Optimism in the financial services sector fell for the third consecutive quarter in 2017 in the three months to December, rounding off two years of continuous flat or worsening sentiment – with Brexit a major concern for businesses – but business conditions saw moderate improvement, according to the latest CBI/PwC Financial Services Survey.

The quarterly survey of 92 firms found that optimism about the overall business situation in the financial services sector fell significantly, having declined in seven out of the last eight quarters. However, the subdued mood last quarter was not universal: while banks, building societies and general insurers were decidedly less positive than three months earlier, finance houses, life insurers and investment managers felt more optimistic.

Growth in overall business volumes slowed for a second consecutive quarter, though conditions varied across the financial services sector. Volumes were unchanged in banking, following two quarterly increases. Building societies reported that volumes rebounded, after falling in the previous quarter.

Meanwhile, providers of specialist finance, life and general insurance, and investment management continued to report robust demand growth. Looking ahead, overall business volumes are expected to pick up a little over the coming three months, with a similarly mixed picture across sectors.

2018 brings several challenges for the financial services sector. Most striking is Brexit, with virtually all firms viewing the impact of Brexit uncertainty as the most serious threat to the UK’s position as a leading global financial centre.

Companies are also concerned about other areas that threaten the UK’s global competitiveness, with half citing the perception that the quality of the UK’s physical and digital infrastructure lagged behind other advanced economies, and around a third pointing to an increasingly complex tax regime and the gold-plating of international standards.

Rain Newton-Smith, CBI chief economist, says, ‘With overall business levels seen as broadly typical, and demand and profitability continuing to expand, the financial services sector ended last year on a stable footing.

‘Scratch the surface, however, and a different story is revealed. Optimism in parts of the sector has been falling for the last two years, whilst firms are nearly unanimous in voicing their concern about the damaging impact of Brexit uncertainty and the need for the UK to remain a vibrant centre of FinTech and innovation. To restore some confidence, financial services firms absolutely must – no ifs, no buts – get as much certainty as possible on what the UK is aiming for in the Brexit negotiations, the opportunities of success and the consequences of failure.

‘The never-ending burden of regulatory changes is slowly sucking the life out of financial services firms, and has repercussions far beyond the Square Mile. It puts a dent in the wider economy by acting as a drag on productivity, and consequently, living standards.

‘A thorough assessment needs to be carried out to identify those regulations that deliver clear economic benefits and that should be carried forward, while pressing the pause button on those where the benefits for financial stability relative to the cost on the wider economy are uncertain.’

Andrew Kail, head of financial services at PwC, says, ‘The UK is set to leave the EU exactly 14 months from today. A transition period is likely, but ultimately the financial services sector – a critical part of the economy – must prepare itself to operate without membership of this key trading market. The industry will need to take positive action if it is to preserve its trading status and business model. There is much activity in boardrooms despite the question mark over trade negotiation outcomes. In the coming months we can expect to see more detail on companies’ updated contingency planning.

‘However, Brexit is just one of the issues the UK financial services sector is grappling with. Investing heavily in technology to improve efficiency and the customer experience, preserving profitability in light of falling margins, and regulatory demands such as Open Banking and PSD2, Mifid II and GDPR are also high on the agenda. How the industry deals with this myriad of challenges will be pivotal to future success.

‘Against this backdrop, businesses are actively thinking about their workforce needs for the future. Focusing on the attributes, skills and number of employees they will require to be successful in the years ahead is now a key strategic issue.’

Profits in the sector as a whole continued to improve, although at a pace significantly below expectations, and growth in profits is generally expected to remain similar in the three months ahead.

Employment dipped, having stagnated in the previous quarter, with firms planning to keep headcount stable in the three months to March.

Looking to the year ahead, financial services firms continue to plan for higher spending on marketing and IT, but expect to cut back in other areas of capital spending. Efficiency improvements remained the most important driver of investment, though the share of firms looking to expand capacity also rose. The main brake on investment spending remains inadequate net returns, with citations well above average and rising to the highest since 2015.

Similarly, three-quarters of firms saw the level of demand as a brake on business expansion, the highest share in over two years. Alongside this, a similar number saw statutory legislation and regulation as a constraint on business expansion. Meanwhile, the importance of new products and services to business expansion in the year has diminished, with growth strategies becoming more focussed on acquiring new customers, aided by a focus on sales and distribution.

Key findings

• Optimism in the financial services sector dropped noticeably, the seventh quarter of declining sentiment in the last eight quarters (the exception was the first quarter of 2017, when sentiment was flat). This marks the longest period of falling sentiment since the global financial crisis of 2008
• 13 per cent of firms said they were more optimistic about the overall business situation compared with three months ago, whilst 35 per cent were less optimistic, giving a balance of -22 per cent (compared with -6 per cent in the quarter to September)
• 19 per cent of firms said that business volumes were up, while 12 per cent said they were down, giving a balance of +7 per cent (down from +13 in the quarter to September)
• Looking ahead to the quarter to March, growth in business volumes is expected to pick up somewhat: 17 per cent of firms expect volumes to rise next quarter, and 3 per cent expect them to fall, giving a balance of +14 per cent.

Incomes, costs and profits

• Overall profitability improved slightly in the three months to December, with 25 per cent of firms reporting that profits had increased and 10 per cent saying they fell, giving a balance of +15 per cent. An improvement on September (+13 per cent), this nevertheless disappointed expectations (+42 per cent)
• Income from fees, commissions and premiums rose (+7 per cent), and growth is expected to gather pace in the quarter ahead (+17 per cent)
• Income from net interest, investment and trading also increased (+10 per cent) with a further rise expected in the next three months (+18 per cent)
• Total operating costs rose rapidly (+32 per cent), while average costs remained stable (-1 per cent). Both total costs and average costs are expected to rise sharply next quarter (+50 per cent and +21 per cent respectively).

Employment

• 27 per cent of financial services firms said they had increased employment, while 32 per cent said that headcount fell, giving a balance of -5 per cent (with employment having stagnated in the previous quarter, a balance of -1 per cent)
• Numbers employed are expected to remain stable (0 per cent) next quarter.

Investment over the next 12 months

In the year ahead, financial services firms expect robust increases in spending on IT and marketing, but to cut back on other forms of capital spending:

• IT: +61 per cent (well above the long run average of +32 per cent)
• Marketing: +40 per cent (the highest since June 2015, +58 per cent)
• Vehicles, plant and machinery: -28 per cent (the lowest since March 2015, -38 per cent)
• Land and buildings: -50 per cent (the lowest since March 2009, -57 per cent)

The main reasons for authorising investment are cited as:

• To increase efficiency/speed (80 per cent of respondents)
• To expand capacity (61 per cent)
• For replacement (45 per cent)

The main factors likely to limit investment are cited as:

• Inadequate net return (71 per cent of respondents)
• Uncertainty about demand or business prospects (45 per cent)
• Shortage of labour, including managerial & supervisory staff (30 per cent).

Business expansion over the next 12 months

The most significant potential constraints on business growth over the coming year are

• Level of demand (75 per cent of respondents – the highest since September 2015, 77 per cent)
• Statutory legislation & regulation (72 per cent – the highest since September 2014, +80)
• Competition (59 per cent)
• 96 per cent of firms see competition coming from within their own sector of financial services
• 47 per cent see competition coming from new entrants
• 34 per cent see competition coming from other sectors of financial services.

Challenges to UK’s position as a leading global financial centre

Concerns about the impact of Brexit uncertainty on the financial services sector shows no sign of abating. Nine out of ten firms (91 per cent) cited it as the most serious challenge to the UK’s position as a leading global financial centre.

Companies are also concerned that the quality of infrastructure in the UK is lagging behind peers, with 53 per cent ranking the UK’s physical infrastructure within their top three concerns, while a similar share (47 per cent) pointed to the UK’s digital infrastructure.

More than a third (37 per cent) of firms listed the UK’s gold-plating of international standards within their top three concerns, with 32 per cent citing the UK’s increasingly complex and unpredictable tax regime, and 26 per cent pointing to increasingly restrictive and costly immigration policies.

In order for the UK to remain a leading FinTech and innovation centre

• 54 per cent of firms want to see steps to attract entrepreneurial, digital and financial talent to the UK’s FinTech sector
• 52 per cent of companies want to see an acceleration in the digitisation of services
• 52 per cent of businesses want greater investment in the UK’s broader technology infrastructure.