The effects of the last major financial crisis have been far-reaching for banks and insurance companies worldwide. Investors tend to look at the negative aspects, like higher capital requirements that put pressure on returns. “But regulation creates opportunities too”, says portfolio manager Patrick Lemmens of Robeco New World Financials Equities, who received the Lipper Fund Award on 31 March for his fund’s strong track record.
Higher capital requirements lead to more expensive banking and insurance services
The banks are responding to the higher capital requirements by charging more for their banking services, says Lemmens. The new global regulatory system for banks, Basel III, is responsible for raising these capital requirements. This system is pushing up the requirements for capital and liquidity, while financial leverage needs to be reduced. Basel III is being introduced to tackle the inadequate regulation that contributed to the major financial crisis of 2008. Lemmers explains the consequences.
“This helps banks boost returns on their capital in order to retain access to the international capital market. There are not many other options for improving profitability. Reducing costs is harder, as cuts have already been made here.” In his opinion, this also applies to insurance companies. The introduction of Solvency II is impacting the European insurance sector. The objective of this European directive is to make sure insurers have sufficient capital reserves. “Covering longevity risk costs more in the Netherlands than in other countries as a result of the regulators’ high capital requirements.”
There is also another reason why higher capital requirements can lead to raised costs. The regulators are scaring off newcomers with more stringent capital requirements and reporting obligations, says Lemmens. “They are putting up daunting barriers that make it increasingly hard for newcomers to enter. This prevents new companies that are willing to slash prices from gaining access and thus benefits the established order.”
But European payment transactions offer opportunities for newcomers
There is one section of the banking world where competition is increasing, however, and where this monopoly is being broken: European payment transactions. The reason for this is that banks in the European Union are required to provide client data to competitors to make it easier to switch from one company to another. “This should make payment transactions cheaper and easier. In the case of client data, for instance, this includes account holders’ direct-debit and standing-order authorizations,” says Lemmens.
“The banks’ monopoly on payment transactions is disappearing. Competition will increase as new players start processing payment transactions for stores and webshops, for instance. A power shift is taking place amongst those parties handling payment transactions, making way for new innovative players. This is why I invest in companies such as Optimal Payments and Wirecard. These companies are expected to show rapid growth in the coming years.”
Lemmens sees opportunities in payment transactions mainly for innovative companies that challenge the established order, and therefore does not invest in large technology companies. “I often wonder what Google is up to in the banking sector. I don’t think they intend to become a bank. Clearly, they have a lot of search data that can make them money. And they can simply buy up a bank to obtain a banking license. But the downside of such a takeover is that it puts you in full view of the regulator, who could then easily decide that Google is a systemically important bank and must maintain additional capital buffers.”
IT companies benefit from increased outsourcing
The pressure of regulation on banks and insurance companies has increased in the aftermath of the financial crisis and has led to the outsourcing of IT activities, says Lemmens. Banks and insurance companies can no longer handle these activities on their own and are finally prepared to outsource them. In his opinion, dealing with IT has become too great a challenge to handle alone.
“Just providing the regulators with all the different loan data is a massive task for the banks. This does not happen simply by pushing a button – it is a complex process. Much of this data is sourced from diverse IT systems and is subject to different methods of administration. Nevertheless, you are expected to provide it in a uniform way, and so banks have to process, match and check their loan data.” “This requires extra investments in IT. Banks now no longer want to do the work themselves and are engaging third parties to handle it for them. An added advantage of outsourcing IT is that it enables you to make the related costs more variable, causing you to become less sensitive to the economic cycle.”
“Companies such as Cognizant, Simcorp and Temenos that supply IT services for banks will benefit from this outsourcing trend. They also happen to be the companies I have in my Robeco New World Financials portfolio.”
Lemmens sums up the consequences of regulation as follows: “Regulation is generating opportunities for investors. While strengthening the established order by setting up entry barriers, it can also generate opportunities for new players such as IT companies that provide services for the financial sector and for specialized companies active in handling payment transactions.”