According to an analysis by the World Bank, the world economy is moving towards a “lost decade” amid the events of recent years, caused mainly by pandemics and wars. The pandemic has affected the economy in an environment of low interest rates and high debt levels, forcing central banks to take emergency measures, and fiscal policy has been adjusted to stabilize the macro economy and accelerate the economic recovery. However, since then, the macroeconomic context has changed, with high inflation forcing high interest rates to be maintained, which limit the potential for economic growth, while public and private debt are at record levels, creating high risks of financial instability. Governments need more revenue for the budget, and they have started to reverse the trend of fiscal policy by increasing taxes. To prevent a possible financial crisis, the central bank tightened regulations. Moreover, digitization and the ESG (environmental, social, governmental) imperative influence, on the one hand, banks’ investment priorities for reformatting their operations, and on the other, lending decisions.

In this context, banks act on several fronts at the same time: they tighten lending standards, carefully monitor deposit flows, optimize operations, and set aside more money for potentially bad loans. At the same time, technology and innovation, increased competition, regulatory complexity and changing customer expectations are putting enormous pressure on traditional business models. Thus, banks must allocate more resources to adapt their model to the changing needs of customers. As a result, they are faced with both managing market challenges and finding solutions to differentiate them to increase their competitiveness.

The main driver of transformation is the very behavior of consumers who are looking for personalized, simple and digital financial services. Even as fintech is in decline around the world, it continues to catalyze the transformation of financial services after the momentum of the pandemic. According to the PwC Retail Banking Monitor 2023 report, the rapid development of the fintech and technology sectors in recent years, as well as changes in consumer behavior, require banks to quickly adapt both their products and the way they reach customers. change the approach to sales: from a sprawling strategy based on multiple channels to an integrated one using the digital environment. The new model will continue to evolve, but it is important to consider five factors: improving the customer experience, integrating additional sales channels and interaction models, rethinking processes and organizational structure to achieve the new approach, strengthening the technological infrastructure, databases, management security and process compliance.

In order to stand out in a crowded market and among new players, banks are increasingly relying on growth at the expense of certain customer segments. Whether it’s commercial services for small businesses, entrepreneurs, a better mortgage experience or focusing on the needs of a particular industry, banks respond to competition by building on their strengths and exploiting niche markets. Many banks have also developed remote consulting capabilities and have transitioned a significant number of retail and SME customers to this new approach.

But one important thing should not be forgotten: the problem is even bigger, given that inflationary dynamics in Europe continue to put pressure on cost management in the banking sector. Thus, banks will experience a new period with many challenges, when they will have to balance the need to spend to improve competitiveness with the need to manage a growing set of financial and non-financial risks. All of this will require continued investment in digital capabilities, along with strategic spending cuts to deal with the expected economic downturn, excessive regulation and rising taxes.

In terms of taxation, for banks in Romania, the additional taxation measure recently adopted by the government and which will apply from next year will obviously mean additional costs. The top ten largest banks in the Romanian market will pay, according to our calculations, a turnover tax of between 23% and in some cases more than 100% of the profit tax during the first two years after the entry into force of the measure, where the applicable rate will be 2%. Banks that had a low effective tax rate and benefited from certain tax benefits (such as exemption from taxation of dividend income, allowance for reinvested profits, etc.) were the most affected.

At the same time, ESG continues to be a driving factor in banks’ strategy, be it operations, lending, investments, risk management or compliance. From energy to deforestation or oil production, financial industry players can monitor the ESG risk of the clients they finance. For this reason, the pressure on the financial sector to act sustainably and take ESG risks into account in its operations is very high.

To reap the tangible and intangible benefits of robust ESG reporting, banks must engage in all three aspects of ESG. However, climate risk seems to attract the most attention from stakeholders because of its importance and complexity for financial institutions.

European Union banks supervised by the European Central Bank (ECB) have been warned in the latest ECB report that most of them are not ready for an ESG transformation. As for risk management, only every second bank managed to outline processes for identifying, assessing and managing climate risks. Less than one in four banks checked their loan portfolios for such risks. Regarding the indicators used to monitor these risks, the ECB noted that “ambition is not always supported by relevant information”.

Given the competitive environment to gain market share, banks are increasingly considering inorganic growth through acquisition. As a result, mergers and acquisitions in the financial services sector continued this year in the local market with significant deals.

The ECB’s supervisory priorities for the coming years are related to strengthening resilience to macro-financial and geopolitical shocks, credit risk management and diversification of funding for credit risk management. The ECB shows that the current turbulence in the market and in particular what is happening in the energy sector is clearly affecting other sectors that are becoming more vulnerable, those that need energy, such as the processing of raw materials, transport or the chemical industry, even the food sector and construction. Therefore, the focus will be on how banks assess credit risk in these affected sectors. As far as retail is concerned, banks could currently make more profit due to higher interest rates in the market. But there remain those loan portfolios that have a variable interest rate and a high degree of falling into the category of non-performing loans.

However, since the global financial crisis of 2008, financial institutions are generally in a better position in terms of compliance and hedging, thanks to massive investments in this area.

In conclusion, despite the uncertainty and challenging macroeconomic conditions, it is time for banks to improve their growth strategies so that they are ready to capture more market share when the economy returns to growth.

This article is part of PwC Romania’s Agenda for Tomorrow editorial project, which will run until the end of this year and aims to discuss the context and perspectives that can guide companies to make informed decisions in the midst of change. Previous articles of the series can be read here.

Article supported by PwC Romania