We are living through a period of major social and technological change. Climate, demographics, technology, economic uncertainty and a host of other factors are challenging the way we live and work, whether it’s where we get our information from; how we earn a living; what and how we consume; or how we interact with each other.
All of these forces must be taken into account when mapping out the future shape of financial regulation.
We have identified seven Future Market Dynamics that we believe capture this welter of change and serve as a starting point for the debate ahead.
Naturally, Coronavirus looms large in many of our minds. But rather than draw this out as a distinct issue, we see Coronavirus as a force that will accelerate some of the key market dynamics and add complexity or new dimensions to others. So, there is no separate section on pandemics or Coronavirus in our three articles. Nevertheless, its presence is evident throughout.
We have not sought to be exhaustive in our analysis nor have we tried to predict the future. Rather we have focused on the market dynamics that have the potential to be transformative, and which are likely to require us to adapt our regulatory approach in some way. While the FCA’s work on Sector Views focuses on the near future, on developments that are probable, this work considers longer term trends that are more uncertain in their effect.
The implications of these market dynamics are likely to be diverse – some will be positive, some negative. The fundamental challenge for a regulator is, as far as possible, to enable what is good, and to mitigate the effects that may cause harm to consumers.
The seven Future Market Dynamics are:
Some of these dynamics relate to consumer behaviour and the choices they will face, others to the behaviour of firms and the challenges they will encounter in earning consumers trust. Wider changes in society in the shape and nature of work as well as changing demographics are another key theme. And, of course, technology looms large, both in the market power of technology firms to the often complex issues of how financial practitioners and customers use and relate to tech advances.
But we begin with a truly global dynamic climate-related disruption.
A global phenomenon with financial sector implications
The decarbonised economy of tomorrow will have been transformed by a new wave of green infrastructure investment, while climate change will increase the frequency and unpredictability of extreme weather events. These changes in the real economy will both require and engender changes in the financial sector.
New patterns of extreme weather events will create new uncertainties and therefore demand for new insurance products. They will also change asset values (for example, by reducing house values in flood prone areas) and so disrupt the financial plans of some households and businesses.
There will be other less direct effects too, especially via the impacts of policy aimed at reducing the economy’s carbon consumption. The aim of such policy will be to change patterns of investment, facilitated by the financial sector, towards “green” investments. This is likely to make “brown” assets less valuable and “green” ones more valuable.
The UK’s role in the global financial system gives it a uniquely powerful role to play in tackling the global problems posed by climate change. The way in which our financial sector adapts and performs to deliver decarbonisation will have impacts far beyond our borders, as is required by the nature of the harm the policy aims to tackle.
The speed of growth in “green” investments is already significant, as shown above. There is real uncertainty over the speed at which the transformation of our economy will take place, particularly in the light of the Covid-19 pandemic. Government and private sector investment in green technology could be accelerated as part of a macro-economic response to the economic downturn. The exposure of the fragility of the economy to a pandemic may also increase political demands for rebuilding an economy that is more resilient to climate change. But, at the same time investment in green technology may have to compete with other demands on Government spending, which could see the pace of change slow. The rate of change will have a substantial impact on the financial-sector, with, for example, more gradual change putting less pressure on investment volumes and ultimately interest rates.
Tackling climate change under the FCA’s objectives
In an ideal world, well-functioning markets in the financial sector will help the economy cope with the implications of climate change: the new uncertainties of the changed climate will be insurable at fair prices; the reallocation of capital to green investments – part of a wider reallocation of resources we are currently witnessing post-Covid - will be made at the lowest possible cost; and savers will be able to allocate their funds understanding the risks they are taking.
But it is easy to imagine the ways in which poorly-functioning markets in the financial sector might make climate change and transition to zero carbon more painful.
The FCA is already taking action to help industry respond to climate change risks through the Climate Financial Risk Forum (CFRF), but the degree to which this will need to be ramped up is as yet unknown. It will require new thinking to reach regulatory objectives of consumer protection, effective competition and market.
The experience the FCA has had in supporting financial services markets to respond positively and rapidly to the Covid-19 pandemic could be critical in facilitating similar responses to the needs of climate change.
Agility in consumer protection is essential during periods of change, both in combatting mis-selling and in providing continued access for the vulnerable. The rising demand for green investments presents dangers: a new demand can invite unscrupulous suppliers to offer poor value products, for example by “greenwashing” (as discussed in the FCA’s Discussion Paper on climate change and green finance). It may also present opportunities for mis-selling to those who lack the information they need to make an informed decision.
Some consumers with homes in areas subject to flooding or erosion - who may already feel, or could become, particularly vulnerable – may lack access to insurance and mortgages and may feel unfairly treated by financial sector providers. The FCA will need to be equipped to deal with these new versions of familiar problems.
Effective competition will assist in the transformational change in the real economy. Covid-19 brings forward additional challenges in this respect. In some scenarios, we might expect competition to intensify as the pandemic forces firms to innovate and adapt. But in other scenarios, caution and a lack of capacity could weaken competition.
Promoting effective competition will be critical in creating new finance markets for big infrastructure as well as in insurance and re-insurance, where the UK has an important global role to play. It is essential that the risks associated with the new uncertainties are pooled widely and affordably, so the global economy can take climate change in its stride.
As well as effective competition, the FCA’s approach to regulation will need to foster an environment that supports innovation in order to assist this development.
One such development might be the emergence of a liquid and competitive market for catastrophe bonds. These work through reinsurers and other investors receiving an income in return for guaranteeing to pay out a sum of money should a defined catastrophic event occur. Covid-19 – which has highlighted the risk to businesses of catastrophes – is likely to increase the demand for such bonds. But the key question is on the supply-side. Will insurers seize the opportunity and respond by offering these and other innovative products, or will they be more cautious in their approach?
The FCA will have an important role to play in facilitating positive supply-side responses and ensuring insurance markets work to deliver fairly-priced catastrophe bonds.
Many other new and existing markets will be needed as part of the green transition. Green bonds and funds as well as carbon markets and new types of commodity and energy exchanges will arise. The FCA’s role will be to ensure that these markets are competitive and encourage innovation.
Market integrity in these new arenas will be essential if they are to play a role in the low-carbon transition – both for the minimisation of capital costs and for the facilitation of new markets that will emerge in response to policy.
In these early days of green finance, there is a profusion of usually voluntary green standards. The FCA is currently consulting on proposals that would require commercial issuers with a premium listing to state whether they comply with the standards of the Taskforce on Climate-Related Financial Disclosures (and to explain any non-compliance). This is intended as a first step towards the adoption of the Task Force on Climate-related Financial Disclosures’ (TCFD‘s) recommendations more widely within the FCA rule book.
Whether this will be sufficient to deliver the outcome of a financial sector playing its full role in delivering decarbonisation will need to be judged as these measures are rolled out.
Delivering wider climate goals?
The FCA’s objectives have already led it to look at measures that contribute towards a green economy. However, it may also be called on in the future to contribute more directly to achieving broader goals directly linked to climate change. The most obvious, perhaps, would be the addition of a direct climate change goal to the FCA’s objectives.
The justification for such a change might come from two directions. First, there is the general recognition that if private costs in the real economy do not fully reflect the social costs of carbon, then the alternative way to achieve the public good has to be through direct regulatory measures. This would apply to financial services as much as any other sector.
The second justification, which probably requires lighter touch but longer-lasting interventions, comes from the degree to which consumers need more than just price signals to change behaviours. Rational ignorance, biases and transaction costs all mean that regulation on information-provision, minimum product standards and sales processes might all be needed to achieve climate change goals.
What sort of regulatory intervention might come out of a broader FCA goal? The FCA might be called on to implement stricter lending controls on mortgages for energy inefficient homes. Or there could be a call for action to establish support for those consumers whose assets are stranded or, perhaps quite literally, underwater. The Flood Re scheme, which was launched in 2016 as a joint initiative by the Government and insurers, is an example.
In both of these scenarios, and numerous other possibilities, the FCA would need to be prepared to design mechanisms for delivering the required social outcome. The extent to which regulatory intervention is needed will turn on whether regulators are asked to take on these wider goals, which is likely itself to be affected by the extent of social pressure to change.
Concern over climate change has also become a powerful motivator among some consumers, particularly Millennials and those now standing on the threshold of adulthood, known as generation Z. It is likely to be one of the factors that will shape their future, their jobs, their consumption and their financial lives.
So with that, we turn to the second of our seven Future Market Dynamics.
Social change – which has been highlighted and in some ways accelerated through our experience of the pandemic - is transforming people’s lifestyles, work patterns and entire financial lifecycles. This is leading to entirely new demands on financial services, both in terms of needs and preferences.
Changing social needs and preferences
New social patterns are bringing new needs. The end of “jobs for life”, the rapid growth of self-employment, and the increased prevalence of flexible working, including short-term, part-time, and zero hour contracts, are all increasing the demand for loan products suitable for consumers with volatile incomes.
At the same time, increased levels of student debt, low real wage growth, low interest rates and rising house prices, mean working-age consumers are acquiring wealth more slowly than previous generations. The Covid-19 pandemic is likely to accelerate this trend with unemployment most heavily concentrated amongst the young. However, if inflation were to take hold as a longer-term effect of the pandemic, this could reverse this trend by reducing the real value of debt and asset prices.
Consumers also expect to be in debt for longer periods of time and many anticipate a struggle to build up sufficient pension savings. Again, Covid-19 is likely to reinforce this effect, as it increases the likelihood that real interest rates will stay at super-low levels for longer. This is likely to increase the demand for longer term debt and for more innovative and flexible products. Examples of this could include loans secured against current and future wealth transfers such as an inheritance, and more flexible mortgage equity release products, as consumers seek to supplement retirement income.
Social change is not just affecting the financial products needed to meet our changing lifestyles. We are also seeing changes in consumer preferences which affect the types of financial products and services consumers want to see. There is a growing willingness among consumers to use social media and digital platforms. These new flows of information are amplifying already existing debates about fairness, fuelled in part by widening wealth and income, but also by unease with business models that, for example, do not reward customer loyalty.
Market solutions will emerge quickly in some cases but create new risks…
The demographic and social changes outlined here are being addressed by a financial sector that is itself going through a technological transformation in consumer markets. We can expect that Big Tech companies, with their rich knowledge of consumers, will play a significant role in using that data to understand changing needs and preferences and devising solutions (we’ll discuss that more in our next Insight article ). Meanwhile, traditional financial services firms will need to keep pace by modifying their product offerings to cater for changes in working patterns and longer life expectancies.
There will undoubtedly be market solutions to many of the needs and demands that social transformation creates and some are already emerging.
- Some digital apps are helping consumers budget realistically and responsibly, which can reduce the adverse effects of income volatility and reduce demand for short-term credit.
- Credit reference agencies are increasingly making use of big data to provide more accurate credit ratings – a higher quality input can lead an already well-functioning market to more appropriate sales for different circumstances.
- Some mortgage firms are allowing parents to contribute to their children’s mortgage deposits, and peer-to-peer lending based on consumer reviews provides an additional means of supplying credit.
- Some financial service providers are beginning to invest in their brands for the long term, to reward loyalty and change their view of fair treatment of existing customers.
Some of these solutions may stalled by the pandemic, but the success of these solutions will ultimately depend on how well will the new and existing players respond and whether consumer demands are adequately met.
However, with new products comes new risks.Will innovation create confusion for consumers? Will these solutions tap into behavioural biases? Will consumers fully understand the products when they haven’t encountered them before? And will these new products really address the needs and preferences they are designed to meet?
New risks will create a need for regulatory change
The rules devised for the analogue world will be full of unintended consequences when confronted with the double transformation of new demands and new technologies. Consumer protection, effective competition and trust in markets will require the FCA to adapt its approaches. This could bite in several ways.
First, the FCA's rules must not stand in the way of new innovative responses to changing consumer needs and preferences that boost competition. These responses will be vital in promoting productivity and economic growth as the UK seeks to emerge from the current economic downturn. The FCA can play a role in ensuring there are positive market responses to social change in the way it develops rules and guidance. For example, rules designed to promote responsible lending and financial stability need to achieve their primary aim, but also allowing innovation in the mortgage market to serve creditworthy individuals with more flexible or complex needs. The FCA’s sandbox is likely to be a particularly important way of fostering new solutions to significantly changing consumer needs and preferences.
Second, the FCA may need to ensure it uses its analytical techniques and rules to protect consumers against new harms. In particular, the FCA will need to be vigilant for where market responses may lead to new consumer harm. But it will also need to understand where markets are not keeping up with social needs and preferences,which could also result in new harms. The role of behavioural and broader social science is likely to be increasingly important in understanding how changing social norms affect decisions to purchase financial products, and in designing new ways of protecting consumers.
Finally, the FCA may also face calls for it to consider wider economic and social goals. For example, there may be a need to link more closely with national economic goals of productivity or to pursue specific aims, such as enabling new ways of working that are both flexible and ‘good’. This issue may be thrown into sharp relief in a post-pandemic world.
Changing views and importance attached to issues of fairness are also likely to lead to the over-arching challenge of what is ‘fair’ and how the FCA should approach its new business priority of ensuring that consumers are offered “fair value in a digital age”. And as the FCA’s views on fairness continues to be developed, new regulatory solutions may be needed to address distributional issues that are long-standing or that won’t change without regulatory intervention.
Technology as a catalyst for social change
Much social change is slow-paced. But it combines with developments which are much more rapid – especially around technology. We are already seeing Covid-19 forcing us into a very different relationship with work and technology. These technological changes will be the focus of our next two articles in this series. Evolving new demands together with fast-changing technology and expectations means that regulation needs to be more agile than it has been in periods of greater stability. A clear focus on what are good outcomes, and a clear sense of how financial markets can help society achieve these will allow the FCA to play its role in bringing about the well-functioning markets of tomorrow.
Next, in Future Market Dynamics – Part 2, we will turn to technology and the opportunities and challenges it will pose for the Future of Regulation.
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