition economies 7.0 4.2 3.8 5.9 6.6 5.5 5.0 4.6 4.4 4.4

Asia & Australasia 4.2 1.8 2.6 3.7 4.7 3.4 3.4 3.5 3.9 3.9

Latin America 3.7 0.3 -0.5 2.0 5.8 4.0 3.6 3.3 3.6 3.6

Middle East & North Africa 5.2 2.0 2.0 4.4 5.5 4.9 4.6 4.3 4.2 4.2

Sub-Saharan Africa 4.5 3.3 3.6 5.0 3.9 4.0 4.0 3.8 3.8 3.6

a At purchasing power parity.


22


The worry is that this picture of slower butstill healthy growth could prove too rosy. A Chinese slowdown, further upwardpressure on oil prices, a fall in house pricesas interest rates rise – all of theseeventualities could alter the trajectory of the global economy for the worse. More menacing still is the risk that thecurrent decline in the US dollar could turninto a headlong slide. If investors holdingUS dollar assets (including foreign centralbanks) decide to reduce their holdings of the depreciating currency significantly,the dollar could crash. This would havesignificant negative implications both forthe US economy, sending interest ratessharply higher and choking off domesticdemand growth, and for the globaleconomy, which will be deprived of its most important growth engine of recent years.

China: The new engine of the world economy?

China’s economic boom of the last few years has played a significant role in drivingforward not just the Asian economic recovery but also a global recovery. Soaringdomestic demand has fuelled strong import growth, lifting sales from exporting countriesworldwide. Global commodity prices have, until recently, been driven up, boosting exportearnings for commodity producers, and foreign multinationals have been able to increasesales and profits in one of the world’s fastest-growing markets.

Financial services institutions are just as smitten by China’s potential as other sectors.Take China’s life insurance sector. Swiss Re estimates that total life premiums in Chinagrew at an average annual rate of 32% in 1998-2003, reaching US$32bn in 2003 andranking second behind South Korea among emerging life insurance markets. Foreign lifeventures in China have just 2% of the market at the moment, but growth prospects aresignificant, especially as restrictions on these ventures loosen.

But there are growing risks associated with the current Chinese economic expansion.The country has experienced an investment bubble in some sectors and, although creditcreation and investment have slowed recently, anecdotal evidence continues to mount ofexcess capacity build-up in some industries, including consumer durables and property.This has raised concerns that recent investment by domestic and foreign firms mayultimately prove unprofitable.

The government continues to enact policies aimed at slowing credit and investmentgrowth and allowing the bubble to deflate gently, and these policies may yet besuccessful. But success cannot be guaranteed – China is not a market economy andslowing demand in runaway sectors may prove difficult. If investment resumes its rapidgrowth and spare capacity in key sectors continues to rise, there is a danger of a furtherbuild-up of bad loans and an economic slowdown in future years as companies retrench.Equally, there is a risk that Chinese policy action proves too effective, stalling economicgrowth. In either case, this would be damaging, not just for businesses operating in China,but also for companies with operations in the rest of Asia or other regions around the worldthat have come to rely on robust Chinese demand growth as a source of revenue growth.

23


Moderating economic growth will increasecompetitive pressures on financialservices, of course. Gains in profitability at major financial services companies in2003-04 – which have taken return onequity at the largest international banks to20% or more, and at the largest insurancecompanies to the high teens – are nowpeaking. Maximising shareholder value inthe next, slower stage of the economiccycle will require closer scrutiny of themost efficient use of capital.

These pressures are global and will broadenthe trend for outsourcing and offshoringbeyond the US, Europe and Japan. SouthKorea is one of the latest countries to haveto consider the sensitivities of letting back-office processing go offshore. Serviceproviders will feel the heat of increasedcompetition, too: at the moment, India isreckoned to account for about 80% of thelow-cost offshore market but rivals,especially from China and Eastern Europe,are lining up to challenge India foroutsourcing and offshoring business.

Bubbling emerging markets will continueto attract cross-border investment, asinstitutions seek expansion into faster-growing areas of the industry. China’spotential is widely appreciated (see box),but India’s banking market will alsobecome an important focus for growth.

So, assuming greater political andeconomic stability, might less obviousmarkets. In the Middle East, for example,oil exporters will continue to benefit fromhigh oil prices (although prices will declineover the coming years, they will remainhigh compared to their long-term average),and a slew of major oil and non-oil projectswill need financing.

In Indonesia, too, the easing of politicaluncertainty following the 2004 election ofSusilo Bambang Yudhoyono as presidenthas improved confidence in both theconsumer and business sectors. Interestrates and inflation will fall, and thegovernment is expected to offer tax andother incentives to encourage investment.The continued sale of state assets,liberalisation in the utility sectors andreform of the mining laws will provideadditional incentives to both domestic andforeign investors.

Expansion by financial institutions into newproduct areas is also likely. Newopportunities in wealth management arisefrom increased demand for productsanswering two needs: more activemanagement in an era of lower overallreturns, and products that help to managewealth over the consumer’s life cycle. In thecapital markets, equity valuations remainhigh in historic terms and there appears to be little risk of further bubbles in the next two to four years. With slower growthin the tail end of this cycle in prospect,stock markets are not anticipating asignificant increase in corporate earningsin the medium term. The rise in alternativeinvestments available to individuals –hedge funds, private equity, and structuredproducts offering guaranteed returns – will reflect disillusionment with conventionalinvestment products on the part of many investors.

Despite pressure for growth, however,financial services companies are unlikelyto be distracted by visionary conglomeratestrategies. Banks will be interested inselected life assurance or assetmanagement acquisitions to give themenhanced capability in long-term savings

products. But there will be little incentive to buy wholesale into the capital problemsof the insurance sector or the growthproblems of conventional assetmanagement companies. Conversely,insurance companies will not have easyaccess to the capital markets for strategiesother than strengthening their existingbusiness – as the UK’s Prudential foundwhen it went to the market for a £1bn(US$1.8bn) rights issue in the fourthquarter of 2004.

Institutions will look to executerestructuring strategies incrementally,undertaking purchases and divestmentsonly if they fit neatly into a coherentstrategy and forming greater numbers of alliances and joint ventures. Instead of seeking to dominate in every segmentand territory in which they operate, manyinstitutions will temper their ambitions,looking to expand regionally instead ofglobally, or focusing on particular financialproducts and services. As a result, therewill be emphasis on what might be termedcompetency-led enterprises, institutionsthat develop and excel in particular areas.

Even for the leading international players, it will be successful execution and growthin specific product areas that will enablefurther consolidation. The bancassuranceleaders in Italy and Spain, successfulconsolidators of their domestic lifeinsurance markets, are the naturalpredators for life insurance assetselsewhere in Europe. It was BSCH’s strongdomestic growth record that allowed it tobe the unchallenged bidder for Abbey inEurope’s largest financial services cross-border consolidation.

The search for new sources of growth

As competitive pressures increase,disintermediation and disaggregation ofparts of the value chain will challengeintegrated companies in all financialservices sectors. In each case, thecrumbling of old structures opens upopportunities for expansion or for newentrants. Every product innovation orpotential cost saving holds out thepotential for wresting part of the valuechain away from an incumbent provider.

In asset management, for example, parts of the core business are beingdisintermediated by alternativeinvestments, while the administrationcomponent of the value chain is beingwidely outsourced. Investment banks facethe risk of Internet-based IPO auctions –first tried on a major scale with the GoogleIPO – disintermediating the highlyprofitable book-building process in IPOs,while M&A fees are coming under pressurefrom in-house corporate finance teams.

Retail banking is especially vulnerable to e-finance business models for deliveringcommodity products. In just eight monthsfrom start-up in the UK in May 2003, ING

Direct, the ING Group’s low-costdistribution channel for developedmarkets, signed up 305,000 customerswith €11.5bn of deposits. In Germany,Volkswagen Bank allied with the nationalcar club ADAC in March 2004 to financeprivate sales of used cars, targetingreceivables of €1.2bn within five years,making Volkswagen one of the fastestgrowing banks in Germany.

Life insurance companies in Europe willalso have to compete against new entrantsseeking access to the impending massmarket for savings products as consumersprovide for their own pensions. Growth ofproperty and casualty insurancecompanies is at risk from the continuingrise of self-insurance, captives and risk-retention groups. Increasing insurancerates since the end of 2001, and lack ofcapacity in areas such as workers’compensation and medical malpractice,have accelerated the use of alternativerisk-transfer mechanisms at the expenseof insurance companies.

24


The threat of the new

25


Even more threatening to the insuranceindustry are serious capital shortages inparts of Europe and Japan. In the UK,Germany and Switzerland, the recovery in equity valuations since early 2003 hasaverted a crisis that originated with a toxiccombination of over-reliance on equityinvestments by insurers – particularly in theUK, generally ranging from 30% to 40% ofassets – and a commitment to guaranteedpay-outs that could not be met once thebull market ended. But it has not resolvedthe capital shortage. In the UK, the FSA ispushing for higher capital reserves againstwith-profits policies, and similar worriesabout under-capitalisation will be repeatedelsewhere in Europe as the industryprepares for the introduction of the newSolvency II regime in the next three to fouryears. In Japan, the mutual life insurancecompanies, still seriously short of capital,will continue to make gradual progressoverhauling their capital structures, costbase and product range.

Banks are in a very different position. Major banks in the US and Europe wereunscathed by the turn of the interest cyclein 2003, with much of their credit risk laidoff on the insurance sector. Two years of steeply rising profits have left capitalratios strong ahead of Basel II. New

weaknesses will emerge in Japan andChina, however. The IMF is pointing to theweak capitalisation of Japanese regionalbanks, with 44% of the country’s non-performing loans, as an area of heightenedrisk as deposit insurance is cut back in2005. And while China has recapitalisedtwo of its largest banks, much of the rest of the banking sector is short of the capitalit will need against loans to ailing state-owned enterprises.

Opportunities can crop up wherecompanies benefit from their competitors’shortage of capital, of course, or wheresurplus capital becomes available fromchanging regulation. More stronglycapitalised reinsurers will continue tobenefit from capacity constraints ofprimary underwriters. Bancassuranceplayers in Europe stand to gain from moresparing use of capital for retail operationsunder Basel II.

Moreover, growing private equity funds will be a source of innovative and flexiblefinance to the industry. Two deals in thefourth quarter of 2004 illustrate this trend.In Japan, Nikko Asset Management, with $65bn under management, sold acombined 38% shareholding to a group of private equity investors, as part of a

strategy of putting its asset managementbusiness at arms’ length from the parentcompany. Warburg Pincus, Government of Singapore Investment Corporation andNikko Principal Investments each gained a 12.5% holding in Japan’s fourth largestasset manager.

In another innovative deal, Apax, a privateequity firm, provided equity alongsidemanagement for the start-up of PictureFinancial Group, an ambitious UKconsumer finance start-up specialising in flexible secured loans sold throughbrokers, with £500m in credit lines fromMerrill Lynch. Private equity funds havebeen major investors in financial services.They will play a significant role in deals that prise out profitable operations fromintegrated financial services players, orthat offer fast growth via disintermediationof established competitors.

A question of capital

• As governments look to the private sector to help put their pensions andhealthcare systems on a sustainable footing, they will require institutions to exercise due care in providing these essential services to their citizens;

• The rising affluence of consumers in emerging markets, and the risingindebtedness of consumers in developed ones, will further focuspolicymakers’ attention on the ethics of the industry;

• Geopolitical risk, much of it related to the so-called war on terror, will threatenthe assets, people and profits of certain institutions and impose a highercompliance burden on all institutions, thanks to tougher anti-money-laundering rules; and

• Broad progress towards deregulation and competition will be faster withinborders than across them.

3. Politics


27


Whether developing their own businessesor supporting those of their clients,international financial services institutionsare some of the principal beneficiaries ofglobalisation and deregulation. Broadlyspeaking, the next few years will see theforces of liberalisation gain further groundaround the world, within the industry andbeyond it. But progress will not beuniformly smooth.

Global trade and investment flows willenjoy buoyant growth over the mediumterm. World trade growth is expected toaverage 7.3% over the next four years,down on the peak years for tradeexpansion but still sufficient to imply risingimport penetration in most markets. GlobalFDI inflows are projected to grow fasterstill, after the sharp declines of 2001-03.Both of these numbers will bring risinglevels of corporate finance activity.

But globalisation will remain a highlypoliticised area. In particular, progress inthe Doha round of international tradeliberalising negotiations will remain halting.The original deadline for a final settlementof January 2005 was abandoned as

unachievable. The next ministerial meetingwill be the December 2005 summit in Hong Kong, but this is more likely to provea staging post than the final round of talks– most analysts are assuming negotiationswill drag on into 2006 or even 2007,assuming that agreement can be reachedat all. Agriculture is the biggest stickingpoint in the negotiations, but progress inliberalising trade in services, includingfinancial services, will also suffer as a resultof further delays.

While global policy initiatives to liberalisetrade stutter, the real action will be at theregional and national levels. Asia and theAmericas, in particular, are in the midst of a free-trade stampede. Policymakersaround the region are rushing to propose,negotiate and sign ever more free-tradeagreements (FTAs) and economicpartnership agreements, both with theirimmediate neighbours and with moredistant economies. These arrangementsrange from relatively straightforwardbilateral affairs to proposals for pan-regional initiatives such as the creation of a Free Trade Area of the Americas ‘lite’.

This increasingly complex web of free-trade agreements has its drawbacks –each imposes administrative costs andtheir differing requirements and externaltariffs have the potential to distort tradeflows rather than create them. But their net impact on the financial services sectorwill probably be beneficial: first, anincrease in multinational clients and highertrade flows will attract large local andforeign banks to service the internationalcommercial sector. Then, as freer tradetakes hold and currencies and marketsbecome less volatile, the large banks willmove into domestic operations in thesmaller countries to provide financing andother services, both to small businessesand to consumers.

Such effects will take time to emerge, of course, but one major lesson of themost spectacular free-trade success of the immediate past – the 2004enlargement of the EU to 25 memberstates – is that integration begins to occurwell before formal agreements come intoeffect. For that very reason, forwardthinkers in European financial services areturning their attention to the next countriesin line for membership of the club. The admission of Romania and Bulgaria is likely to take place in 2007. Further EUenlargement to include other countries inthe Balkans and eventually Turkey (whichposes special challenges) is also likely, and the next few years will see rising levelsof direct and portfolio investment interestin all of these countries.

Access: Prospects for globalisation and deregulation

World trade and investment

% growth 2003 2004 2005 2006 2007 2008

World trade (goods) 5.5 10.5 7.0 7.0 7.5 7.8

Global FDI inflows –16.5 40.4 30.2 17.8 9.8 8.1

Source: Economist Intelligence Unit, April 2005

28


Institutionally, the swelling of the EU to 25 members cannot help but impededecision-making: don’t expect too manyradical initiatives from Brussels over thenext two to four years. But the absorptionof the new members is likely to add weightto the liberalising faction within the Union.Poland aside, most new members arelikely to play a modest individual role in policymaking, given the limitationsimposed by their small size. Butcollectively, they will share a similar stance on a number of issues, notably anopposition to attempts to force corporatetax harmonisation.

In the European financial services arenaspecifically, the Financial Services ActionPlan is due to be implemented in 2005. Thebiggest impact will be on capital markets.

Allied to the introduction of InternationalFinancial Reporting Standards (IFRS), rules to harmonise listing prospectusesand rules on market manipulation willspeed consolidation of capital markets as well as initiatives in the clearing andsettlement systems underpinning them.

Research in 2002 by London Economics inassociation with PricewaterhouseCooperspredicted that financial market integrationacross Europe would reduce the equitycost of capital by 40 basis points. Thatgoal is still some way off, however. As theUK’s response in October 2004 toconsultation about next steps for the FSAP expressed it, ‘agreeing regulation, in the form of EU legislation, does notautomatically lead to an efficient, integratedsingle market in financial services’.

Insurers too will feel the impact of EUderegulation: the Insurance MediationDirective, for example, permitsintermediaries to sell insurance throughoutthe EU, provided they meet certain criteriain their home markets.

It’s a different story in European retailbanking, where the cultural, linguistic and political barriers to cross-borderintegration will not be easily dismantled.The 2004 acquisition of the UK’s Abbey by Spain’s BSCH will be closely watchedas a test-case for integration but is likely to remain the exception, rather than therule, particularly if efforts to pass a long-delayed EU Directive on takeover bidsremain stalled.

Consolidation and restructuring withinborders rather than across them is likely to occupy most attention within bankingcircles in developed markets. This isparticularly true of Germany, one of theworld’s more fragmented markets (seetable), whose traditional three-tieredbanking system will come under furtherpressure as state guarantees for public-sector banks are phased out andprivatisation of these institutions creepshigher up the agenda. In the US, another

The next big things?

2004 estimates

Series Unit Romania Turkey

GDP per head USD 3,290 4,050

Population million 21.7 72.3

Total lending/GDP % 18.6 64.7


29


highly fragmented market, restrictions oninstitutions undertaking both commercialand investment banking operations, alongwith other financial sector businesses suchas insurance, have been stripped awayand there is also plenty of opportunity touse M&A to broaden banks’ nationalgeographic coverage. And in Japan,continuing concerns over asset quality willencourage further mergers, particularlyamong the wobblier regional banks.

Cross-border acquisition and growthopportunities are greater in less maturemarkets. In China, the four statecommercial banks continue to dominatethe sector, but competition from smallerdomestic banks and, especially, foreigninstitutions, is increasing. Regulatorychanges – most recently a relaxation ofcontrols on foreign investment in localbanks – will lead to greater foreignparticipation in investment banking, fund management and venture-capitalfinancing. Restrictions on foreign insurersare also being peeled away.

In India, the rise of successful privateinstitutions such as ICICI Bank and HDFCBank, and the growing presence of foreignplayers, has forced the state-owned sectorto begin a process of restructuring. The Middle East, risky though it is, is alsoan area to watch, particularly as the rivalrybetween Dubai and Bahrain to become the region’s financial centre heats up.

If the broad trend is towards deregulationand competition, however, domesticpolitical considerations are always capableof stalling progress. The Indian authoritieshave sent decidedly mixed signals aboutthe extent of foreign incursions into thefinancial services sector, for example. Andin more dirigiste developed markets, too,bailouts and interventions to protectnational champions remain possible.

Assets of the top 10 banks as %of the assets of the bankingsystem, 2001

Brazil 67.8

India 64.7

Taiwan 63.6

United Kingdom 59.1

Russia 46.7

Greece 46.1

Germany 44.3

United States 33.0

Finland 27.5


30


The allure of emerging markets as growthopportunities is undeniable. But so are therisks associated with them. The past threeyears, from the events of September 11 to the war in Iraq, have dramatically raisedthe profile of geopolitical risk and itscapacity to impact the financial servicesindustry, whether as direct targets ofterrorist attack, frontline players in the waron terror, or victims of the economic andfinancial fallout of political chaos.

Looking ahead, the Middle East will remainthe crucible of geopolitical concerns. Therisks of continuing chaos in Iraq remainhigh. The prospects of a return to any formof peace process between Israel andPalestine remain low. More alarming,because less obviously factored into riskpremia, is the threat of political upheaval inSaudi Arabia. States such as Saudi Arabia

could be particularly at risk if deepeningconflict between Sunni and Shia groups in Iraq amplifies tensions between the same communities in their own countries.The risk of continuing attacks on Westernnationals also poses a threat to the Saudieconomy, which is structurally dependenton expert Western workers across key sectors.

Elsewhere, ongoing antagonism fromnuclear-armed North Korea towards bothits neighbours and the US could result ininstability in north-east Asia. Suspicionsthat Iran is failing to disclose full details of its nuclear-development programmes to international inspectors may flare. The states of the Western CIS will remaininstitutionally fragile, particularly as thedoor to EU membership appears to haveswung shut.

Stability: Geopolitics and the war on terror

Countries with highest levels ofpolitical risk

Azerbaijan

Pakistan

Ukraine

Iran

Venezuela

Ecuador

Bahrain

Nigeria

Saudi Arabia

Kenya

Peru

Morocco

Note: The Economist Intelligence Unitrates 100 countries on 11 separatemeasures of political risk.


31


Hanging over any discussion of politicalrisk is the threat of another major terroristattack to rival the events of September 11.Another incident on that scale in one of the world’s major financial centres is aneventuality that will continue to preoccupyfinancial institutions, from insurers pricingtheir policies to investment banks planningtheir business continuity systems.

A far more certain outcome of the terroristthreat is the rising compliance burden onfinancial institutions as they are called onto assist governments in cutting offsources of terrorist financing. Relatedly,efforts to crack down on money-launderingactivity – estimated by the IMF to accountfor flows of money worth 24-25% of worldeconomic output – will retain a highpolitical profile over the coming two to fouryears. Legislation such as the USA Patriot

Act will raise the pressure on financialinstitutions in developed markets toscrutinise a wider range of businesstransactions and to conduct much moredetailed due diligence on the identity andactivity of customers. Institutions will needto work hard to minimise the impact ofthese requirements on legitimate customerswhile meeting their regulatory obligations.

Expect issues such as money-launderingto feature more highly in emerging marketstoo, particularly where the US governmentis involved. Financial institutions incountries such as Nigeria, Indonesia andthe Philippines, all of which are listed asnon-cooperative countries by the FinancialAction Task Force on Money Laundering,an inter-governmental organisation, shouldprepare for more stringent requirementsover the coming years.

32


Joining the war on terror and moneylaundering isn’t just a compliance issue, of course. There are reputational issuesinvolved for financial institutions andjurisdictions too, and questions over the industry’s ethics and standards ofbehaviour will be a significant politicalissue in many markets over the mediumterm, for a number of reasons:

• The industry has been found wanting inthe past. Public revelations have run thegamut from private-banking pricingabuses in Japan to overcharging byretail banks in Ireland, from cartelpricing among German insurers topensions mis-selling in the UK. EliotSpitzer, New York’s energetic attorney-general and Wall Street’s bête noire, haswidened his sights from investmentbank research to mutual fund markettiming abuses and now to price riggingat insurance brokers. Few would betagainst him, or others like him, openingup fresh prosecutorial fronts over thecoming months and years.

• Economic and demographic dynamicsare bringing more and more people intocontact with a wider range of financialproducts. Rising income levels inemerging markets are introducing acredit culture to markets in parts of Asiaand Central Europe for the first time. Incertain Asian countries, governmentsare actively encouraging domesticdemand growth as a complement toalready strong export growth. But theevidence from the recent credit-cardbinge in South Korea underlines the

duty of care the industry has to thesenew customers. The government inSeoul has launched a so-called ‘badbank’ to absorb a large proportion of thenearly 4m credit-card loans that are inarrears and around 1.8m card users arethought to be eligible for the bad bank’sdebt relief scheme.

• Levels of consumer ignorance aredisturbingly high in developed marketstoo, and the problem will be exacerbatedas previously abstruse investmentvehicles, from venture capital funds tohedge funds, become increasinglyaccessible to the mass market and asthe state scales back its involvement inpension and healthcare provision.

• High personal debt levels make thethreat of unsustainable consumerborrowing a particularly sensitivepolitical issue in certain countries. In theUK, for example, personal debt toppedthe £1trn (US$1.75trn) mark for the firsttime in July 2004. Debt-servicing costsare still manageable, but a rise inunemployment, further increases ininterest rates or a collapse in houseprices could trigger a sharp consumerretrenchment. It’s a similar story in theUS, where the waning impact of taxrebates over the next two years willforce consumers to bring their spendingback into line with earned incomegrowth. Rising interest rates and high oilprices will also eat into consumers’ability to spend on discretionary items.

Ethics: Educating and protecting the consumer

1 Excludes ‘PO laundering’, ‘Analyst,’ and ‘Mutual Fund’ cases.2 Fourth quarter lead plaintiff data is not yet available. The projected total has been estimated based on the trends of the first three quarters of 2003.

0

10

20

30

40

50

60

1996 1997 1998 1999Years files

Number of cases

2000 2001 2002 2003

4

1014

19 19

32

58

37

492

Cases with public pension funds as lead plaintiff1

33


What does all this mean for financialinstitutions? It might mean tougherregulations and a higher complianceburden: UK legislators are among thosereviewing the transparency of retail lendingpractices, for example. It will almostcertainly mean closer scrutiny of theindustry from a variety of actors, fromregulators to consumer groups to media.To take one emblematic example, recentindependent research into the proxy votesof US mutual funds at corporate annualmeetings, which funds are now obliged todisclose, showed that a majority of thenation’s 100 largest mutual funds opposedall social issue shareholder resolutions thatcame to votes in the first half of 20043. As transparency increases, reputationalrisk for the industry in developed marketswill remain high.

There are opportunities here, too. Financial institutions that are associatedwith transparency, openness and honestycan acquire a competitive advantage as a result. It is also important to rememberthat concerns over standards of corporatebehaviour cover many more industriesthan just financial services, and that theinvestment management side of theindustry will be under pressure to play a more important watchdog role of its own. Recent research fromPricewaterhouseCoopers shows a steadyrise in the number of cases of privatesecurities litigation in the US where publicpension funds have taken the role of lead plaintiff.

The longer view: Climate change

Gloomy predictions about global warming and greenhouse gases are nothing new. Much of the science of climate change remains controversial, and the pace of climatechange is gradual, not abrupt. But the issue is steadily moving to the centre of politicaldiscourse in the developed world and the next two to four years will see rising awarenessof the issue among financial services institutions.

Insurers in particular will spend more time grappling with this area than ever before.Incidence of extreme weather is on the rise, as are associated losses. Insurance claimpayments for the series of hurricanes which battered the eastern seaboard of the US in2004 are expected to exceed US$22bn, according to the Insurance Information Institute (III).A recent report by the Association of British Insurers4 estimates that weather risk in theUK property insurance market is rising at a rate of 2-4% a year. Insurers and reinsurers are already responding by spending more time assessing climate-related risk and byadjusting pricing and deductibles terms accordingly. If and where premiums risesignificantly, government intervention may be required to fund coverage. Alternative risktransfer mechanisms such as catastrophe bonds and weather derivatives may also gainin popularity.

Other parts of the financial services industry are not so obviously affected by climatechange issues, but there are impacts. Emissions trading regimes, so far fragmented and embryonic, will begin to look more coherent and integrated over the next two to fouryears. An EU-wide trading scheme is due to launch in 2005, joining existing schemes inthe US and UK. As market liquidity deepens, financial institutions will take a closerinterest in its potential.

Greater awareness of environmental issues will feed through into other areas too.Environmental compliance requirements are rising, particularly in developed countries,creating potential liabilities to take into account when offering corporate financing. The market for environmentally responsible investment vehicles is likely to grow, too.

3 Most Mutual Funds Opposed All Social Proposals, Investor Responsibility Research Center, 30/09/20044 A Changing Climate for Insurance, Association of British Insurers, June 2004

• Regulatory challenges will focus on three main areas – better, risk-calibratedcapital requirements, higher standards of governance, and new standards offinancial reporting;

• A tighter focus on capital management will encourage corporaterestructuring and disposal of non-core activities;

• New standards of governance will be embedded into the running ofbusinesses and daily operations through enterprise-wide risk managementprogrammes and incentive structures related to good governance; and

• The introduction of IFRS will result in an increasing alignment of accountingand financial reporting.



35


The growing level and intensity ofregulatory oversight will be a centralfeature of the financial services landscapeglobally in the next few years. Financialservices firms in developed markets canexpect a growing volume of regulation – for starters, consider Basel II, IFRS, anti-money-laundering and anti-terroristfinancing measures, or the 42 componentsof the EU’s Financial Services Action Plan(FSAP) exercise – and more rigour inapplying them.

New regulatory activity over the next two to four years will be focused particularly onthree inter-related areas: new capitalrequirements, higher hurdles for corporategovernance, and more transparentreporting regimes. For each of these areasthere is an emblematic initiative – Basel II,Sarbanes-Oxley and InternationalFinancial Reporting Standards (IFRS),respectively – as well as a host of otherrules and regulations.

Underlying new regulatory capitalrequirements is the need to ensurefinancial stability in global markets bymatching prudential capital more closely to the risks financial institutions take on.Basel II provides a framework for movingtowards the common goal of bothregulators and major banks, a system in which each bank can be relied on togenerate its own accurate ‘real-time’assessment of all its risks and allocate thecapital to support them. A worthy goal,except that reaching it may take years, andin the meantime, planning efforts for BaselII will be hampered by the discretion left to national regulators to implement theregulation and assess the need for furthercapital against operating risks.

On a slower timetable, the Solvency IIexercise in Europe is building towards asimilar regulatory regime for life and non-life insurance companies. Again, theuneven pace and uncertain direction ofchange carry risks of their own. EUregulators are keen to bring in capitalrequirements for reinsurance that matchthose of primary insurers for a transitionalperiod until Solvency II becomes effective.This could have a major influence on theability of the European reinsuranceindustry to compete on a global basis.

A tighter focus on capital management willhave a significant strategic impact on theindustry, through corporate restructuringand disposal of non-core activities. Expectto see more challenging questions askedof banks with mainly retail customers, for example, about more risky and hencecapital-hungry operations they may havein structured finance or securities trading.Investors will want to have good reasonsfor holding securities of financial servicescompanies with a broad range ofbusinesses exhibiting very different riskcharacteristics. The capital markets’natural aversion to conglomerates withdiverse earnings streams will extend, with greater disclosure, to scepticismabout companies blending widely varyingrisk profiles.

Greater discipline on capital will haveknock-on effects elsewhere. Less capitalwill flow to low-return businesses. Surpluscapital will migrate from areas like retailfinance, where Basel II will allow moresparing use of capital resources to newbusinesses and new jurisdictions. Assetand liability management will be tightenedup as economic capital measures are more

accurately applied. Product margins will bemonitored more closely as interest rateschange. More accurate costing of capitaland higher compliance costs willencourage financial services companies to review their entire cost structure.

Enhanced risk management will be centralto another area of acute focus forregulators – corporate governance.Corporate governance is to this decadewhat shareholder value was to the 1990s: a general framework for thinking throughwhat managers and their companies oughtto be doing. Implementation of improvedgovernance structures, processes andcultures will be one of the major challengesfacing financial institutions over thecoming two to four years.

Many changes have already been made, of course. The passage of the Sarbanes-Oxley Act, governance reforms pursued bythe World Bank and IMF since the Asiancrisis in 1997-98 and new codes of ethicsin jurisdictions from the Netherlands toAustralia have all intensified the focus oninternal controls (and driven up D&Oinsurance premiums as a result). Butfurther regulation should not be ruled out,particularly if there are fresh revelations ofpoor decision-making and inadequatecontrols at financial institutions.

Even in the absence of more regulation,enhanced standards of governance haveyet to be embedded into the running ofbusinesses and daily operations. What thatmeans in practice is enhanced riskmanagement, improved managementprocesses and more risk-awareperformance cultures. There is a pressingneed to strengthen enterprise-wide risk

On the up: The intensity and volume of regulations

36


management systems, particularly aroundaggregation of risk and allocation of capitalto competing activities. Managementprocesses must ensure business modelsand positioning are continually re-assessed, implying major advances inmanagement information and reporting.

Underlying any sustained improvement inprocesses is an improvement in howinstitutions manage people. An effectivecontrol framework can only be achieved ifa coherent management team is in placeand if clearly defined reporting structuresare in place throughout the organisation.Human capital programmes, successionplanning, and the construction of incentivesand remuneration packages that reward aculture of good governance – these are allinputs needed in the new regulatory age.

Governance concerns will also lead toheightened sensitivity around certain areasof financial activity. Tax is one example.There is a cultural shift in the approach toavoidance in the tax world – recent changesin UK rules on notifying tax planning areone sign of this – that means financialservices companies will need to be moresensitive to the relationship, real orperceived, between tax planning and good governance.

Reinforcing the emphasis on both goodgovernance and prudential capital will be a drive towards greater transparency, both inside the organisation, throughimproved performance measurementsystems, and outside the organisation,

through new reporting requirements suchas IFRS. These reporting requirements willalso influence tax reporting, once IFRSgoes beyond consolidated accounts, andwill drive decisions on implementingtechnologies for enterprise-wide datamanagement and risk aggregation.

Although many countries are preparing toadopt IFRS, Europe is in the driving seat,given the European Commission’scommitment to have IFRS applied to all7,000 or so listed companies in the regionfrom 2005. However, lobbying by majorcontinental banks led the EuropeanCommission in October 2004 to limit thescope of IAS 39, on recognition andmeasurement of financial instruments. This effectively blocked the introduction of full fair value accounting for liabilities, a key component of the new rules for the financial services sector. The UK’sAccounting Standards Board counteredimmediately by recommending that UKcompanies should comply with the IASB’soriginal proposal and not the dilutedEuropean version. So the debate aboutclosing the gap between financialinstitutions’ historic and fair valueaccounting goes on, although its ultimatedestination – reporting that reflects currentvalues – is not in doubt, even if the timingof change is.

Greater transparency will also affect therelationship between financial servicescompanies and their sources of capital.Investor relations will need to be fine-tunedto reflect more detailed reporting, greater

potential volatility in earnings and the riskprofile and capital position of eachcompany, and also more intensivedialogues with ratings agencies andregulators. At the same time, financingopportunities can be expected to growwith the increasing diversity of capitalstructures needed to support a widerspectrum of different risks.

Rating agencies will emerge with a muchmore central role. They and other researchintermediaries will use enhanceddisclosure to further differentiate eachfirm’s capital requirements and signal moreaccurately when and how much capital isneeded. This will be the basis for financialservices companies to free up resources insome areas, such as consumer lending,and for impending strategic decisions tospecialise in, or exit from, businesses withmore demanding capital requirements. The growing influence of rating agencies isalso reflected in their development ofratings for corporate governance, a clearindication that capital markets no longerdistinguish between compliance and good governance.

37


More rules means a higher compliance bill, and not just as a result of paying forincreasingly sought-after complianceprofessionals. More importantly, the bill for compliance also covers the cost ofchanging the whole basis on which a financial services business reports and reaches decisions, plus the risk ofpaying fines and compensation imposedby regulators.

Such costs have potential effects on newentrants to financial product markets, notjust as a result of direct costs, but also as a result of the competitive advantage in the capital markets that major institutionswill build up through a reputation for beingable to manage and disclose their riskprofile accurately.

The reputational cost of failures to complywith regulations will continue to grow. Not only are expectations of corporategovernance standards higher, regulatorsworldwide are also alert to what their peersare doing, and recent examples haveshown that failure to comply in Tokyo orNew York, say, may then become an issuein another market, such as Seoul. The 40%decline in the share price of Marsh &McLellan in October 2004, following theannouncement of an investigation by NewYork’s attorney-general Eliot Spitzer intoinsurance broker commissions, helps toquantify the potential penalty for loss of

reputation and concern about non-compliance. In the worst cases, thepenalty for non-compliance can be moresevere still – closure and permanent loss of income.

There are other risks related to regulationas well. Changing product structures canexpose producers or distributors to the riskof breaching new regulations whoseprecise implications will only be workedout through precedents set over a numberof years. While these precedents are beingestablished, financial services providerswill be subject to unforeseen risks fromproduct innovation.

The knock-on effects for tax of IFRS couldpose additional risks for financial servicescompanies, such as tax regulatorychanges to reflect IFRS and possiblethreats to tax neutrality between savingsproduct structures. And fair valueaccounting is likely to increase the volatilityof earnings in the financial services sector,and with that, an increase in the tendencyof rating agencies to make more frequentadjustments to credit ratings and hence tothe cost of capital.

But regulatory upheaval will bringopportunities as well as obligations. More accurate costing of capital willcontinue to force financial services playersout of non-core businesses, allowing

stronger competitors to expand along thevalue chain. The large financial servicescompanies rapidly absorbing theadministrative operations of assetmanagers provide one example. Newmarkets for insurers are being created by environmental liabilities regulations.Regulatory action against distressed or insolvent companies will be windfalls to stronger players as policyholders are transferred.

The EU’s harmonisation of financialmarkets through FSAP will knock downsome barriers to entry, though detailedimplementation on the ground is asimportant as changes to the rules.Worldwide, the move towards a levelplaying field in regulation and reporting willadd momentum to liberalising markets.This marks a major and positive changefrom the principal driver of liberalisation inthe early part of this decade, when systemfailure and crisis, most notably in Japan,finally overcame the aversion to foreigncapital in financial services.

The costs and benefits of heavier regulation

• Technology investment in the next two to four years will be determined by three major priorities: optimising profitability from a more demandingcustomer base, increasing distribution capabilities while reducing costs, and achieving a step-change in the management of risk, including theresilience of IT systems themselves;

• Predictive approaches to customer data will enable institutions to anticipateand react to customer demand with greater precision and intimacy;

• Advances in compression technology, the spread of consumer broadbandand the impending shift to IP networks all give the financial services industrythe infrastructure it needs to deliver on the promise of e-finance; and

• Grid computing and offshoring are two of the primary ways in whichtechnology will help institutions to realise greater levels of operational and cost efficiency.

5. Technology


39


Whether they are buying banking,insurance, securities or any other financialservice, today’s customers are becomingmore sophisticated, less loyal and moredemanding. They take the speed and pricetransparency of Internet-based servicesfor granted. But they also want personalservice and the benefit of longer termrelationships to purchase more complexproducts, such as the long-term savingsvehicles that an ageing population needsin the US, Japan and Europe.

To optimise profitability from thesecustomers, the financial services providermust deliver new products, develop andnurture customer relationships, measureand manage the risk involved, and do allthis at lower cost. This requires a continuedevolution of the technology now deployedfor customer relationship management.CRM needs to move away from itsconventional focus on assembling historicaldata on the customer and ensuring efficientprocessing inside the financial services firmtowards anticipating what each customerneeds, and then meeting that need withenough precision to create a ‘virtualintimacy’ with the customer.

That means investing much more inpredictive approaches to customer data.High-quality data about how differentsegments of the customer base are likelyto react to product, pricing and cross-selling proposals at different stages of the

life cycle are essential for the dynamiccustomer service and on-demandcapabilities that CRM technology nowneeds to deliver. Relationship managersand call centre agents increasingly need torespond in real time to a customer, usingsystems that generate proposals tailoredto each customer’s current and futureneeds and that reflect major changes inpersonal lives such as marriage, childrenand bereavement. Targeting, acquisition,sales, retention, cross-selling – all thesecustomer-related tasks are more productiveas a result of predictive modelling, whichenables fewer people to crunch morevariables and generate more effectivemanagement of customers at a lower cost.

Rapidly changing demographics illustratewhy marketing by banks, insurancecompanies and securities firms needs tobe more targeted and more focused onpredicting future demand. While ageingpopulations throughout the industrialisedworld will put pressure on those in work to save more, the savings requirement in Europe will be dramatically increased by the inability of the state to pay forpensions. Millions more customers will be looking for long-term savings productsand advice, and major European financialservices players will be relying on theirCRM capability to predict the needs of anentirely new type of customer with a lowernet worth and different risk profile from thetraditional buyer of long-term products.

The opportunity for new technology toreinforce customer relationships alsoextends to improving customerexperience. The automation of manycustomer contact functions, effectivelyoutsourcing to the customer, may bereaching its limits, as competitors seek todifferentiate their offerings and to enhancecustomer loyalty by personalising theirinteraction with each customer. The revivalof branches by some banks is oneinstructive sign of this trend.

But technology does offer the potential forextending online capabilities to meet theneed for greater personalisation on amass-market scale, with smarter front-endsystems. These start with improvedmanagement of customer data, softwarefor generating recommendations, andcustomer contact systems that facilitatehanding the right customer over torelationship managers at the right point.Growing availability of video calls overbroadband connections could enablebanks, for example, to offer consumersvirtual branches. Technologies forenhancing CRM and improved customerexperience will assume much greaterimportance as financial services firms seekto build new customer relationships in fast-changing mass-market segments such aspension products.

Optimising customer satisfaction and profitability

40


The imperative for enhanced distribution atlower cost will drive technology investmentby financial services companies in twoareas: Internet-based delivery, along withthe automation of workflows to support it,and cost efficiencies, mainly viaoutsourcing and offshoring.

Internet-based delivery is increasinglycentral to distribution of financial services.On World Bank estimates, e-financepenetration among Internet users willincrease from between 40% and 50% inmajor markets such as the US, Japan andthe UK in 2005 to 90% by 2010, withpenetration rates in emerging marketsrising from less than 20% in 2005 to 60%-70% by 2010. Much of this growth is beingdriven by the rapid spread of broadband,enabling richer content to be delivered atgreater speed to individual households.The remarkable growth in mobile phoneownership in emerging markets suggeststhat they too will become a significantdistribution channel for financial services,particularly electronic payments, over thecoming years.

Electronic distribution delivers lower costsand facilitates faster expansion – witnessthe success of ING Direct in penetratingthe UK retail savings market without aphysical branch network. But it has its

drawbacks. Increased bandwidth hashanded consumers unprecedentedinformation on pricing, leaving financialservices providers with a potential trade-off between expanding distributionof a product online and exposing it to thethreat of lower margins from transparentprice comparisons.

Internet distribution also spells morecomplexity, as financial services providersseek to integrate their offerings on multiplephysical and electronic distributionchannels: branches, third party sales, call centres, Internet, PDAs, and ATMs.Automating distribution further will take thesame basic tools as broader CRM goals –high-quality data, predictive models, web-based workflow for marketing and sales,tools for personalising customer interaction– combined with the flexibility needed foraddressing different electronic channels.

In the back office, communicationstechnology advances continue to supportoffshoring and in/outsourcing, withabundant bandwidth on major routesenabling low-cost virtual private networksfor connecting up remote sites. The convergence of voice and data onpublic IP networks – not just on VirtualPrivate Networks (VPNs) – also opens upnew opportunities, such as delivering

personal advice to customers on a low-cost basis using remote video links.Since the financial services industrymanufactures and distributes digitalproducts and is global in scope, it isuniquely positioned to benefit from thearrival of an all-IP communicationsenvironment by the end of this decade.

Indeed, outsourcing and co-sourcing byfinancial services industries is oftenmotivated by access to technology, notjust enabled by it. A recent EuropeanCentral Bank survey of European banks’motives for outsourcing predictably showscost reduction scoring highest (89%), butthis was followed by 60% of respondentswho rated access to new technology as areason for outsourcing. The current waveof mergers and outsourcing of back-officefunctions of asset managers demonstratesthat this push for lower costs goes hand inhand with the desire to get access tosuperior technology that is now beyondthe means of smaller independent players.

Distribution: Greater complexity, lower cost

41


Risk management, the third major driver oftechnology investment, has escalated to atop priority for every player in the industry.Each dimension of risk management hasimplications for technology strategy.Operational risk has increased with thegrowing complexity of new products, withthe reliance on models for valuing financialinstruments and positions, and with theuse of outsourcing and shared services forincreasingly important functions. The useof predictive models will continue toexpand fast throughout the financialservices industry over the coming years,from refining insurers’ estimates of losses,to reducing card issuers’ acceptance ofrisky customers and honing the tradingstrategies of investment banks and hedge funds.

Upgrading technology to track riskexposure accurately and in real timeacross the whole firm is crucial to survival.Allocating capital to maximise returns

relative to risks, real-time knowledge of thefirm’s total risk exposure, and an effective,transparent dialogue with regulators, ratingagencies and the capital markets – theseare now minimum standards for the well-governed financial services firm.

Major investment is therefore likely over thenext two to four years as financial servicesfirms adopt corporate performancemanagement systems for firm-wide riskmanagement and reporting to regulatorsand securities holders. Approaching riskmanagement at the enterprise level is notjust an urgent task for ensuring a properdegree of managerial control and meetingnew regulatory and reporting requirements.It is also an opportunity to take out costs.The transformation of reporting tasks forinternal risk management and financial and regulatory disclosure throughstandardising data around the XBRLformat is the most powerful example of these potential efficiencies.

Risk management: Wrestling with the data deluge

42


Advances in technology promise greateroperational efficiency, wider distributionand more intimate customer relationships.But what are the risks to this scenario oftechnology as a major strategic driver forfinancial services companies? The first,most important risk is that while thenecessary technology may be in place, its effective adoption requires a fundamentaloverhaul of the organisation’s culture,reward system and IT infrastructure – to re-define target customers, matchproducts to their needs, automate theprocesses for delivery, and generate andapply the information for finding, cross-selling and retaining these customers.

Internally, adoption may be slowed by a lack of readiness for the majororganisational change needed to earn a return on the investment. One case inpoint: the slow pace at which XBRLreporting is being adopted, relative to thepowerful benefits of this technology fordelivering improved risk management andreporting. XBRL makes most sense as partof an enterprise-wide revolution in datamanagement, which is still too big adeparture for many financial institutions,particularly in Europe.

Poor returns on existing IT investment alsoinhibit adoption, as does poor dataintegrity – though both of these factorsreflect weaknesses in past processes ordecisions, rather than on the potential fornew technology. A further brake onadoption of new technology, in this case e-finance, is the regulation of financialservices delivered on the Internet. Widelyvarying rules in different jurisdictions onremote intermediaries lag far behind theglobal potential of Internet distribution.

Another major source of risk for thesuccess of strategic investment intechnology is legacy systems. The inabilityto link disparate legacy systems leads to costly and complex networkinfrastructures. Legacy systems are alsorooted in old organisations and processes.In key areas for financial services firms,such as risk management, reporting andCRM, the choice between building on aninadequate legacy or introducing newtechnology combined with new processeswill have to be scrutinised very closely.

One likely solution will be increasedadoption of grid computing, a technologywhich links diverse computers to creategreater processing power and which isparticularly suited to data-intensiveprocesses such as pricing derivatives. The Tabb Group, a financial marketstechnology strategy consultancy, expectsglobal grid spending in the financialservices market to skyrocket to US$683min 2008 from $59m in 2003, at a compoundannual rate exceeding 60%.

Technology risk: Adoption angst and security scares

43


Grid computing has other benefits, too, not least in enabling improved businesscontinuity systems through the flexibleredistribution of computing power withinand across organisations. There are otherexamples of how technology can enhancesecurity around financial transactions,such as the widespread adoption of Chip &PIN electronic transactions at retail outletsin Europe.

But technology is itself a source of securityrisk, particularly as the growth of e-financeand web-based services increases thethreat of fraud and sabotage. Customers

worldwide are clearly worried aboutsecurity and confidentiality of e-financetransactions. Disruption through virusesand spamming, or phishing, is reachingepidemic proportions: the Anti-PhishingWorking Group reports that in May-July2004 the incidence of phishing attacks wasgrowing by an average of 50% per month.For financial services providers, thereputational and operational risks frombreaches in security are growing, andfranchises and brands can suffer immensedamage from unauthorised release of data or leaks from their own or anoutsourced database.

Source: True Grid, Economist Intelligence Unit survey, June 2004

Improved business continuity 52%

51%

48%

43%

38%

27%

5%

Deferment of new investment through maximising utilisation of current assets

Ability to cope cost-effectively with predictable or cyclical spikes in demand

Accelerated processes for IT-intensive tasks

Ability to cope with unpredictable spikes in demand

Flexibility to test new applications quickly

Other

0 20 40 60 80 100%

What in your view, are the most significant benefits of grid computing?Please check no more than three benefits. (% respondents)

Conclusion


45


Financial services institutions clearlycannot afford to stand still. The complexityof the environment in which they operatewill only increase, as disintermediationcontinues, regulations proliferate andcompetition sharpens. There are significantareas of growth to exploit, in high-potentialemerging markets such as China andIndia, and product areas such as life-cyclewealth management. Greater transparency,particularly around institutions’ riskprofiles, will expose the true profitability of individual lines of business. Critically,the power of the customer, fostered bytechnology and competition andreinforced by political and regulatoryactivity, will grow further, encouraginginstitutions to turn themselves fromproduct-led enterprises to ones in which

reward systems, organisational structuresand technological advances are all gearedto nurturing a customer-centric culture.

All of this will force players in the industry toconsider where their true competencies lie.In an environment where being globalcreates as many compliance headaches asit does revenue opportunities, institutionsmust decide whether it is better to beinternational, national or even regional. In an industry where commoditisation anddisintermediation can happen rapidly anddamagingly, institutions must hone theirbrand in the markets and product areaswhere they are strongest. The competency-led enterprise, not the conglomerate, willwin out as the rest of the decade unfurls.

What do all these drivers add up to?

Contacts


47


Jeremy ScottChairman, Global FinancialServices Leadership Team44 20 7804 [email protected]

Thomas F. Barrett1 617 530 [email protected]

Etienne Boris33 1 56 57 10 [email protected]

Javier Casas Rúa54 11 4891 [email protected]

Diana Chant1 416 365 [email protected]

Rahoul Chowdry61 2 8266 [email protected]

Ron Collard44 20 7212 [email protected]

Richard Collier44 20 7212 [email protected]

Ian Dilks44 20 7212 [email protected]

Simon Jeffreys44 20 7212 [email protected]

Chris Lucas44 20 7804 [email protected]

John Masters61 2 8266 [email protected]

David Newton44 20 7804 [email protected]

Phil Rivett44 20 7212 [email protected]

Tim Ryan1 646 471 [email protected]

John S. Scheid1 646 471 [email protected]

Nigel Vooght44 20 7213 [email protected]

Brett Yacker1 646 471 [email protected]

Akira Yamate81 3 5532 [email protected]

If you would like to discuss any of the issues addressed in more detail please speak with your usual contact at PricewaterhouseCoopers.

This report is supported by PricewaterhouseCoopers Global Financial Services Leadership Team:

PricewaterhouseCoopers (www.pwc.com) provides industry-focused assurance, tax and advisory services for public and private clients. More than 120,000 people in 144 countries connect their thinking, experience and solutions to build public trust and enhance value for clients and their stakeholders.

This report is produced by experts in their particular field at PricewaterhouseCoopers to address important issues affecting the financial services industry. It is not intendedto provide specific advice on any matter, nor is it intended to be comprehensive. If specific advice is required, or if you wish to receive further information on any mattersreferred to in this report, please speak to your usual contact at PricewaterhouseCoopers or those listed in this publication.

For information on this and other PricewaterhouseCoopers Global Financial Services reports and publications please contact Áine O’Connor, Director, Head of GlobalFinancial Services Marketing, on 44 20 7212 8839 or e-mail at [email protected]

For copies please contact Alpa Patel at PricewaterhouseCoopers on 44 20 7212 5207 or e-mail at [email protected]

© 2005 PricewaterhouseCoopers. All rights reserved. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited,each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP. Designed by studio ec4 17438 (06/05).

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