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RISK MANAGEMENT IN BANKING: HOW TO PREVENT ANOTHER CRISIS

Audit
Banking
Board Reporting
Capital Planning
CCAR

7 min read
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AUTHOR:
Grant Ostler
Industry Principal
John Stephens
Industry Principal, Banking & Financial Services
Published: April 26, 2023
Last Updated: August 4, 2023
IN THIS STORY
Banks need longer sight lines Overlooked risk bubbles up in unexpected
placesMultiple systems invite vulnerabilities Tone comes from the top

Risk management in banking has played a critical role in banking crises that
have made headlines. As new lessons from the recent banking panic emerge,
financial institutions can take actions now to strengthen resiliency to lessen
the occurrence of another financial contagion. Let's take a closer look.

 


KEY TAKEAWAYS

 

 * Swift macroeconomic shifts may require risk managers in banking to adjust how
   frequently they update their risk assessments and how far they look ahead

 * Broader cultural changes, including the rise of mobile phones, social media,
   or even remote work, should influence how teams approach banking risk
   management and assess risk.

 * Risk management software for banks has changed the face of risk, but the
   right technology can enhance risk managers’ abilities to analyze, assess, and
   monitor risk as well as document and share their recommendations across an
   organization

 * Full disclosures of risks and financial health are not enough to protect a
   financial institution if no one acts upon them

 


BANKS NEED LONGER SIGHT LINES 

 



A key catalyst of the banking sector’s turbulence was short-sighted risk
assessments and risk identification leading to uninformed management of those
risks. It’s easy to forecast threats that could transpire minutes from now, but
planning for them over a multi-year period is more challenging. However,
assessing and managing risks with extended horizons tend to foster more
risk-conscious practices, which brace and sustain controls processes,
reinforcements, and incentives. Otherwise, financial institutions that don’t
adequately fortify themselves are more susceptible to get whipsawed by the
market. A best-in-class scenario would be for the funding and liquidity, capital
planning, and banking risk management teams to forecast on a basis of two,
three, or five years ahead, factoring in key macroeconomic indicators such as
interest rate risk, among others.

Even so, planning with these long views is difficult because financial
institutions operate in a dynamic environment of evolving risks, which fluctuate
in tandem with a shifting economy. A couple of years ago in a lower interest
rate environment, the scare of interest rate risk retreated. Now, in an economy
of swelling interest rates, interest rate and liquidity risks have unexpectedly
become foreground concerns because banks haven’t adequately hedged against
sagging market values of their held-to-maturity securities.

The digital era in general is a new risk in banking that should be factored in
simultaneously, as mobile communications and banking accelerated flight risk
from uninsured deposits at Silicon Valley Bank (SVB) and Signature Bank. With so
much enforced transparency in the market, the banks were required to promptly
issue disclosures. After they issued them, depositors withdrew funds at digital
speed, sapping the banks faster than their historical responses to a run.
However, if banking risk management teams had heightened visibility into and
control of their data and planned accordingly, they could better know when and
where risks could occur to more deftly respond to a crisis.

As proposals to new regulations increase in response, the role of compliance,
management, capital planning, and liquidity functions will become much more
critical. Banks are required to follow hundreds of banking regulations, but some
can fall short in operationalizing best practices through alignment of controls
processes, IT systems, and personnel management. If they’re disordered, errors
could result, potentially leading to stiff regulatory fines that cast a long
shadow in the marketplace.

 


OVERLOOKED RISK BUBBLES UP IN UNEXPECTED PLACES

 



Not only do compliance, risk management, capital planning, and liquidity
functions need to operate in unison, but also the three lines of defense. Big
banks often employ thousands of employees to work in risk specialization areas
and coordinate with peers in operations. But if threats aren’t monitored
holistically—regardless of a bank’s size—then impairment from one neglected risk
control could destabilize other controls.

The first line of defense frequently interfaces with regulators, who tend to
focus their attention on causes of the most recent crisis or regulation, which
can negatively impact banks’ abilities to control risks collectively. For
example, they’ve zeroed in on credit risk management in banks since the global
financial crisis of the late aughts, so organizations have reacted by doubling
down on monitoring this vulnerability. However, over indexing on one type of
risk results in under emphasizing others, causing them to resurface
unpredictably in various areas, like squeezing a balloon. Thus, the second
line’s broader, technical expertise is essential to rein in these banking
threats. The third line should always operate as the contrarian that constantly
identifies uncertainties.

Together, the three lines lose their resiliency from a shortfall in talent,
time, resources to address complex processes, and data. Sometimes banks lack the
right talent to identify and bridge controls and think outside the box by using
risk management technology that can aid in their work. Time is limited because
teams are racing to finalize month end close reporting, which takes days with
outdated workflows. While buried in paper-bound work and without access to
timely, accurate, and complete data, banks struggle to build in robust
controls. 

Banking risk management software closes risk gaps because risk management teams
can access centralized data and collaborate in real time without the hassle of
running multiple applications at once. It also provides a broad vantage into
where risks exist and their probability of occurrence and impact on others. With
this dashboard capability, management can identify systemic and isolated
problems and take corrective actions.

 


MULTIPLE SYSTEMS INVITE VULNERABILITIES 

 



Monitoring banking risks with fragmented IT systems also weakens controls and
exposes threats. As the Globally Systemically Important Banks (G-SIBs) grew
through organic growth and acquisitions of other banks, they absorbed each
firm’s infrastructures and databases. Using the SVB and First Citizens Bank
merger as an example, if SVB’s architectures and platforms aren’t interoperable
with First Citizens Bank's and teams from both business units can’t access and
synthesize data fluidly, then something may fall through the cracks.

The same vulnerabilities arise from data silos within various risk areas. One
contingent may use a fit-for-purpose tool that’s customized to its needs, while
another group may use a separate platform. In particular, an acquired bank may
prefer a specific solution for credit risk, but it may not align with what the
parent bank uses for liquidity risk. And forcing teams to adopt various risk
management technologies at once could cause change management resistance,
further reversing proper risk oversight.

 


TONE COMES FROM THE TOP

 



The quality of risk controls standards is driven by a bank’s risk culture. Set
at the board level, it percolates throughout the entire organization, varying by
the board’s experience, aptitude, and risk appetite. If the board has expertise
in risk and compliance, then it may lean toward embracing more risk-oriented
practices. Rather, if the board’s risk appetite is overly aggressive, then chief
risk officers (CRO) face friction in gaining buy-in for new policies. This
opposition could ultimately scuttle their efforts and, thereby, forestall timely
bank risk management practices, leading to blind spots for banks down the road. 

Resistance can come from banks’ prioritization of booking metrics because
business is measured by them, but banking risk management evaluates if a
financial institution will lose money from new business accounts. Therefore, it
should be a leading, not a lagging function. Also, these benchmarks can cause
bureaucracies to form. Employee performance is measured against metrics, but if
management resists broadening the scope of controls to accommodate the
benchmarks, then CROs face considerable hurdles.

Regulators are pushing for companies to hire CROs with the requisite knowledge,
qualifications, and pay structure to counterbalance the outsized credentials and
compensation of their other functional first-line peers to further strengthen
risk cultures and risk management in banking.

 


THE FUTURE'S UNCERTAIN

 



As the Fed and other bank regulators propose new rules to correct lurking
troubles in the financial system, banks are expecting tighter capital and
liquidity and stress-testing requirements in the near future.

Whether new regulations will solve these issues or not is debatable.
Nevertheless, risk is unpredictable because it’s a function of human behavior,
so risk management in banking should ensure the enterprise thinks and operates
prudently. As banks await the regulatory turnabouts, they can begin asking and
facing difficult questions.

 

Don't wait! Secure your spot for Amplify and get the advice and insights you
need to upskill your career. Join us Sept. 19-21 for 60+ sessions, 13 CPE
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ESG STATE OF PLAY: BANKS’ COMPLIANCE AND AUTOMATED REPORTING TRENDS

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About the Author
Grant Ostler

Industry Principal

Grant Ostler, Industry Principal at Workiva, has more than 30 years of finance
and operations experience, primarily in internal audit, enterprise risk
management, and process improvement. Ostler served as the chief audit executive
over almost two decades for entities ranging from Fortune 500 companies to a
pre-IPO technology company, including building internal audit programs from
scratch and leading the implementation of SOX 404 compliance programs for three
companies. He is an active member of the Twin Cities Chapter of the IIA where
he’s held numerous leadership positions, including Chapter President, over the
past 20-plus years.

John Stephens

Industry Principal, Banking & Financial Services

Prior to this role, John spent over two decades in the financial services
industry in a wide range of roles, including lending, relationship management,
finance, risk management, and data analytics. His research and area of interests
include the role of financial statements and information in capital markets,
data analysis, and ESG's function toward value creation.


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