WHY THE TIME IS NOW TO BANK BEYOND BORDERS

Navigating the changing contours of the global economy

A slowing global economy coupled with a divergent economic landscape will challenge the banking industry in new ways in 2024. Although recent efforts to combat inflation are showing signs of success in many countries, the risks brought to light by supply chain disruptions, rewiring of trade relationships, and ongoing geopolitical tensions will complicate economic growth worldwide. Extreme weather-related events, such as floods, heatwaves, and hurricanes, may also cause severe economic disruption.

With this backdrop, the International Monetary Fund (IMF) expects the world economy to grow at no more than 3.0% in 2024.¹ Advanced economies—i.e., the United States, the Euro area, Japan, the United Kingdom, and Canada—are forecast to experience tepid growth at 1.4% in 2024.² But many emerging economies should see higher growth on the back of strong consumer demand, younger demographics, and improving trade balances. In particular, India is expected to have one of the strongest growth rates: 6.3% in 2024.³

On the other hand, China is facing a potential economic slowdown with weak consumer demand and distressed property markets. The weakness in Chinese exports and imports will not only impact its trading partners, but may well challenge supply chain dynamics and further weaken global recovery. Recent efforts to revive consumer and corporate confidence in China could influence economic growth in other countries, particularly in Asia.

Global inflation is expected to drop to 5.2% in 2024, from a high of 8.7% in 2022, as per the IMF. In countries such as the United States, the labor market and consumer spending are showing signs of deceleration but are still elevated, challenging the targets set by central banks. In fact, the IMF predicts that inflation in almost all countries will remain above target rates.⁴

Central banks will be fine-tuning their monetary policies through 2024 (figure 1). The federal funds rate in the United States is expected to remain elevated at or above 550 basis points going into 2024 but may drop to between 450 and 500 basis points in the second half of 2024, according to latest FOMC projections.⁵ The European Central Bank (ECB) is expected to begin decreasing interest rates; in August 2023, the ECB policy rate stood at 3.75%, matching the peak in 2001.⁶

Meanwhile, the Bank of England is expected to lower the policy rate in the first half of 2024 after reaching a peak of 5.75% at the end of 2023.⁷ The story is similar to the Bank of Canada: Rates should decline in the second half of 2024 after surpassing 5%, as per the Canadian Economic Quarterly Forecast by TD Economics.⁸ In contrast to other central banks, the Bank of Japan has kept the policy rate near zero, but its July 2023 meeting indicated that it would tweak the bond yield curve control schemes to respond more nimbly to price pressures.⁹

But generally, central banks’ quantitative tightening measures will contract global money supply. In fact, in the United States, money supply, as measured by M2, has been falling at its fastest rate since the 1930s.¹⁰

These challenges will result in divergent and sporadic economic growth. Some economies will face a brighter future, while others will still be fighting stickier inflation and low growth.

How will the macroeconomic environment in 2024 impact the banking industry?

Banks globally will face a unique mix of challenges in 2024. Each of these hurdles will impact banks’ ability to generate income and manage costs (both interest costs and operational expenses).

Deposit costs are here to stay—for now

Higher interest rates have been a boon to the banking industry. In 2022, net interest income increased significantly in many jurisdictions, with American and Canadian banks posting a rise of 18% year over year (YoY), followed by their European peers at 11%.¹¹

However, elevated rates will continue to push funding costs higher and squeeze margins. The pace and steepness of the current rate cycles have dramatically boosted the cost of interest-bearing deposits for US banks. But these costs have risen more sharply for regional and midsize banks. For instance, deposit costs for the largest banks stood at 2.2% in Q2 2023, compared to 2.5% for the smaller banks.¹² This is a similar pattern in other countries that have experienced rate hikes.

Going forward, the global banking industry may be hard-pressed to bring down high deposit costs (and lower deposit betas) even as interest rates drop. Customer expectations of higher rates, coupled with increased market competition, will force many banks to offer higher deposit rates to retain customers and shore up liquidity. The situation will vary by region, though. European banks may be able to decrease deposit costs more rapidly, for instance. The European banking industry has not faced as much competition from money market funds, unlike in the United States. During the banking turmoil in March 2023, inflows into Europe’s money market funds totaled US$19.3 billion, dwarfing in comparison to US$367 billion into the US money market funds.^13,14 Similarly, Asian banks, in India, for instance, may sustain higher rates in the wake of stronger economic growth. In fact, banks in the Asia-Pacific (APAC) region are expected to outpace global peers in generating stronger net interest income.

Loans growth will be modest, at best

In terms of loan growth, we expect demand to be modest given the macroeconomic conditions and high borrowing costs. Banks will also likely continue their restrictive credit lending policies. According to the recent bank lending surveys conducted by the Federal Reserve and the ECB, many banks have already tightened credit standards across all product categories. They anticipate further tightening due to a less favorable economic outlook and likely deterioration in collateral values and credit quality.^15,16

However, the impact of the macroeconomic environment will be disparate across loan categories. Consumer spending has remained robust in major economies, but as consumer savings deplete, demand for credit card and auto loans should remain strong. At the same time, across the United States and Europe, bank loan demand from firms has decreased significantly. Bank loans to corporates may weaken in the short term but could pick up later in 2024. (See sidebar, “Real estate jitters” for commentary on commercial real estate loans.)

Looking over a longer-term horizon, exchanges should consider how quantum computing can improve the performance, speed, and cost of market operations. The immense processing power of quantum algorithms should make it possible for exchanges and market participants to perform tasks that were previously deemed too complicated, such as tasks in derivatives pricing,²⁰² order matching,²⁰³ fraud detection and risk management,²⁰⁴ and portfolio optimization through natural language processing.²⁰⁵ A Deutsche Börse pilot, for example, found that quantum computing could reduce the time required for a business risk model simulation with 1,000 inputs from multiple years to less than 24 hours.²⁰⁶ While it may be a few years before this nascent technology can be applied to practical trading applications, some large financial institutions have started to work backward to identify problems that quantum technology may be best suited to solve.²⁰⁷

US banks and financial institutions are also exploring ways to maximize the value of data repositories they built for the SEC’s Consolidated Audit Trail (CAT), which became fully operational in 2023. The consolidated tape now provides organizations with a coherent view of current and historic order and trade life cycle events, which they can mine on cloud-based data platforms that support advanced algorithms.²⁰⁸ These tools can unlock new insights, for example, by allowing sell-side analysts to review systematic trading patterns and providing a window for them to advise clients on new trade opportunities. Over time, merging equities data with other securities may bring an even more expansive range of trades across asset classes.

Finally, generative AI will transform securities exchanges globally. Some institutions are already engaged in pilots of various kinds. Nasdaq, for example, is exploring how the technology can more effectively spot financial crime, a capability the company wants to advance as “deepfakes” become more sophisticated and pervasive.²⁰⁹ It is also assessing how generative AI can assist in building code, writing blog posts, and summarizing legal documents.²¹⁰

Meanwhile, this technology also has enormous potential to transform trading operations, both on the sell side and buy side. In the near term, traders can use LLMs to process large amounts of text to inform trading strategies. Some big banks, for example, have started using generative AI to pick up on trade signals by deciphering speeches and messaging from the Federal Reserve and other central banks.²¹¹ These innovations could impact the speed and volume of trading on exchanges. It could also usher in a new demand for new types of market data from exchanges.

Exchanges want to be more than just exchanges

While listings and market data continue to be prized assets, many exchanges are expanding into other areas of the financial system to create more sticky relationships with corporates, buy-side, and sell-side firms. These ancillary businesses will become more critical as exchanges contend with heightened competition, increasing fee pressure, and the possibility of stagnated transaction volumes.

Several exchange operators are exploring strategic acquisitions that can bolster their value proposition. Nasdaq, for example, is accelerating its decade-long push to supplement traditional revenue streams with software-based businesses that primarily offer pretrade and at-trade risk management and anti-financial-crime technology. In June 2023, the exchange made its largest ever purchase in a US$10.5 billion deal for a fintech that will be integrated into its business line dedicated to supporting corporate clients.²¹² About one-third of the Nasdaq’s recurring revenues now stem from software subscriptions, and it is aiming for the share of total revenue attributable to its solutions business to grow from 71% to 77% by the end of 2023.²¹³

UK exchange operators are also branching into new areas to help set the foundation for future growth. The London Stock Exchange (LSEG), for example, entered into a 10-year partnership with Microsoft to catalyze the migration of its infrastructure to the cloud. The partnership also plans to develop products that can be delivered through Microsoft’s offerings, such as data and analytics shared on the Teams messaging platform.²¹⁴ In addition, LSEG is also expanding into green financing; its recently launched voluntary carbon market sets listing rules for investment funds and businesses to raise capital for carbon credit-yielding projects.²¹⁵ Other alternative revenue streams that exchanges can pursue include platforms to host fintechs and other ecosystem players, direct market access that targets specific customers, and smart contract-based KYC processes.²¹⁶

Digital assets continue to attract new market infrastructure firms, which can play a unique role in offering proper governance and cross-market risk management. European institutions will likely have a leg up piloting digital securities, given the flexibility that some regulators are extending to that market. Luxembourg, for example, adopted a law that expands the definition of financial instruments to include products issued on the blockchain. This will open the door to the greater issuance of tokenized securities.²¹⁷ The Luxembourg Stock Exchange (LuxSE) is only issuing tokens rooted in fiat currency that qualify as debt financial instruments, but exchanges may soon facilitate the launch of other novel listings. Exchanges and market infrastructure firms can instill credibility into blockchain-issued instruments by building out complementary services, such as repo solutions and digital custody.

However, expanding revenue streams into nascent markets is fraught with some uncertainties. Digital assets and securities tokenization do not have a globally consistent regulatory framework. Similarly, voluntary carbon markets could benefit from greater regulatory guidance and clarity, not to mention ambiguous legal and accounting standards. Finally, carving out too deep of a niche may subject exchanges to antitrust concerns and/or claims of data monopolization.

Time’s up for the T+1 transition

The move to an accelerated trade settlement period in Canada and the United States continues to be a major undertaking. Many firms are scrambling to prepare before the May 2024 implementation date. The transition to T+1 is expected to reduce credit, counterparty, and operational risks arising from unsettled trades. But crossing the finish line—and adapting to new workflows once the changes take effect—will be a major hurdle.

While the shifts to T+3 and T+2 were largely technology-driven, accelerated settlement will trigger many changes in processes and behaviors. Chief among them is reduced time available for post-trade operations. In fact, the Association for Financial Markets in Europe predicts that the transition from T+2 to T+1 shortens the settlement operations window by 83%.²¹⁸ This truncated timeline will impact how institutions interact with global clients. Large North American firms may adopt the “follow-the-sun” model of assisting clients from multiple global locations, but other institutions may need to rely on second/staggered shifts. In addition, non-US investors could begin prefunding FX trades to accommodate the T+1 settlement cycle. Investment managers outside the United States may need to sell a day earlier to make US funds available for trades, which could impact their other holdings.²¹⁹

Costs are widely expected to rise if there is an increase in trade fails, which will require higher margins, more collateral, and increased funding. Firms can bring about operational efficiencies by working to automate post-trade processes that currently require manual intervention and moving to straight-through processing. One area ripe for automation is the allocation of institutional trades; only about 20% of allocations in the United States occur when markets are open.²²⁰ Increasing trading-day allocations can provide more time to process confirmations and execute timely affirmations.²²¹ In addition, the industry should update service-level agreements to improve the consistency and reliability of information shared between market participants.²²² Roughly four out of 10 trade fails are the result of incomplete or inaccurate settlement instructions and unavailable securities.²²³

There could also be more friction in securities lending. Not only will lenders have a shorter time frame to identify and recall securities, but custodians and agents may not receive sufficient notice to return them if batch processing limits their access to real-time information. This can lead to an uptick in breaks and fails, as well as an increase in penalties. As a result, global firms may be hesitant to extend loans if they believe time zone differences will prevent them from making a recall on the US and Canadian trade date, which have the latest market closing times among developed economies.²²⁴