Reporting and Governance

Regulators in the UK and Europe have had plenty to consider over the past 12 months, with start-stop Covid restrictions, the re-emergence of long-dormant inflationary pressures, climate change imperatives and technological innovations all making the delivery of stable, efficient and fair credit markets harder to achieve. By Mark Somers, director of research at 4most.

The winter break is no doubt a welcome respite. As for those who work under their benefaction, we can only hope they return with a positive outlook, while we ponder upon what fears regulators may be brooding over and how this will influence the outlook for 2022. 

Various published regulatory roadmaps give some indications of the known areas of change. The main themes include setting up an environment for sustainable economic recovery from the pandemic, protecting the consumer from the unintended effects of financial innovation, and ways of reflecting climate change risks in prudential frameworks. Perhaps more open to debate are the underlying doubts that may crystalise in 2022 and evolve into as-yet unknown regulation and guidance for the consumer lending industry. The lists of published priorities give some indication of the likely traits that may pique regulatory attention and merit prioritisation in the coming year:

• capacity to touch on existing political sensitivities (such as ESG disclosures and road maps to net zero, consumer use of credit information);

• risk of failing to influence a trend before it has become too big to easily unwind later (such as digital and cryptocurrency);

• new business models that cause systemic and possibly unexpected linkages between participants (such as buy now, pay later, transparency into third-party IT Infrastructure, adoption of AI);

• avoiding stifling of industry innovation (such asframeworks for smaller banks); and

• managing the risks arising from any material divergence in regulation or practice from those of the EU – particularly where this gives rise to what might be perceived as an unfair competitive advantage. 

Observed through this lens, it is reasonable to look at the horizon risks that remain currently unaddressed and to identify one group that has the potential to result in near term regulatory attention. 

Stranded assets

As the economic tide starts to come in, moving from fossil fuel-based operations and increasingly globalised towards sustainability, with a more regional focus, it is likely that key assets will be revalued. We can see this across many areas, from the risks to valuations of companies reliant on globalisation or fossil fuels to those of residential property affected by increasing flood risks or requiring energy efficiency investment. The question for regulators and government is two-fold. First: how best to ensure the markets adjust smoothly? Second: which costs should be borne by lenders, industries and the customer? And, ultimately, what needs to be socialised through regulation? 

Smooth adjustment requires that market participants have a long-term assessment of the risks and that expectations are reasonably closely aligned across the market. This may be viewed by some as an extension of past regulatory objectives of compliance to principles, into a more political territory of supporting or achieving a particular social outcome. In this respect we can see the requirements to conduct climate change, other forms of stress testing and scenarios analysis, falls directly into this camp. Regulators hope that by requesting a thorough assessment of the risks from the main lenders, they can drive the market to price them into products, and thereby influence the real economy.

However, making the scenarios realistic requires the second issue to be addressed in good time. Lenders need to understand which risks they will hold and which they can pass on. We can see this playing out in the aftermath of the UK’s Grenfell Tower fire disaster driving a sudden reassessment of properties affected by the fire risks associated with dangerous cladding. Currently, the costs are chiefly being borne by the property consumer leaseholders and indirectly by their lenders. However, this is potentially politically tenable in the long term. 

As a result, it seems possible the property industry (either the property freeholder or builder) or the government will ultimately need to underwrite the cost (to the potential benefit of leaseholder occupants and their lenders). Given the current situation, lenders need to assume the worst case. However, the potentially binary nature of who bears the risk leads to undesired volatility in bank estimates of loss.

The example of high-flood-risk properties, however, demonstrates that the risks can also work out differently. Currently the UK government has mandated through the Flood-Re scheme that excess flood risk premiums are socialised across the whole residential property insurance market. This means that consumers are not currently paying the full cost of their insurance in high-flood-risk zones. By the end of the 2030s it is projected that this scheme will unwind, which would lead to much higher property insurance and lower property values for the specific properties where flood risks remain unaddressed. That risk is typically not yet fully reflected by banks’ capital allocations. Clearly the government may extend or otherwise underwrite the losses. However, at some point it must be the case that increasing flood risks mean some properties are no longer viable and a smooth transmission of that fact to the market would minimise financial market disruption as opposed to the current position where the government-mandated scheme is creating a potential cliff edge.

As politics have become more polarised, so regulators are being required to do more of the work to achieve social objectives. In this environment, regulators may well be required to respond quickly and in new ways to manage policy risks around the valuation of a wide range of stranded assets to ensure the transition in credit markets is as smooth as possible.

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