United States

Financial services industry outlook

Volume 9, Winter 2022

Along with rapid technological advancements, matters of environmental and social importance are continuing to shape sectors across the financial services space. In this latest quarterly outlook for the industry, we examine how banks can tap into new opportunities by catering to historically underserved communities, what growing attention on clean energy and small business equity means for specialty finance lenders, and how climate change-related risks are affecting insurers.

We also assess how asset managers are ramping up pressure around environmental, social and governance initiatives but are also feeling this pressure themselves, and the role smart contracts are playing in reshaping capital markets.

“Players in the financial services space have an opportunity to be more intentional in seeking out ways where innovation, customer experience and new technologies can help them adapt to evolving priorities, including ESG and focusing on underserved customers and communities,” says Peter Brady, national financial services industry leader at RSM.

KEY TAKEAWAYS FROM THE WINTER 2022 FINANCIAL SERVICES INDUSTRY OUTLOOK

  • Financially underserved individuals and businesses are likely to represent new customers and additional sources of growth for banks as the sector faces increasing competition from financial technology companies.
  • Technology as a disruptive force, clean energy, and equity in financial services are broad themes we expect to characterize the Consumer Finance Protection Bureau’s regulatory agenda moving forward.
  • With assets invested in ESG strategies growing rapidly, managers' responsibility for executing their stated ESG mandates has drawn greater attention from regulators and investors.
  • Insurers have to prepare for the potential impact of climate risk factors and incorporate climate mitigation as part of their enterprise-wide corporate strategies, risk management, and investment portfolios.
  • The gross value of assets locked into smart contracts has been growing, and such contracts have even expanded into traditional capital market functions.

BANKING

The financially underserved: How banks are positioned to make a lasting impact

For the financially underserved in the United States—primarily socioeconomically disadvantaged people of color who are unbanked or underbanked as well as minority-owned small and medium-sized businesses that lack sufficient access to the banking ecosystem—the widening wealth gap and financial hardships resulting from the pandemic are not just media headlines. They are a reality.

Herein lies an opportunity for banks. There are millions of U.S. households that are unbanked or underbanked, according to the Federal Deposit Insurance Corp., and nearly 1 million minority-owned small businesses across the country, according to the U.S. Census Bureau. Without access to the banking system, these groups often turn to higher-cost alternatives for their banking needs and as a result may be unable to build wealth for financial goals such as retirement or a home purchase. This lack of access also means people in these groups may be unable to borrow to attend college or start a business.

“Players in the financial services space have an opportunity to be more intentional in seeking out ways where innovation, customer experience and new technologies can help them adapt to evolving priorities, including ESG and focusing on underserved customers and communities,” says Peter Brady, national financial services industry leader at RSM.

These groups need the support and security the banking system offers. Now, with more banks assessing the fee structures of their deposit accounts and financial products, financially underserved individuals and businesses are likely to represent new customers and additional sources of growth for banks as the sector faces increasing competition from nonbank financial technology companies. What’s more, bringing the financially underserved into a banking system that fosters an environment of trust and promotes their financial well-being can directly benefit U.S. economic growth. A recent study by McKinsey & Co. indicates that narrowing the wealth gap for Black Americans could add roughly $1 trillion to the U.S. economy by the end of this decade.

Growing disparities

Household wealth in the United States continues to grow, but a large number of people still may lack financial assets such as stock market investments or nonfinancial assets such as real estate.

Data compiled by the Census Bureau shows the disparity in homeownership rates among various racial groups in the United States.

As the pandemic continues, the data shows that homeownership rates for all races, except white Americans, is declining. Further, the gap between white and Black homeowners is yet again nearing its widest point since the Census Bureau began tracking the data.

And the economic disparities don’t stop with financially underserved U.S. households.

Data published by the Federal Reserve shows how deeply the pandemic has affected small businesses owned by people of color. Here are some of the findings from the Fed’s 2021 Small Business Credit Survey:

  • “Ninety-two percent of Black-owned firms reported experiencing financial challenges in 2020 (up from 85% in 2019), followed by Asian-owned firms (89%, up from 70%) and Hispanic-owned firms (85%, up from 78%). White-owned firms were the least likely to report financial challenges (79%, up from 65% in 2019).”
  • “Black business owners were the most likely to tap into their personal funds in response to their firms’ financial challenges (74%) compared to Hispanic-owned firms (65%), Asian-owned firms (65%), and white-owned firms (61%). Almost half of Black-owned firms (46%) reported concerns about personal credit scores or loss of personal assets as a result of late payments, the highest share among the owner groups. In contrast, white-owned firms were the most likely to report that there was no impact on the owner’s personal finances.”

The Fed also points out the concerns faced by small businesses owned by people of color in how they obtain financing needed to operate their businesses. From the report:

  • “Across owner groups, Black-owned firms that applied for traditional forms of financing were least likely to receive all of the financing they sought (13%). Hispanic and Asian-owned firms (20% and 31%, respectively) were also less likely than white-owned firms (40%) to receive all of the financing for which they applied.”
  • “Firms owned by people of color were twice as likely as white-owned firms to report that they did not use a financial services provider. Twelve percent of Black- and Hispanic-owned firms did not use financial service providers, followed by 11% of Asian-owned firms and 6% of white-owned firms.”

The financing challenges before the pandemic, coupled with the shock of the pandemic itself, has created a perfect storm for minority-owned businesses.

Returning to their roots

The current economic environment is highlighting the need to help the financially underserved. Banks can play a significant part in this effort—as they did in the early 1800s, when some of the earliest banking organizations helped support people and communities in need by providing a means to save or finance the building of homes or business activities.

Because of the variety of needs among financially underserved communities in the United States, banks can deploy support in numerous ways. Here are some options:

  • Invest in community development financial institutions (CDFIs) or become CDFI-certified: CDFIs promote economic opportunities in financially underserved or distressed communities by helping individuals finance a home purchase or small business and investing in local community initiatives. For example, Bank of America has invested over $1.6 billion in more than 250 CDFIs across all 50 states and Washington, D.C., creating a directory that can connect small-business owners with additional capital.
  • Create programs to support community development activities: Get creative in how the organization, through its own customers, can support community development activities in underserved communities. Sunrise Banks, a nearly $2 billion community bank headquartered in St. Paul, Minn., has created a deposit impact fund, which will help it drive local development efforts in underserved areas. At Sunrise, a customer or business can open a deposit account and designate it as an impact deposit fund, and the proceeds will then be used to support those community development efforts. The funds still belong to the account owners, but their use is allocated to support these important efforts.
  • Increase educational outreach to the under- or unbanked: While the latest data compiled by the FDIC indicates that roughly 5.4% of U.S. households are unbanked, it doesn’t take into account the additional U.S. households that are not fully engaged with the financial services system. This refers to households that have an account at an insured institution but also obtain financial products or services outside of the banking system.
  • In an effort to attract more households, banks can look to increase their marketing campaigns and awareness efforts around the importance of participation in the banking system. Through a new initiative, Wells Fargo plans to redesign roughly 100 branches in underserved communities to create a more comfortable and accommodative environment to educate people about the importance of banking access and financial health, whether one-on-one or through group seminars.

  • Support minority communities through charitable giving:Consider allocating a higher portion of charitable giving to underserved or minority communities. In 2021, 69%—or $1.9 million—of charitable giving made by Pacific Premier Bank, a nearly $21 billion bank with branches across the west and desert southwest, was pledged to support minority communities.

Banks don’t necessarily need to be creative with ways to support the financially underserved, but they do need to be intentional.

Banks don’t necessarily need to be creative with ways to support the financially underserved, but they do need to be intentional. 

During the current economic recovery, banks have been viewed much more favorably than they were coming out of the Great Recession. But in the near term, working to blunt the increasing wealth gap and support the financially underserved will likely be key areas in which banks can make the biggest difference and also cultivate increasingly favorable views from customers and the broader public. In doing so, banks can unlock a means to new growth while simultaneously supporting continued economic expansion.

SPECIALTY FINANCE

The Consumer Financial Protection Bureau’s emerging agenda

Since its formation in 2011, the Consumer Financial Protection Bureau has been perhaps the most significant federal regulatory agency for the specialty finance sector and middle market financial service companies. Nearly a year into the Biden administration, recent announcements are starting to shed light on a few broad themes that will characterize the CFPB’s regulatory agenda moving forward: 

1. Technology as a disruptor to traditional financial services: There is nothing new about the rapid digital transformation of traditional financial services companies. Through the development of new technologies and partnership with established technology firms, traditional financial services institutions are changing the ways in which they acquire, engage with and service their customers. As companies change how they do business, it is challenging for regulators to enforce existing rules. 

Twice a year, the CFPB publishes an agenda of its planned rule-making activities. The most recent agenda indicates that the CFPB recognizes the role of technology and the need for a reevaluation of current regulations. One long-term topic on the agency’s action list is artificial intelligence. The CFPB recognizes the impact on consumers of increasing deployment of AI, including machine learning, across a wide range of financial services functions. 

Use cases for AI have emerged in areas such as assessing creditworthiness of borrowers with limited credit history and in the use of algorithms to automate the entire loan decision process. In these examples, AI completely transforms the way in which traditional financing decisions are made, replacing human decisions with technology, a dynamic not fully contemplated by existing regulations. Furthermore, the CFPB states it is “continuing to monitor the use of AI and is evaluating whether rulemaking, a policy statement, or other Bureau action may become appropriate.” 

2. Financing clean energy: The administration’s emphasis on the expansion of clean energy, along with companies’ and consumers’ growing awareness of its importance, means new opportunities for specialty finance companies. Businesses in this space can play a role in financing residential solar panels and other clean energy sources. 

The Economic Growth, Regulatory Relief, and Consumer Protection Act signed in May 2018 amended the Truth in Lending Act to mandate that the CFPB prescribe regulations relating to Property Assessed Clean Energy (PACE) financing. The PACE model encompasses the financing of energy-efficient and renewable energy upgrades and installations in residential and commercial properties. In 2019 the CFPB took the first step in fulfilling its mandate by issuing an advance notice of proposed rule-making related to PACE financing. 

In its latest agenda, the CFPB noted that it is continuing to engage with stakeholders and is pursuing quantitative data on the effect of PACE on consumers’ financial outcomes. As this type of financing becomes more popular, it is reasonable to expect that the CFPB will issue a policy statement or regulations that will affect the way in which PACE financing is conducted. 

3. Small businesses promoting equity: In a proposed rule on Sept. 1, the CFPB acknowledged the role small businesses play in wealth creation for individuals, families and communities. According to the Small Business Administration, more than 60 million Americans work in small businesses, and small businesses created nearly twice as many new jobs as large businesses did between 2010 and 2019.  

Fairness in lending to small businesses can foster greater equity and community development, while the absence of fair practices highlights existing inequities. To provide better information about lending to small businesses, the CFPB’s proposed rule would require lenders to collect and report data about credit applications from small businesses, including information about whether those businesses are women-owned or minority-owned. The objective is to increase transparency of organizations that lend to small businesses and to ensure that such businesses have access to fairly priced credit.  

Technology as a disruptive force, clean energy and equity in financial services continue to be emerging areas of focus in financial services, specifically in spaces where specialty finance companies operate. Recent communication and action by the CFPB indicates that these areas will also require regulatory focus, with the likely introduction of new rules. Any company operating in these areas will need to stay abreast of changes to the regulatory environment. 

ASSET MANAGEMENT

Asset managers are turning up ESG pressure—and feeling it, too

In May, Engine No. 1, a small hedge fund with $250 million of assets under management, pressured oil giant ExxonMobil to rethink its business model and embrace environmentally friendly practices. The push came in the wake of ExxonMobil's declining profitability, but it is also a notable example of increased investor interest in more sustainable and climate-conscious corporate policies.

The effort was a success for Engine No. 1. Its win against ExxonMobil—with its $250 billion market capitalization—was significant because while the hedge fund held only a $40 million stake in ExxonMobil, it was able to take three board seats. Engine No. 1 also secured the support of the oil company's top three investors: Blackrock, State Street and Vanguard, which collectively are pushing for the oil company to prepare for a future without fossil fuels.

This proxy battle highlights that investors are looking to influence even those companies many people may not see as friendly to environmental, social and governance initiatives.

This proxy battle highlights that investors are looking to influence even those companies many people may not see as friendly to environmental, social and governance initiatives. They are also looking to influence company boards; in reviewing shareholder proxies by type and isolating environmental proxies, 44% of all proxies in 2021 related to climate risk. This percentage was only 22% in 2016.

Engine No. 1’s effort came during a year that has seen an uptick in the number of proxies related to ESG topics and a significant jump in the success rate compared to last year as measured by the percentage of ESG proxies that were approved by shareholders.

Drawing on the interest it gained after winning the proxy battle, Engine No. 1 raised additional capital, now has $430 million under management and recently launched an exchange-traded fund (ETF) focused on influencing the decisions of the largest 500 U.S.-listed companies. Through the ETF, Engine No. 1 will attempt to hold companies accountable in prioritizing ESG matters.

It might be easy to think of Engine No. 1 as an isolated case that will not have repercussions in the broader asset management space; however, the data shows that interest in ESG is not going away. U.S. ESG assets under management now exceed those of Europe, which held the number one spot before 2020, according to Bloomberg data. In fact, during the last two years, ESG assets in the United States have grown more than 40% and now sit at $17 trillion, or nearly half of the total global ESG assets of $35 trillion. This figure is projected to grow to $50 trillion by 2025, and at that level, ESG assets will represent almost a third of the total $140 trillion of projected global assets under management, according to Bloomberg.

As asset managers turn up the pressure around ESG, they themselves are also subject to keeping up with these increasingly important criteria. With assets invested in ESG strategies growing rapidly, managers' responsibility for executing their stated ESG mandates has drawn greater attention from regulators and investors.


Regulatory attention

Throughout 2021, the Securities and Exchange Commission has focused on the lack of uniform standards around ESG. When the SEC's Division of Examinations published its 2021 Examination Priorities in the first quarter, ESG reappeared after also being on the priority list in 2020. Around the same time, the SEC established the Climate and ESG Task Force in the Division of Enforcement, which among other duties, will "analyze disclosure and compliance issues relating to investment advisers' and funds' ESG strategies."

risk alert followed in the second quarter, providing detail on areas SEC examiners would focus on based on deficiencies observed in the examination of investment advisers and funds regarding ESG investing.

At the SEC's Asset Management Advisory Committee July meeting, ESG featured prominently on the agenda. In his remarks, Chairman Gary Gensler discussed his concerns on fund disclosures and naming conventions in connection with sustainability investing and the lack of diversity in the asset management industry.

More recently, speaking before a European Parliament committee, Gensler referred to funds marketing themselves as "green," "sustainable" or "low carbon" and indicated that he had asked SEC staff "to review current practices and consider recommendations about whether fund managers should disclose the criteria and underlying data they use to market themselves as such."

Given this tone from the highest level at the SEC, along with the combined efforts of the Division of Examinations, the Climate and ESG Task Force, and the Asset Management Advisory Committee, we expect the SEC to keep putting pressure on asset managers as it works to establish clearer guidelines.

Looking forward

The SEC’s focus on ESG disclosures and practices will require asset managers to be more vigilant when curating ESG marketing materials and more deliberate about the execution of their ESG strategy and the supporting compliance program. The threat of enforcement action for ESG infractions has become real in the wake of the recent news of European and U.S. regulators launching an investigation into possible violations by DWS, a global asset manager affiliated with Deutsche Bank.

Asset managers are also feeling the heat from investors. Large-asset owners have continued to put companies and asset managers on notice. One such high-profile investor is Harvard University's endowment fund, which announced in September that it had divested all direct investments in fossil fuel companies and planned to make no further investments in such companies. The announcement from such a prominent asset pool is significant and will ring loud in the asset management community.

For years, limited partners have been increasing their incorporation of ESG into the new-manager selection process through the use of tools such as the United Nations Principles for Responsible Investment's due diligence questionnaires for hedge funds and private equity. This focus has continued to grow, prompting organizations such as the Institutional Limited Partners Association to update the ESG-linked questions in its due diligence questionnaire this year.

Heightened scrutiny on asset managers’ ESG investment strategies has prompted some to use lines of credit linked to ESG goals, seek more transparency on ESG initiatives and make commitments to do more.

Clearly investors will continue to push asset managers for ESG accountability at the investment strategy/portfolio level—but increasingly they will also focus on this issue at the asset manager's own organization.

INSURANCE

Risk without reward: Climate change and the insurance industry

Against the backdrop of the pandemic’s disruption, millions of people have also experienced extreme weather disasters such as wildfires, hurricanes, droughts, tornadoes and hailstorms over the last year and a half. These types of catastrophic events expose the insurance industry to climate-related liabilities for property and casualty insurers.

In 2020, the United States experienced over $20 billion of damage from weather and climate disasters, according to information from the National Oceanic and Atmospheric Administration. Despite having fewer severe weather events in 2021 to date, storm-related costs this year across the country have already exceeded costs in 2020.

With climate events expected to continue increasing in severity and frequency, and loss frequency predicted to rise as well, insurance companies must understand climate risks and the implications greater exposures can have on their business.

Climate factors affecting insurance

Insurers should prepare for the potential impact of climate risk factors and incorporate climate mitigation as part of their enterprise-wide corporate strategies, risk management and investment portfolios. Climate change risk factors that may affect the insurance industry typically fall into three main categories: physical, transition, and liability.

Climate change risk factors that may affect the insurance industry typically fall into three main categories: physical, transition, and liability.

1. Physical risks arise from extreme changes in weather and the climate. They are categorized as either chronic (droughts, landslides, rising sea levels) or acute (wildfires, heat waves, storms, floods) and may increase in severity or frequency over time.

2. Transition risks relate to the process of adjusting to a low-carbon economy, a shift that companies and governments are making to address the impacts of climate change. For example, regulatory changes and policies around corporate climate-risk disclosures can potentially advance, accelerate, slow or disrupt the transition toward a low-carbon economy.

3. Liability risk is a type of operational risk that a company or its directors and officers assume if failing to demonstrate they have taken actions to mitigate climate change risks or failing to fairly represent asset values in the context of weather-related events. Common claimant allegations could be a breach of fiduciary duties, failure to comply with regulations, or reporting errors.

These risk factors related to climate change pose threats to the insurance industry on a macroeconomic scale from both supply and demand perspectives. Supply-side shocks affect the productive capacity of the economy in the form of shortages of commodities, diminished labor supply or damage to capital stock due to extreme weather events. Raw material and commodity price increases have been further exacerbated by the pandemic, and for insurers, this can directly contribute to rising claim costs for catastrophic events.

Demand-side shocks may include negative impacts on business investments and large financial losses due to extreme weather events. An example would be a decrease in capital flow in high climate-risk areas, leading to growth headwinds for insurers concentrated in those regions. While some insurers may temporarily offset a loss in volume with higher rates, long-term ripple effects may include insurers decreasing capacity in those areas and diverting capital elsewhere.

Taking action

Understanding climate risks and the implications for the company’s reputation is a good place to start for insurers that understand the need to take action now. As the number of extreme weather events continues to increase, incorporating an enterprise-wide climate risk strategy is paramount. Insurers should focus on three key areas:

  • Organizational readiness: Leveraging historical climate-related data and using forward-looking climate risk scenarios while taking long-term actions to prepare for economic resilience and long-term sustainability
  • Climate-related mitigation: Integrating peril-specific insights and climate change risk modeling in managing climate-related risks and investment decisions through products and services
  • Brand reputation: Maintaining strong relations with investors and understanding shifting societal expectations to better demonstrate climate readiness to regulators, analysts and customers

Achieving a balance of affordability, availability and financial stability requires a plan rooted in risk management and climate analytics to drive informed decisions.

MARKET STRUCTURE (DEFI)

How decentralized finance is reshaping capital markets: The smart contract

This is the second piece in our series on decentralized finance, known as DeFi. In our initial piece we introduced the concept of DeFi, examined its core elements (the smart contract, the token and the exchange), and took a look at DeFi’s growing impact. In this installment we’ll take a deeper dive into the first core element, the smart contract, which is the backbone of DeFi.

The ability to run a smart contract is one of the features that separates a cryptocurrency system like Ethereum from that of Bitcoin. Bitcoin’s intended purpose is to be a peer-to-peer electronic cash system. While Bitcoin is famously volatile and occasionally subject to network congestion, it has proven to be largely successful, and many consider it to be revolutionary. It is good, and getting better, at what it set out to do.

If we think of the Bitcoin blockchain as a pocket calculator, then the Ethereum blockchain—and its native currency, ether—is more like a computer: capable of handling many types of applications. Anyone can write lines of code to the Ethereum blockchain and submit a transaction with inputs and commands to run those lines of code. These lines of code are called smart contracts.

One benefit of smart contracts is that everything is in the open. The code, transactions and outputs are all written to the public Ethereum blockchain, and anyone can verify that that the execution of the code was correct. This feature allows counterparties to enter into programmable transactions that settle in accordance with the code without others having to even know who the counterparty is.

Here’s an example of how it works based on a prediction market called Augur, which is one of the first uses of smart contracts in dApps on Ethereum:

John and Tom both hold ether. John thinks ether will go down in value in the future and would like to hedge against his position. Tom believes ether will go up in value and would like to add leverage to his position. John and Tom could send their ether to a smart contract to accomplish their individual goals. The smart contract is open-source and both parties can inspect its terms. John does not have to trust Tom, or even know him. If one party doesn’t deposit the appropriate collateral, the other’s is returned. Alternatively, the smart contract may stay open until the counterparty position is filled.

Once both parties have contributed their ether, the smart contract would hold the combined ether until an agreed-upon maturity date, much like a futures contract. On that date the smart contract will then automatically check an agreed-upon price oracle and distribute the appropriate amount of ether back to John and Tom. If ether went up in value, Tom would receive more than he contributed. John would receive less, but the same value in terms of dollars. Settlement is final and nearly instantaneous.

More advanced smart contracts can operate as fully functioning dApps—which may need to rely on real-world data to execute as intended. This brings us to the concept of an oracle, which serves as an agreed-upon source of truth. It is a data feed that links the blockchain to the real world, providing external and executable information. Creating an oracle can be as simple as coding a dApp to check ESPN for sports scores or USPS for confirmation of delivery. There are also blockchain-based oracles like Chainlink, which serve to decentralize the function of the oracle, making it more tamper-proof.

Market implications

The gross value of assets locked into smart contracts has been growing exponentially. According to data from DeBank and The Block, there is currently more than $75 billion locked into Ethereum-based smart contracts, with another $25 billion locked into other smart contract-enabled blockchains. A year ago, there was less than $10 billion locked into all smart contracts.

While assuming DeFi could maintain this enormous rate of growth may be ambitious, it is staggering to imagine that based on current growth the value locked into DeFi could match the assets under management by Fidelity Investments, $10.4 trillion, in just two years.

Growing from prediction markets, smart contracts have expanded into traditional capital market functions too. We now see DeFi applications operating as lending platforms and decentralized exchanges (DEXs). MakerDAO, a DeFi lending platform, has over $6 billion in loans outstanding. The leading DEX, Uniswap, regularly sees daily trading volume in excess of $1.5 billion. On that volume, and with fewer than 40 employees, Uniswap generates nearly $4 million in daily fees, all of which goes straight to the liquidity providers.

Smart contracts facilitate the removal of the financial intermediary, pair counterparties directly on the blockchain, distribute fees directly to the liquidity providers, and can scale with near-zero cost. This combination may make for formidable competition.

The Real Economy: Industry Outlook

The Real Economy: Industry Outlook

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