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Forecasting into the unknown:

Financial modelling challenges during the new bank application process

For firms at the beginning of their journey to become an authorised bank, the process of producing financial forecasts for an entity that is not yet operational, covering an undefined 5-year period in the future, can be somewhat challenging. This has never been more relevant than the current environment, with the rate tightening cycle seemingly approaching its peak but the broader macroeconomic impact still to fully crystallise. Once consideration is given to the ever-evolving regulatory landscape such as Basel 3.1 (to be covered in a separate blog), there is much uncertainty on the horizon.

Given that a typical authorisation process takes on average 2-3 years, business plan forecasts submitted in the application process will need to remain appropriate into the medium-term in anticipation of changes in both the target market and the macroeconomy. These projections are essential in building a compelling case to the regulator (along with investors and other stakeholders), demonstrating how the model will become self-sufficient in a credible, sustainable way that justifies a banking licence. Below are some of the key areas firms should be considering as they develop the central plans that will underpin their submission.

Interest Rate Risk

Whilst for much of the last 15 years we have seen a low, stable rate environment, this has changed rapidly over the last 18 months. With the current yield curve inverted, firms will need to consider where rates may be in several years and how this may impact their Net Interest Margin (NIM). Any such planning should incorporate robust sensitivity analysis to account for material deviations from the base case rate path assumptions. Central banks will respond to further macroeconomic developments as they unfold and therefore the rate environment in another 18 months’ time could again look considerably different to now. This uncertainty should be considered when preparing forecasts.

Regulators are increasingly focused on interest rate risk management within the sector and it is therefore crucial that aspirants seek to demonstrate the viability of their business proposition within a range of rate scenarios, showing a clear and plausible path to profitability. Unrealistic NIM assumptions in the eyes of the regulator may invite significant challenge on this viability. This should be supplemented with a specific strategy to managing the impact of interest rate risk on the balance sheet.

Depositor Behaviour

A key development stemming from the increase in interest rates is the simultaneous change in depositor behaviour. During years of sub 1% base rates, depositors were less inclined to move money to earn a few more basis points on their savings. With rates now much higher and inflation eroding incomes, this has changed, alongside regular headlines highlighting a lack of pass-through in the sector garnering further attention in the public eye.

This change also impacts firms that until recently had benefited from large amounts of non-maturing deposits (i.e. current accounts) paying 0% interest. Assumptions regarding depositor behaviour are now under scrutiny, with customers less tolerant of a significant negative real return on their money amid the current inflationary environment. Aspirant banks must ensure that their business model is not materially dependant on large volumes of low cost, instant access deposits, else they may face difficulties in convincing the regulator they are a viable proposition.

Capital Raising Challenges

Raising sufficient levels of capital within an appropriate timeframe has always been one of the biggest obstacles for new banks, even once reaching mobilisation. Following the period of funding scarcity that arose during Covid, the higher rate environment we are now experiencing has again led to challenges in sourcing investment. During the recent years of low rates, banks did not need to demonstrate significant returns in order to beat base rate and satisfy investors’ yield expectations. Now however, given the returns on offer in even the safest asset classes, there is increased emphasis on banks’ ability to deliver an attractive return that scales appropriately with the rate cycle. With broader macroeconomic challenges and uncertainty, identifying and securing sources of capital is proving increasingly difficult.

Firms need to be mindful to ensure that capital raising plans are not unattainably ambitious. Given the level of capitalisation will typically be the main restriction on growth in the early years post-authorisation, the path to profitability, including lending volumes and costs, must be based on realistic capital injections. This should also reflect the nature of the proposed business – low margin models that depend on scale will likely require long-term buy-in from investors before a return is generated, with operating losses eroding the capital base in the short to medium-term. All aspirants should also robustly assess the operating costs required to get through the authorisation process and consider how these are impacted by the current inflationary environment.

Macroeconomic Headwinds

Although we are starting to see some decline in UK house prices and a continued rise in corporate insolvencies, the wider economic impact of higher rates and inflation has so far not translated into the expected recession and associated credit shock. With many more mortgages due to reprice in the next 2 years, inflation still well above target and energy costs remaining elevated however, we may see the current headwinds fully crystallise in the coming years.

Firms should ensure they consider a deteriorating macroeconomic outlook in their projections and/or sensitivity analysis, avoiding an assumption of a benign environment within their base case at the point of authorisation. This should be evident in firms’ expectations for impairments and lending volumes, with a clear link between the core market they will target and the wider economy.

Key Takeaways

Despite the challenging environment, a thorough articulation and justification of a proposed business model can ensure aspirant banks are able to satisfy the demands of both the regulator and investors. Undertaking robust forecasting, sensitivity and stress testing analysis is a crucial process to support this. The key points below should be central considerations as firms produce their banking application:

  1. Net Interest Margin – Assess the sensitivity of the NIM to a variety of rate environments to ensure the business is adaptable.
  2. Funding – Consider the impact on volumes, cost and stability through changes in the macroeconomy.
  3. Return on Investment – Justify how the business model will deliver attractive, scalable returns within different periods of the interest rate cycle.
  4. Profitability – Be clear on the growth strategy, where the break-even point is and tailor capital raising plans accordingly.
  5. Assumptions – All elements of the above should be built upon clear, justifiable assumptions, with reference to relevant supporting data.

Deloitte New Bank Start-Up Page