Financial services industry outlook
Volume 6, Winter 2021
The financial services industry is emerging from a year of whipsaw change that few could have predicted. But that uncertainty is giving way to optimism as the distribution of the coronavirus vaccine and an improving economy bring a sense of hope, and stability. Banks, faced with unrelenting pressure on their margins, can see some relief in sight, while the capital markets are looking to a year of reduced volatility and improving financial conditions. The private equity industry is looking to continue its robust recovery, with middle market firms poised to play an important part. Then there is the ever-accelerating pace of technological change. Making those investments is how savvy specialty finance firms are staying current with ever-changing regulations. The race to keep up with technology is leaving many financial services asking a question: Just what is a fintech company? Amid all of these trends, there is still the overhang of the coronavirus. And the potential for a pandemic to happen again has prompted the private and public sector to search for an approach to insurance that won’t leave businesses vulnerable. Such private-public partnerships have succeeded before, and they can again.
- FINANCIAL INSTITUTIONS: As the economy improves, so will banks’ bottom lines.
- CAPITAL MARKETS: After a year of dramatic change, volatility will ease.
- ASSET MANAGEMENT: Middle market private equity firms are poised for a strong year.
- SPECIALTY FINANCE: How consumer lenders can keep up with an ever-changing regulatory environment.
- FINTECH: The lines are continuing to blur between fintech companies and their traditional counterparts.
- INSURANCE: The search for an effective way to provide pandemic insurance continues.
Banks leaving the pain of 2020 behind
Banks are looking ahead to 2021 with the hope that the human and economic toll of 2020 can be left in the past.
Few could have expected such a difficult year for banks; after all, they were coming off a record year for earnings in 2019, and the future seemed bright. But then in March, they were confronted by a global health pandemic that sent the economy into a tailspin, prompting the Federal Reserve to cut the federal funds rate twice, to zero, and Congress to step in with a fiscal aid package.
The effects of these cuts fell squarely on the banks, which depend on interest earned from loans for a majority of their income. The result was that their net interest margins were compressed to record lows, according to the Federal Deposit Insurance Corporation.
But in late December, President Trump signed a $900 billion fiscal aid package to provide direct fiscal aid to households and businesses equal to 4.25% of gross domestic product. This package, the second-largest economic aid measure in the nation’s history, was expected to give a much-needed boost of fiscal relief to the economy, just as the novel coronavirus was surging again.
“We expect the aid package will bolster U.S. growth conditions in the first half of 2021, likely preventing another economic downturn, which our forecast had previously implied,” RSM US Chief Economist Joseph Brusuelas stated.
Because of the coronavirus relief package, the continuing distribution of a vaccine and the growing prospects of further stimulus given Democratic control in Washington, D.C., RSM revised its forecast for first-quarter growth in 2021 to 2.5%, up from 1.1%, and an increase in second-quarter growth to 8.7% from 4.6%.
Further, as the economy continues to recover, all signs point to robust growth in the second half of the year. RSM forecasts year-over-year growth in gross domestic product for 2021 of roughly 5.4%, with risk to the upside. After the traumatic events of 2020, it’s hard to think about there being a possibility that things could be better than forecast, but it’s certainly an option.
Now, with economic conditions improving, we are likely to see some modest inflation and a steepening of the yield curve along the midrange to the longer end. Looking at the Fed’s five-year, five-year forward rate, a key measure of future inflation, we can see this steepening.
In addition, RSM’s projection for the closely watched 10-year Treasury yield, which bottomed out in August at 0.51%, shows the rate approaching 1.3% by the end of 2021. Already, in the early days of the new year, the yield pushed past 1%.
Along with the rising rates, improving economic conditions will lead to a positive impact on loan portfolios as banks return to normal lending—not stimulus lending—and see the benefits of a strong growth cycle easing credit concerns. This, in turn, will lead to fewer credit losses.
Rising rates, new lending and fewer credit losses are enough to spur optimism in any banker
While 2020 was characterized by stimulus funding, low interest rates and credit concerns, 2021 will most likely see a recovery and a revival of the U.S. economy. Banks will be positioned to capitalize on the momentum and help drive economic growth while also seeing the benefit to their financials.
MIDDLE MARKET INSIGHTWith the economy improving, interest rates are likely to increase modestly and the yield curve will steepen along the midrange to the longer end.
Volatility in capital markets easing as financial conditions improve
After enduring a first half of 2020 that had record volatility, capital markets closed the year strongly, boosted by historically low interest rates, improving financial conditions and a stronger-than-expected economic rebound. The gains were broadly shared by trading firms, underwriters and advisers.
It is in this light that 2021, while still a year of recovery, will most likely see some downside risk to the profitability of capital markets organizations as volatility continues to ease, rates move off their historic lows and financial conditions improve.
While volatility rose in 2020 as the pandemic set in, it subsided in the later stages of 2020 thanks in part to the prospect of multiple vaccines being distributed, and the hope that both a global and domestic economic recovery will continue to accelerate. The strong trading revenues earned by capital markets participants in 2020 are not likely to be replicated in 2021. But should a speed bump appear in either the economic recovery or the rollout of vaccines, short periods of volatility could allow traders an opportunity to capitalize on market movements.
Whether it was in debt markets or equity markets, underwriters had a strong year in 2020.
With financial conditions improving off the yearly lows and support from the Fed and the U.S. Treasury blunting the steepest economic decline in generations, a combination of confidence in the markets and cheap credit had companies and municipalities lining up looking for liquidity to help them navigate the crisis.
According to Bloomberg, investment-grade corporate borrowers issued roughly $1.75 trillion of debt last year while municipalities issued approximately $457 billion in long-term debt obligations. While the beginning of the year is likely to see some spillover origination activity, this level of activity is unlikely to be replicated as rates, buoyed by confidence in the vaccine and a recovering economy, begin to rise and the need for cash subsides.
Equity markets had a flood of activity as businesses used traditional and nontraditional means—such as special purpose acquisition companies (SPACs) and direct listings—to gain access to capital. SPACs, once derided, became one of the largest components of public offering activities in 2020. SPACs raised a record $79.2 billion in 2020, which exceeded all prior years of SPAC issuance activity, according to Bloomberg. More important, SPAC issuances made up 44% of 2020’s $179 billion of initial public offering volume, Bloomberg data shows. The interest in SPACs is likely to continue in 2021 and beyond as equity markets continue their rise on the hopes of vaccine adoption and economic recovery. If the past year has shown anything, it’s that nontraditional ways of raising capital have found a place in the market.
The first half of 2020 was highly stressful for capital market organizations that generate fees associated with investment banking advisory activities as challenges tied to business closures and the toll of the novel coronavirus all but shut off deal flow. But as businesses reopened and the economic recovery got underway in the second half of 2020, deal activity increased significantly.
In the fourth quarter alone, deal volume in the United States increased by more than 78% compared to the same period the previous year and increased by more than 50% quarter over quarter, according to Bloomberg.
As the economy continues to recover, advisory services for capital market participants may prove to be the brightest spot in the new year.
With momentum poised to carry over into 2021, capital markets organizations are in position to benefit from what are likely to be robust markets amid an improving economy.
MIDDLE MARKET INSIGHT
Special purpose acquisition companies raised a record $79.2 billion in 2020, which exceeded all prior years of SPAC issuance activity, according to Bloomberg.
Middle market private equity firms poised for a strong year
Middle market deal activity recovered from the second to the third quarter last year as quarterly deal activity grew from $57 billion to $81 billion, and amounted to $234 billion year to date. Deal output was soft compared to pre-pandemic levels when a reading as low as $80 billion was observed in the third quarter of 2016. Still, this is far better than some predicted amid the initial COVID-19 lockdowns in March and April that sidelined in-person meetings.
Middle market investment managers played a significant role in the rebound of mergers and acquisitions and are expected to continue to do so. Middle market deals as a percentage of all 2020 private equity buyout deals swelled to 70.2%, a six-year high, according to PitchBook data.
There was a seismic shift in the upper middle market deal-making category—$500 million to $1 billion—which decreased to only 12% of all middle market deals, 5 percentage points lower than any similar reading over the past 11 years. This implies that managers were less willing to write large checks that were commonplace before the pandemic. By comparison, upper middle market deals represented 13% and 22% of all deals in 2008 and 2009, during the financial crisis. And the median deal size was $157 million in 2020, down from $200 million in 2019.
This trend toward smaller check sizes was further evidenced in the third-quarter data with a surge in add-on acquisitions. Middle market add-ons amounted to $150.3 billion of all deal value, or 64%, which is the largest reading by far over the past 14 years. Add-on acquisitions are attractive in a bearish economy, because they tend to be less risky since an investment has already been effectuated. In addition, many portfolio companies—especially those in retail, hospitality and real estate—have suffered financially, which leads them to refocus on existing rather than new investments.
Initial estimates for M&A transactions in the final two weeks of 2020 show a record level of deal output over comparable periods, suggesting that U.S. investment managers were planning for possible tax policy changes. What’s ahead remains a question mark but could come together with Democrats gaining control of the Senate following the two runoff elections in Georgia.
As we look ahead to 2021, we expect more deal activity resulting from low interest rates, central bank stimulus and overall improved economic conditions. In addition, private equity firms are sitting on significant amounts of cash, which will be necessary for struggling companies needing another dose of capital.
It is still difficult to gauge the ultimate cumulative economic losses caused by the pandemic. But what’s clear is that private equity will play a big role in what we expect will be a U.S. economic recovery in the second half of 2021.
MIDDLE MARKET INSIGHT
Middle market private equity managers played a significant role in the rebound of mergers and acquisition and are expected to continue to do so in 2021.
The challenge of collecting consumer debt
The ability to collect on consumer debt is important to the profitability of any lending institution or debt collection firm, and these companies must invest heavily in infrastructure and resources to ensure they have an effective collections function.
The regulatory environment is continually changing. For example, in October, the Consumer Financial Protection Bureau (CFPB) set new guidelines on communications between lenders and borrowers—which required a considerable investment by lenders and debt collection agencies.
Then there was the COVID-19 pandemic, which only added to the challenges for specialty finance companies as they adapted to remote work environments.
Now, with the Biden administration preparing to take over, specialty finance companies face the prospect of more vigorous oversight and enforcement actions. RSM has identified three trends defining the future of collections.
Collecting on consumer debt does not lend itself to a one-size-fits-all approach. Customer preferences and demands vary dramatically. Understanding that customers have different preferences for how they engage with their creditors is key to developing a collection approach that is effective and accepted by the borrower. Successful collection companies are able to identify the mode of communication that works best for each customer segment, deliver tailored messages to their customers and communicate in a manner that sets the right tone.
Engaging borrowers throughout the lending cycle, from origination to payoff, with personalized communications is essential. Companies must invest in understanding who their customers are in order to develop an effective collections approach. Even in a digital environment, companies that make these investments are able to reintroduce the human element to the collections process and prove more effective.
Investments in technology-driven collection functions can more easily be adapted to changing markets and product offerings than a traditional brick-and-mortar operation. Code-driven collections systems can be adapted to new regulations and expanded without the same investment in staffing and physical space. This allows financial services companies to nimbly respond to changes in the competitive landscape. Many companies that are successful have invested in the development of their own technology-driven collections functions or have partnered with fintech firms that have the technology expertise.
Technology-driven solutions provide a wealth of data on customers and their payment behaviors to enable the development of a personalized approach. There are many solutions developed by fintech companies that assist in predicting customer delinquencies using combinations of historical data, easily accessible demographic information and behavioral influencers (such as call notes). Collection strategies can then be developed to communicate with borrowers before they reach the later stages of delinquency. Companies can also use the data to intelligently prioritize their collection efforts. The result is a targeted, more efficient collections process that brings in more revenue.
Collecting on consumer debt will always be challenging. Companies that invest in technology will create a nimble collections function that can respond to an ever-changing and complex regulatory environment, while remaining profitable.
MIDDLE MARKET INSIGHT
Companies must invest in understanding who their customers are in order to develop an effective collections approach.
The blurring lines between fintechs and their traditional counterparts
As traditional financial services firms continue to embrace new technologies and as digital-first finance companies enter the market, investors are asking a question: Is every company a fintech company?
The industry may still be a long way from that, but the lines are continuing to blur between fintech companies and their traditional counterparts. Helping to push along this digital evolution are two trends: embedded finance and banking as a service, or BaaS.
- Embedded finance refers to nonfinancial companies integrating a financial product—such as a loan, a payment plan or a credit card—into their service offerings.
- Banking as a service allows any platform business, like Facebook, to provide the full suite of traditional banking products, such as loans, credit cards and deposits, by partnering with a fintech company and a licensed bank.
Both have recently experienced rapid growth—fueled in no small part by the pandemic—as consumers and businesses have moved away from cash and embraced online shopping.
Global investment in fintech has grown and, as of December, has captured 14% of all venture capital investments. In deal value, $41.2 billion has been invested in fintech companies, with 73% of the capital going to later-stage startups, according to PitchBook. When looking at the investment in fintech by segments, investment in payments has led the way.
How have embedded finance and banking as a service experienced such a rise? Three recent examples illustrate why they have won over consumers and businesses:
- Credit when you need it: In June 2020, Amazon partnered with Goldman Sachs to provide credit lines of up to $1 million to merchants selling on the Amazon platform—an example of embedded finance. Through the partnership, Amazon offers a streamlined Amazon Marketplace seller experience as the line of credit surfaces at checkout—when it is needed. The approval process is fully digital and done in real time. Interest rates are in line with the market, and repayment options are reasonable. The growth of credit when you need it is also evident in the rise of buy now, pay later (BNPL) options among online vendors. According to Bloomberg, BNPL has gained popularity among millennials and Gen Z, who prefer the flexibility of paying in installments, and is expected to grow at a 40% annual compounded rate through 2023.
- A smart credit card: In October, Venmo announced its first credit card, which will be equipped with a quick response, or QR, code to select customers. The card will offer rewards programs based on individual spending patterns—offering 3% on the category that the customer spends the most on, 2% on the second category and 1% on all other purchases. No longer will cardholders need to use the right card to max out traditional credit card companies' cash-back rewards.
- A bank account fit for 2021: In November, Google announced a revamp of its Google Pay app for both Android and iOS. The revamp builds on the app's functionality—customers can still pay for services and goods and request or send payments to friends. Starting this year, Google will partner with 11 banks, including Citi and Stanford Federal Credit Union, to offer a digital-only bank account with no minimum balance requirements, no monthly fees and no overdraft charges. The app also allows customers to link to their current banks. The result is a bank account that leverages data—allowing customers to split bills easily, make or request payments from friends or businesses, provide real-time financial health information and even tailor offers based on preferences.
Embedding a financial product seamlessly and at the time of need is redefining what we think of as a fintech company. In turn, platform businesses are ready to embrace new business models, and application programming interface-driven technology allows the service to be easily added. Because the trends allow platform businesses to employ a choose-your-adventure approach to deliver more value, we expect it to continue.
MIDDLE MARKET INSIGHT
Platform businesses are ready to embrace new business models, and application programming interface-driven technology allows a service to be easily added.
Insuring the uninsurable to protect a recovering economy
As COVID-19 vaccines are administered and the global economy begins to show signs of recovery, leaders in business and government have been looking for ways to mitigate the risk of future pandemics. In the traditional insurance model, the losses of the few are paid for by the premiums of the many. But global pandemic risk is uninsurable by nature; this is because risk diversification, a core tenet of the insurance business, is not possible. For this reason, a government backstop is necessary to support the insurance industry and to build resilience in businesses going forward.
A first attempt
In May 2020, Rep. Carolyn Maloney of New York proposed legislation for the Pandemic Risk Insurance Act (PRIA), which would establish the Pandemic Risk Reinsurance Program within the Department of the Treasury.
The program would provide compensation to insurers up to a $750 billion cap if they incur losses as a result of coverage related to pandemics on or after Jan. 1, 2021.
In November, the Subcommittee on Housing, Community Development and Insurance held formal hearings to discuss insuring against pandemic risk and the proposed PRIA bill with senior executives in the insurance industry. It was clear from the testimony that there has yet to be a consensus on the insurance solution. There is, however, broad agreement that the economic impact of the pandemic, estimated at approximately $1 trillion per month, cannot be borne by the property and casualty insurance industry, which would only have enough capital to sustain a month or two of losses.
The PRIA bill died in the previous session of Congress, and managing future pandemic risk remains an outstanding issue for the government and the insurance industry to address.
Collaboration is critical
But this is not the first time that the insurance industry and the government have been at an impasse. In previous cases, they have found solutions to these issues:
- The Terrorism Risk Insurance Act (TRIA) was passed following 9/11 to address an insurance coverage gap in the real estate industry when property insurers began excluding coverage for acts of terrorism.
- The National Flood Insurance Program (NFIP) expanded quite rapidly following the events of Hurricane Katrina and Hurricane Sandy to provide flood coverage to regions that are underserved by the private markets.
- The Federal Crop Insurance Program (FCIP) was established to provide economic stability to farmers through a sound system of crop insurance products, backstopped by the federal government.
Mind the coverage gap
Without a way for the private sector or the government to address pandemic risk, businesses renewing their commercial insurance programs going into 2021 are experiencing significant price increases, but in some cases are receiving much less coverage.
Commercial insurance markets have hardened steadily over the past five years because of underlying claim trends, which have only been amplified by the pandemic. Many commercial insurance carriers are implementing broader infectious disease exclusions in their policies, and in extreme cases, they are outright declining to renew policyholders in certain higher-risk industries.
The ripple effect of being underinsured or uninsured can be crippling to a business where insurance is required for financing activities, for example. Middle market businesses are not immune to these trends and are often hit harder compared to larger counterparts because they lack the capital to self-insure against the coverage gap and to provide liquidity in a time of crisis.
A public-private program could offer cost-effective access to insurance against pandemic risks that would be uninsurable in the private insurance market. It would allow the insurance industry to deliver a great customer experience and stability to the economic recovery while gaining greater control over the risk on their balance sheets. The solution will require a novel, creative and innovative approach from both government and the insurance industry.
MIDDLE MARKET INSIGHT
Middle market businesses often lack the capital to self-insure against the coverage gap and to provide liquidity in a time of crisis.
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