Financial Services Industry: What Lies Ahead

With the vote of Brexit completed and the initial reactions consid­ered, two consistent themes have emerged that will impact compa­nies and economies globally: “uncertainty” and “volatility”.

These two factors directly impact value, especially in the financial services industry.

Just as the markets have been driven up and down since the vote, the next two years will likely be marred with uncertainty and volatility, not only by Britain and the EU, but in the economies of countries around the world. Treaties, trade negotiations, passporting, immigra­tion, relocation and nationalism could take on new meaning for Britain and the Europe Union, the effects of which may ripple out to other nations. All of these changes have the potential to create severe shifts in economies, businesses, strategy, opportunities and value.

Immediate Observations Impacting Financial Institutions We have seen decisions to delay an increase in interest rates, or to maintain status quo interest rates, by many of the global central banks for the near-term and potentially intermediate-term. This increases pressure on the banking industry which was expecting future increases in interest rates (spreads) which could have resulted in higher profits and potentially higher returns to their shareholders (i.e., dividends and capital appreciation), while maintaining or increasing their regulatory capital levels. This will likely result in lower stock prices and market multiples for these institutions, creating potential goodwill impairment and going concern issues not seen since the 2008 Financial Crisis. Goodwill and other intangible assets will need to be examined and tested by banks, as appropriate, under current and proposed accounting guidance as well as regulatory stress testing scenarios.

Trade negotiations between countries will likely take significant time, contributing to uncertainty as to business decisions and the ability to repay loans in the future. Further, decisions surrounding employment and licensing through the shifting of headquarters and primary operations (employees and intellectual property) from London to another base in the EU, as well as the impact of immigration policy, could result in a movement of employees in the UK to other EU countries. The potential result in economic changes, including higher unemployment rates, reduction of business, lower taxes and higher vacancy rates, could mean a higher probability of a recession and higher default rates on loans to be experienced primarily by the global banks. Therefore, banks should be prepared to re-examine the valuations of their loan portfolios for financial reporting purposes, which should be consistent under various stress testing scenarios performed for regulatory reporting.

Prior to Brexit, evidence indicated that net credit losses for banks were on the rise from their lowest levels since the financial crisis. In some EU countries, net credit losses are at significant levels for which banks may require infusions of capital or bailouts. Additional pressure could be observed as worsening economic conditions may result in significantly higher than expected/probable credit losses and defaults that banks will need to record, as borrowers fail to repay their debts. Further, the value of the underlying collateral, given the changing economic environment (GDP, inflation, unemployment rates, and interest rates), may need to be re-assessed for recoveries.

Asset managers and retail brokerage firms could possibly need to revalue their investments in illiquid and complex instruments, which may require a reduction in value resulting in fewer assets under management. Additionally, the observed risks in the market have resulted in a flight toward quality and safety, whereby, investors have flocked toward U.S. treasuries. Significant redemptions, lower profitability, and asset valuation declines have resulted in lower valuations and multiples for asset managers and retail brokerages at least on a short-term observable basis. Going concern questions and potential goodwill and other impairment issues may need to be examined for these institutions, as well as potential restructuring of the manager or the terms of the fund vehicle that limit redemptions.

For the investment banks and broker dealers, delays in M&A and IPO activity for the short/intermediate-term and expected reduced levels of fixed income and equity sales and trading are expected to reduce bottom lines. Derivatives relating to FX currencies, interest rates and commodi­ties, which have all currently experienced volatility, and potential declines in the levels of investments portfolios including complex and illiquid securities, loans, real estate, etc., may result in additional risks for these institutions and a potential need for more capital.

Insurance companies, which have currently been considered the safest and most stable of the financial institutions, also have exposures to complex and illiquid securities. Insurance companies have reduced their exposure to these financial instruments since the financial crisis. However, in their efforts to chase yields in this low interest rate environment, many insurance companies have invested a portion of their portfolios back into these instruments. Many of these instruments, which are hard to value, may require a write-down that may result in a need for regulatory capital by certain insurance companies. Additionally, economic downturns could delay rate and price increases by insurance companies to their clients, which in turn, may result in lower revenue and profitability projections, and pressure on goodwill and asset impairment testing.

Duff & Phelps Observations and Solutions

Duff & Phelps has monitored the events prior and subsequent to the announcement of Brexit, and the global economic, valuation and regulatory impacts to the global financial services industry. Volatility and uncertainty typically bring incremental risks, transformations, and impacts on a company, its business operations and its assets in the short and intermediate-term, as well as potentially into the longer-term.

Institutions could be faced with decisions around reorganizations and divestitures that require independent assessments of strategic alternatives, which may require development of restructuring plans, enterprise and asset valuations, impairment testing, fairness and solvency opinions, tax planning (i.e., business tax incentives from relocations, cost segregation from acquisition of corporate offices), M&A advisory, dispute consulting and regulatory compliance. Moreover, valuations of legal entities, business enterprises and/or assets may be required for tax, regulatory and financial reporting purposes. Intellectual property transfers between jurisdictions will need to be arm’s length in nature, while existing transfer pricing of intellectual and proprietary properties may need to be re-examined. 

In the wake of Brexit, financial institutions may need to address lower profits, higher capital requirements and increased levels of redemp-tions/withdrawals in the short-term and intermediate-terms, which may result in a potential triggering event and annual goodwill impairment issues that should be addressed for financial and regulatory reporting purposes.
Further, financial institutions may need to understand and analyze their cost of capital implications given the economic, political and market volatility to best allocate regulatory capital, as well as for budgeting and forecasting and value creation.

Following the regulatory capital and financial reporting requirements are essential during periods of uncertainty when downward valuations occur. Valuation of complex and illiquid assets including loans, not only require appropriate valuation methodologies and assumptions, but also objectivity and independence to truly meet the requirements from a risk management and best practices perspective. Financial institutions should consider obtaining independent and objective analyses of the underlying assumptions, such as credit quality and potential losses (probability of defaults and loss given default curves) in the future under current and proposed accounting requirements that may have a material impact on their financial and regulatory statements. Additional­ly, the underlying collateral to loans must be valued for recoveries, such as for real estate, closely held businesses and other illiquid securities, which may lose value in the current environment.
Furthermore, alternatives, such as potential sale of non-performing loan portfolios and complex assets and capital infusions, should be reviewed, considered and assessed to increase regulatory capital and liquidity reserves at certain financial institutions.

Duff & Phelps has a long history of assisting global financial services companies during challenging time periods, as well as during periods of growth where significant levels of profitability and M&A are high. While volatility and uncertainty will likely continue for the foreseeable future, financial institutions that prepare for all possible scenarios will be in the best position to succeed in these challenging times. Following Brexit, Duff & Phelps has already responded to many financial services institutions around the world who are looking to us for assistance with issues facing them currently and potentially in the future.

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