July 25, 2023
As the year began, Capstone believed European Union and UK regulators would step up their intervention in the pricing of retail financial services, including consumer credit, insurance, and payments, on the back of mounting political pressure to respond to the cost-of-living crisis (see Capstone’s European Financial Services 2023 Preview).
A sluggish economy, persistent inflation, the worsening cost-of-living crisis, a banking meltdown, and a host of other issues have reinvigorated European policymakers to take on several underappreciated topics, including competition in payments, “value for money” in insurance-based investments, and liquidity risks in the banking sector. And that’s before layering on the specter of changing electoral dynamics. Capstone expects the second half of 2023 to feature a swath of action across the European policy landscape that we believe should be top of mind for companies and investors alike.
In a recent Q&A, Capstone’s Mathew Gilbert, head of Capstone’s pan-European Financial Services practice, provides updates on what the remainder of 2023 holds for European financial services policy and its unheralded implications for companies and investors.
What expectations did you have for the year that are playing out?
In Europe, we are seeing the first steps towards greater consumer protection in retail financial services, with progress on the much-discussed Retail Investment Strategy (RIS)—with notable implications for both companies and investors. In January, Mairead McGuinness, European commissioner for financial services, said inducements paid to financial advisers by product manufacturers are leading to poor outcomes in the EU, suggesting a full ban on inducements is the best way to protect retail investors. We have seen significant lobbying on both sides of this debate, with certain Member State officials vocally opposing a blanket ban, whereas groups within the European Parliament were advocating the other way. In May 2023, the RIS published by the European Commission (EC) stopped short of proposing a full ban, despite finding it to be the most effective policy option. However, we don’t believe the debate has ended here.
The EC’s proposals must now be negotiated and approved by the European Parliament and the Council, where amendments will be presented for discussion. More importantly, a review clause will allow policymakers to revisit the topic in three years, where proposals could re-surface. The EC did, however, propose a ban on inducements for execution-only services and notably proposed a “value for money” concept. Under this new process, firms will be required to compare the costs and performance of a product against wider benchmarks. We expect regulators to focus increasingly on pricing and benchmarking in the European savings and unit-linked market in the coming months and years.
What do you think was overlooked this year that companies and investors should be paying attention to?
There have been several false dawns when it comes to challenging Visa Inc. (V) and Mastercard Inc.’s (MA) dominance in European payments. However, we believe EU policymakers have been quietly sowing the seeds for a payments framework that will facilitate greater competition for the large US card networks. The European Payments Initiative (EPI) was recently revitalized with the acquisitions of iDEAL and Payconiq. iDeal is the most used online payment method by Dutch consumers, holding a 70% market share. Although the ambitions for the EPI have been significantly scaled back, including its prior goal of launching a pan-European card scheme, we see the potential for tailwinds to the growth of instant account-to-account (A2A) payments in Europe, aided by the EU’s payments legislation.
We expect the EPI and the instant payment regulation, in addition to EU and UK Central Bank Digital Currencies, Open Banking, and A2A payment reforms, to further drive the growth of digital wallets in Europe at the expense of Mastercard and Visa. On 28 June, the European Commission published proposals for a third Payment Services Directive (PSD3). They are aimed at improving the competitiveness of open banking services, as well as improving access to payment systems and bank accounts for non-banks. Although European reforms will likely have limited impact on transaction growth for Mastercard and Visa in the next two to three years on a groupwide basis, we believe alternative e-commerce payments rails in Europe will become more competitive and start eating away at the companies’ dominance over the longer term.
What underappreciated themes do you expect to play out this year in your sector?
We believe the UK Labour Party’s annual conference in October will focus investors’ minds on the risks and opportunities from a potential change in the UK government. The Labour Party has been out of power for eleven years. The last Labour government was led by Gordon Brown, who took over from Tony Blair, and then lost the general election in 2010 to a coalition of the Conservatives and the Liberal Democrats. At a certain point in each political cycle since then, commentators have touted the prospects of a Labour comeback and the left-leaning policies that will come with it, only for the Conservative party to prevail. Investors in UK assets will be questioning what will be different this time around.
In a post-pandemic environment of persistent global inflation, made worse by war in Ukraine, the Conservative government has set itself up for criticism with a series of political mishaps. Former Prime Minister Boris Johnson was forced out of office following several scandals and resignations from his own cabinet. Then his successor Liz Truss’s flagship economic policy sent the markets into chaos, and she was forced out in turn by her party. Although current Prime Minister Rishi Sunak has somewhat steadied the ship, the prospect of crowd-pleasing pre-election tax cuts will have to be measured against the need to maintain market confidence in the UK’s fiscal policy. In this context, the polls point towards a large Labour victory at the next general election (which must be held by January 2025). We believe the most controversial area for investors will be the potential reform of the UK tax system, which will range from targeting private equity’s carried interest to increasing tax on capital gains and “buy to let” investment income. In the retail financial services sector, we believe a Labour government will prioritize consumer protection regulation in areas including “buy-now-pay-later,” with speculation that the current government is delaying the implementation of more stringent oversight in this area.
What are the big questions you are paying attention to for the balance of 2023?
In the context of the turmoil seen at US regional banks and the failure of Credit Suisse, we expect the liquidity risk of uninsured deposits to be a near-term focus for global bank regulators. The fallout experienced by UK and Euro area banks has, in comparison, been more limited. Nevertheless, we believe higher rates, in response to persistent inflation, will keep the banking sector on its toes for the remainder of the year.
Higher rates are positive for a bank’s top-line growth; however, the expected revenue gains need to be viewed in tandem with the risks from balance sheet losses, including on commercial real estate exposure and the revaluation of bond portfolios. European banks have reduced their vulnerability to higher bond yields, booking a higher proportion of bonds as held to maturity (HTM). However, the fallout from Silicon Valley Bank’s HTM losses, has spurred a debate amongst regulators on the merits of fair value accounting rules.
We believe the application of fair value accounting will be most keenly felt in the bank M&A context. In an environment where low valuations and the associated recognition of “badwill” should spur acquisitions, the rising rates (and the speed of increases) have meant negative fair value adjustments when marking assets to market upon acquisition.
HSBC Holdings plc (LON: HSBA) recently had to change the terms of the sale of its French retail bank to Cerberus after rate rises increased the capital impact for the private equity firm. We believe a key issue, in this case, was not just the bond portfolio but rather the long-dated mortgage book, which is typically biased towards fixed-rate mortgages in France. The supervisory approach to European bank M&A has evolved over the years, with regulators viewing bank consolidation as a tool to raise the sector’s low profitability and overcapacity. However, we believe a strict application of accounting rules may temper investor hopes for the long-awaited consolidation of the banking sector.