The pound in your pocket today, in real terms of its purchasing power, is worth a little less than 91p compared to a year ago.  

As UK inflation hits 9.4%, everything from food to fuel is considerably more expensive.  

Companies and individuals alike are running to catch up, looking for ways to mitigate the effects of the increases. Where they have them, they are looking to their accountants for help. 

Outlook for financial services

Higher inflation has triggered the Bank of England to raise interest rates, which Chris Woolard, UK financial services partner at EY, and former interim CEO at the Financial Conduct Authority, pointed out, offers some benefits for households; savings can now work a little harder as rate changes are passed onto customers (in some cases).  

Equally, most banks will benefit from higher net interest margins – customers without savings or excess disposable income will be forced to borrow so will be seeking credit to support household spending.  

Yet Woolard added the inflationary environment has raised concerns around higher lending costs and balance sheet stress on non-performing assets. He said: “We can already see the number of small firm defaults is starting to rise. Today, the immediate impact on retail consumers seems limited but the picture could look very different in 12 months’ time.”  

Access to mortgages and loans may become restricted as lenders tighten affordability assessments. There may be an increase in the use of payday loans as people struggle to meet their day to day living costs. 

The effect of inflation on insurance firms’ business models will, EY expects, be negative for at least a year. In the private equity and venture capital space, assets will likely be priced lower.  

Customers of wealth and asset management firms face discomfort, likewise the sector, as higher prices will heavily impact those clients reliant on securities for long-term saving, especially if they are close to retirement or drawdown.  

Woolard pointed out “in this environment incoming regulatory changes, such as the Financial Conduct Authority’s (FCA) cost of living package as well as the new Consumer Duty, pose additional challenges and opportunities to firms which are already seeking to mitigate their own rising costs and protect their balance sheets”. 

Wage inflation has also been higher in the financial and professional services sectors than other industries.  

The Institute for Fiscal Studies calculated average monthly pay in finance was 31% higher in February 2022 than at the end of 2019, above the 14% rate prevailing across all sectors. With low unemployment, the supply of experienced workers into the sector is constrained, which makes continued wage inflation likely.  

Hugh Fairclough, partner at RSM UK said: “Financial services and accounting businesses will benefit from reminding their staff and potential recruits of their employment offer, not just headline wages.” 

Possible protections 

Anticipating the looming effects will be key. A reduction in consumer’s discretionary spending will mean some businesses will see their revenues fall at a time when their costs are increasing.  

Fairclough said: “These businesses will need to be prepared to manage that.”  

Reforecasting their expected cash flows and funding needs should be done fast. Stress testing and sensitivity analysis of potential inflationary changes, said RSM’s Fairclough, should also feature in client assessments and accountants’ advice to clients: “Accountants should advise clients on re-budgeting for any reduction in revenue or increases in supplier costs,” he added. 

Fairclough also pointed to the significant impact of rising freight costs and other price increases following Covid-19 and the war in Ukraine, factors feeding inflation and the cost base of all types of businesses.  

He said: “Businesses should be consistently revisiting their budgets and pricing decisions, and also assessing credit risks among their clients and customers.”  

Finance providers may also need to consider whether their clients can extend repayment terms or agree repayment holidays during any pinch points in these forecasts, he added.  

The UK's Prudential Regulation Authority warned credit insurers to keep a close eye on credit risk and inflation when it laid out its 2022 regulatory priorities for the industry.  

Fairclough said: “Inevitably, early assessment and action will drive better outcomes than waiting until there is an immediate need for cash flow.” 

Accountants also can ensure their clients are using the full range of tax reliefs, grants and schemes available to them, said Phil Hall, head of public affairs and public policy at the association of accounting technicians, “including things like business rates relief, Government Help to Grow schemes, and on HMRC “Time to Pay” arrangements for those who find themselves in difficulty and are struggling to pay any tax due”.  

An increasing number of firms, he added, are making one off payments to staff rather than making inflationary pay rises that are then locked in for future years.  

This provides a degree of protection for the employer whilst assisting the immediate needs of employees, though such payments are a one-off and not pensionable. 

Stress testing and responses 

Firms will need to be prepared for more customers to fall into stressed situations. FCA treating customers fairly rules make it clear it expects firms to do all they can to support customers in financial difficulty and mitigate risk of harm.  

PwC told ICAEW it recommends that firms improve staff training and oversight, have a plan to increase collections and customer support capacity if needed, use a range of communication channels which set the right tone to encourage customers to engage early, and offer forbearance that considers the full range of options and is tailored to customers’ individual circumstances. 

As markets are disrupted, PwC advises stress tests and scenarios be revised to ensure risks are adequately captured and capital levels remain appropriate. Organisations will need to be careful not to overly restrict access to credit despite the likely deterioration of credit quality due to economic conditions.  

Crucially the performance of financial models, used to support business and risk management decisions, will require attention, PwC pointed out.  

Many of these models were developed and calibrated in times of low interest rates. It is important the model assumptions and performance are revisited in light of the new environment.  

Organisations will need a strategy for dealing with supplier price increases and procurement functions will need to be well prepared to offer balanced responses. 

Potential upsides 

One unglamourous positive in the current situation is, as PwC noted, the ‘new paradigm’ in financial services compared to the global financial crisis (GFC).  

External supply side shocks, the current driver, are very different to the GFC, which was exacerbated by a relatively weaker financial services sector. Harsh lessons were learned by financial services in the GFC.  

As such, PwC anticipates banks could now be in a position, through advanced forbearance practices, to genuinely support consumers and businesses through this downturn.

Much of this is the result of macro and micro prudential regulation which has significantly 'beefed up' regulatory scrutiny of the conduct of banks regarding their clients, alongside very significant levels of capital and extensive stress testing undertaken by banks. This will now position them with a very robust balance sheet to be able to better ride out downturns.

Banks, said Michael Magee, UK financial services deals leader at PwC, could also look to invest in improving productivity. He said: “While much capital investment has gone into remediation of regulatory and conduct driven change, the new environment could provide the stimulus for banks to consider far more strategic investment, such as enhancing their technology capabilities.” 

In Magee’s view, by drawing on a broader scope of technology capability and using fintech providers, banks can “generate a step change in productivity, customer experience, and returns to their investors”.

Mortgage lenders will also, in due time, enjoy the advantages of inflation-driven higher interest rates. 

Thomas Pugh, economist at RSM UK, pointed out the proportion of new fixed rate mortgages in the UK has risen from less than 50% in 2010 to more than 90% in 2021, with many homeowners locking in rates for 5 years. 

He said: “As such, the impact on the economy and banks revenues from rising interest rates is likely to take considerably longer to be realised than previous tightening cycles.” Though, he added, higher interest rates tend to be positive for financial services firms as it allows for wider spreads between borrowing and lending. 

Impact of regulation 

The Financial Conduct Authority recently told more than 3,500 lenders they need to provide customers in vulnerable circumstances with more support as the rising cost of living threatens to tip millions into financial difficulty.  

In addition, the regulator has published some guidance urging consumers to get support if they are struggling financially.  

Catherine Brittain, partner at RSM UK said: ‘The regulator will expect firms to adapt their forbearance practices and debt help for customers who can’t afford repayments.” She compared this to the onset of Covid-19 – customers might be offered repayment holidays or extensions to their credit agreements to help manage their cash flow.  

Future inflation 

Projections on how long inflation will remain high vary greatly. By RSM’s calculations, financial markets are expecting interest rates to rise to around 3% by this time next year, but are factoring a small fall after that so interest rates in 5 years’ time are expected to be lower than this time next year.  

At the same time, inflation is expected to peak in Q4 2022 and fall sharply in 2023 as the huge rises in goods and energy prices over the last year fall out of the annual comparison.  

RSM’s Pugh said: “Inflation should be back between 3%-4% by the end of 2023. Admittedly, it may take a bit more time for inflation to get back to the Bank of England’s 2.0% target. But the combination of higher interest rates and a much weaker economy should ensure that inflation continues to fall to 2.0% by the end of 2024.”