Financial services update: FedNow, banking results, reinsurance disruption

REAL ECONOMY BLOG | June 09, 2023

Authored by RSM US LLP

In the latest installment of our monthly financial services update, we take a look at the upcoming launch of the Federal Reserve’s instant payment system, banking results for the first quarter and disruption in the reinsurance sector.

FedNow set to modernize nation’s payment system

The Federal Reserve is set to launch its instant payment system, FedNow, this July. The system will allow participating financial institutions, regardless of size, to send and receive payments instantly, 24 hours a day, seven days a week, 365 days a year.

In addition to real-time settlement, FedNow is expected to have several benefits for both businesses and consumers, including the ability to accept payments from customers and suppliers, improved cashflow management, bill pay, purchases, and money transfers. The launch also represents a significant development in the payments industry, making it easier for businesses to operate and for consumers to better manage their finances.

The service is part of a broader initiative to modernize the nation’s payment system. The real time payment network (RTP), currently operated by the nationwide automated clearinghouse system, has been available for over five years but serves a limited number of financial institutions. FedNow is expected to be more widely available and easier to use than the RTP network and allow participating financial institutions to send and receive payments with each other directly, eliminating the need for intermediaries such as the clearinghouse.

Some more details about FedNow:

• The system will use the same encryption standards as the other Federal Reserve payments systems. It is designed to be highly secure with advanced features to protect against fraud and other security threats.
• It includes a scalable infrastructure that is flexible, can handle large volumes of payments and allows for easy integration with existing systems and technology.
• When it launches, the system will only be available in the United States but there are plans to expand its capabilities to support cross-border payments in the future, enabling lower transaction costs and further the reducing the need for intermediaries.

FedNow’s success will depend on how many institutions adopt it. The system is expected to provide many potential benefits but could potentially increase the prevalence of wire fraud (once a wire has left, it’s difficult to recall it). Participating financial institutions should consider the necessary people, process and technology changes—including change management programs—they will need to make to ensure the transition is successful.

On the technology side, since an institution’s digital footprint will increase with the use of FedNow, the organization may also need to assess changes necessary for its know-your-customer compliance, real time monitoring and alert systems and their use of machine learning to aid in fraud detection.

Banking results reflect resilience, but with caveats

Net income at Federal Deposit Insurance Corp.-insured financial institutions was $79.8 billion in the first quarter, an increase of 17% compared to the previous quarter, according to the FDIC’s latest quarterly banking profile released at the end of May. Those results reflect resilience among the nation’s banks, but it’s critical to remember that recent stress within the banking ecosystem is only partially reflected in the data. We will need to see activity from the second quarter to truly understand the tension and challenges organizations have faced.

Alongside net income, the increase in both total interest income and total noninterest income, 8% and 37% respectively, exemplifies resiliency across the banking sector. But the enchantment stops there; it appears we have finally seen the peak in net interest margin, which dropped for the first time since the Federal Reserve’s rate hike campaign started.

Although there is no extreme fluctuation just yet, with NIM dropping by 7>basis points over the quarter, we’ll continue to see bankers have a laser focus on expenses in an effort to heed the continuous increase in cost of funds. Cost of deposits increased by 1,126% year over year, jumping from 0.2 as of Q1’22 up to 1.42 as of Q1’23. Albeit a large leap, the increase doesn’t compare to the staggering growth in the cost of Fed funds purchased, which jumped from 0.19 as of Q1’22 to 4.74 as of Q1’23.

It’s no secret that concerns over deterioration within commercial real estate credit are on the rise. Earnings calls for the first quarter exemplified the prime focal point as mentions of CRE increased by 55% compared to the prior quarter, and for good reason. An estimated $1.4 trillion in CRE loans are set to mature this year and next, and although there are specific subsectors within CRE that have heightened risk of deterioration compared to others, the FDIC’s quarterly publication showed the first signs of deterioration across the board.

Commercial real estate represents 48% of total loans at FDIC-insured banks as of March 31. Non-performing metrics were at all-time lows last year due to a mix of factors, but as the economic headwinds come to fruition, Q1 displayed an uptick in these non-performing metrics as they start to bounce off those incredible lows.

CRE net charge-offs were in a negative stance for the first three quarters of last year, showing the true fortitude that institutions have built in the past decade, as recoveries continued to outpace charge-offs. The fourth quarter last year showed charge-offs pick up slightly, but the real standout was the change between Q4’22 and Q1 23, as net charge-offs increased by 123%, coming in at $368 million as of March 31.

Further, CRE makes up a large chunk of the nonperforming loans in the ecosystem. Although past>–due loan trends are consistent with the fact that CRE represents 48% of total loans, the nonaccrual metrics show a more concerning result, as CRE nonaccruals represent 66% of all nonaccrual loans. As we continue to see a trend of deterioration in these nonperforming metrics, lenders will shift their focus to mitigation techniques in an effort to alleviate any potential future defaults.

Disruption continues for reinsurance

The reinsurance industry is expecting significant changes this year—some more positive than others—as a result of three key factors: rising and evolving risks, technology breakthroughs and regulatory reforms.

The advent of new and more complicated risks related to cybersecurity, climate change and politics, to name a few, is driving change in the reinsurance industry. Due to the difficulty in assessing and insuring these risks, reinsurers are under pressure to provide new products and services to satisfy their clients.

Technology also continues to drive significant change in the reinsurance market. Reinsurers can better evaluate risks, set rates and handle claims using big data, artificial intelligence and machine learning. This results in more effective risk transfer, which benefits both reinsurers and insurers.

Regulatory developments are also having a significant impact on the reinsurance market. In recent years, regulators have been focusing on ensuring that this market is adequately capitalized and able to withstand shocks. This has led to changes in current regulations, which are forcing reinsurers to adjust the way they operate.

There are numerous ways reinsurers can respond to these disruptions. These include:

• Enhancing their risk assessment and underwriting processes to account for cyber risks.
• Developing models and tools to evaluate the likelihood and potential impact of cyber incidents, data breaches and ransomware attacks
• Working closely with primary insurers and insured organizations to improve their risk management practices such as cybersecurity measures, and incident response plans to proactively respond to regulatory changes
• Investing heavily in climate risk modeling capabilities, advanced analytics and modeling techniques while incorporating climate data and projections into their underwriting processes to better assess the potential impact of climate change

Overall, reinsurers are adapting to the evolving landscape of cyber and climate risks by leveraging advanced analytics, expertise and collaboration. Their aim is to provide effective risk transfer solutions and support the resilience of the insurance industry and society.

The reinsurance industry is going through a period of upheaval. The factors mentioned above are just a few of the causes pushing this transition. As the market continues to evolve, reinsurers will need to adapt to new challenges and opportunities to remain competitive.