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SIX WAYS FOR BOARD DIRECTORS TO REDUCE THE ‘UNKNOWN UNKNOWNS’

on February 23, 2024 Community Banking, Compliance and Risk, Featured, Retail
and Marketing

By Rafael DeLeon and Dave Coffaro

The late Donald Rumsfeld described them as “unknown unknowns.” Economist Nassim
Nicholas Taleb calls them “black swans.” But whatever memorable expression one
chooses for the old adage that we don’t know what we don’t know, the statement
begs for action: Now is the time to ask!



The velocity of change in the financial services industry—from technology to
economic forces to geopolitical turbulence–amplifies the need for bank directors
in particular to expand their scope of inquiry. Looking ahead through the rest
of 2024, here are six areas of inquiry for directors to deepen their
understanding for the benefit of the bank and the board.

1. HOW WILL EVOLVING EARNINGS PRESSURE (REVENUE CONTRACTION, MARKET DECLINE)
AFFECT THE BANK’S ACTIVITIES?

Expense reductions are the first go-to step to address earnings pressure. With
personnel expenses the largest line item on most banks’ P&L statements, staff
reductions are often the first cut. Many banks have taken this approach and
concluded also the same time compromise the quality of customer service.
Reducing staff may also increase the risk of processes and controls not being
properly maintained.

There are alternatives to navigate earnings pressure in challenging economic
environments. For instance:

 * Take an “anything but staff” approach to surfacing cost savings
   opportunities.
 * Opportunistically hire displaced customer-facing, revenue-generating talent
   from other firms (grow through the downturn).
 * Invest in training and upskilling to help the bank adapt to rapidly changing
   market conditions or downturn.
 * Ask: What will our staffing need to be in one, three, and five years to
   fulfill our strategic goals?
 * Ask: How can we capitalize on opportunities our competitors will forego due
   to their expense reduction activities?

2. HOW ARE WE USING AI TODAY? HOW DO WE PLAN ON APPLYING AI OVER THE NEXT 12
MONTHS? WHAT RISKS SHOULD WE MONITOR IN OUR APPLICATIONS OF AI?

The industry is in the early stages of integrating AI into financial services.
It is likely that AI is already being used in your operations to streamline
processes and improve decision-making. A recent McKinsey report states that
“[a]cross the banking industry, for example, the technology could deliver value
equal to an additional $200 billion to $340 billion annually if the use cases
were fully implemented.” Over the next 12 months, we expect the rapid
advancement of AI to focus on generative technologies, potentially
revolutionizing how banks work.

As institutions integrate AI into their systems, it’s crucial for directors to
monitor several risks:

 * Data privacy and security: AI applications often require vast datasets,
   posing a risk to data privacy and potentially leading to unauthorized data
   access.
 * Bias and fairness: Machine learning models can inadvertently learn biases
   present in their training data, leading to unfair or discriminatory
   decisions.
 * Operational risk: Over-reliance on AI can lead to operational disruptions if
   AI systems fail or produce inaccurate outcomes.
 * Deepfakes: AI-generated deepfakes can produce convincing false images, audio
   or video, posing a risk to an organization’s reputation and integrity and
   compromising some of today’s authentication protocols.

Navigating these challenges necessitates robust risk management strategies for
bank leaders and directors, incorporating elements like ethical guidelines and
contingency plans to ensure the responsible deployment of AI technologies.

3. WHAT DIFFERENCES DO WE ANTICIPATE ACROSS EACH SEGMENT OF OUR CLIENT BASE IN A
SLOWING ECONOMY AND WHAT DO WE THINK THE IMPACT WILL BE?

Each segment of a bank’s client base is affected differently by a slowing (or
accelerating) economy. Therefore, headline numbers need to be deconstructed to
fully understand the impact of various economic change scenarios. Most banks do
a good job of deconstruction in their reporting, but there may be more for
directors to understand.

For instance, according to a recent LendingTree study, baby boomers led
generations as the group that paid off the most credit card debt between 2021
and 2023, decreasing credit card balances by 35.4 percent. Gen X decreased their
card balances by 7.2 percent. However, Millennials and Gen Z experienced
significant growth in their credit card debt between 2021 and 2023, increasing
their balances by 26.2 percent and 174 percent, respectively. Headline: Credit
card debt is increasing. Anticipated impact to the bank: Varies by borrower
segment.

Trends differ by bank, geography and target markets. That said, the takeaway for
directors is to go below headline numbers (in the example above, increasing
credit card debt levels), and understand the composition of assets, liabilities,
and fee-based business drivers to get a bank-wide view of existing, emerging,
cyclical and counter-cyclical risks. Directors are not expected to be the bank’s
risk managers. However, they do have strategic oversight responsibility, which
includes testing management’s readiness for changing operating conditions and
asking hard questions about their assumptions and forecasts.

4. WHAT MACRO TRENDS OR ONE-OFF EVENTS ARE WE AWARE OF THAT HAVE NOT YET SHOWN
UP IN OUR SERVING AREA, BUT WE SHOULD BE AWARE OF?

This line of inquiry for directors is intended to engage the CEO and management
in real-world scenario-based conversations with the board. What is happening
globally, nationally, and locally in the economy and business operating
environment? Are trendlines similar to the macro picture or different within the
bank’s serving area? If conditions differ locally, what is the reason for the
variance?

For example, if job cuts at technology firms are being reported nationally, but
have not yet taken place in a particular bank’s serving area, what is unique and
nonsystemic about that bank’s market? Is the bank’s technology clientele working
with government contracts that may account for countercyclicality? Or are local
tech firms simply suppliers at a different point in the end-user value chain and
likely to experience economic contractions later in the cycle?

Professional boxer Mike Tyson once said “Everyone has a plan until they get
punched in the mouth.”
This type of conversation helps directors demonstrate agility as conditions
change, guiding the evolution of the bank’s strategic plan — and avoiding
getting a surprise punch. Engaging in this area of inquiry can stimulate
valuable “what if” conversations between directors and bank leadership.

5. HOW SHOULD WE REVIEW AND EVALUATE BUSINESS CONTINUITY PLANNING IN THE CONTEXT
OF THE MANY DEVASTING WILDFIRES, 100-YEAR FLOODS AND CHANGING HURRICANE PATHS?

The keyword for any effective business continuity plan is “resilience.” This
isn’t just about bouncing back. It’s about bouncing back better and stronger,
especially in the face of environmental calamities like wildfires, floods and
hurricanes. Resiliency is your organization’s ability to adapt and respond, not
just recover. These questions will help guide directors’ conversations with bank
leadership:

 * Is the plan updated regularly? A resilient BCP is continually updated.
   Changes in climate patterns and environmental risks necessitate constant
   adaptation.
 * How comprehensive is the risk assessment? For resilience, you must factor in
   every conceivable natural disaster relevant to your geographical location.
 * Are response strategies realistic? Ensure management conducts a tabletop
   exercise to test response mechanisms for agility and adaptivity in handling
   real-world disruptions.
 * Is there a communication protocol? Resilience requires clear, quick
   communication during a crisis to adapt to changing circumstances.
 * How quickly can operations resume following an unexpected event? Assess the
   speed of restoring functions. In a resilient system, not only is recovery
   quick but improvements are made to avoid future vulnerabilities.

Remember, a resilient BCP isn’t a one-time task. It’s an ongoing commitment to
adaptability and foresight.

Lastly, the speed at which operations can resume is another indicator of a
resilient BCP. Faster recovery coupled with lessons learned for future
improvement is a hallmark of resiliency in business continuity planning.

6. WHAT ARE OUR RISK CONCENTRATIONS, AND HOW ARE THEY CHANGING?

Monitoring concentrations of risk, particularly in real estate or liquidity, is
essential to directors’ oversight duties. Concentrated risks can lead to
large-scale financial losses, compromise the bank’s ability to meet its
obligations and may even result in regulatory sanctions or failure.

For instance, a significant investment in real estate could expose the bank to
market volatility, potentially reducing asset value. Similarly, liquidity risk
could leave the bank without sufficient funds to meet short-term commitments,
severely impacting its operational functionality and market reputation.
Effective management of these concentrations involves implementing appropriate
policies and strategies along with comprehensive risk analysis. Directors should
actively monitor and control these risks across business lines, which aids in
decision-making and ensures alignment with the bank’s risk appetite.

Here are key questions bank directors can ask:

 * What is our current exposure to real estate and liquidity risk?
 * Do we have adequate policies and strategies in place for managing these
   concentrations of risk?
 * How often are we reviewing our portfolio mix and risk limits?
 * What contingency plans do we have for adverse market conditions affecting
   real estate and liquidity?
 * Are we in compliance with regulatory guidelines for risk concentrations, and
   how are we preparing for potential regulatory changes?

Bank directors play a crucial role in today’s financial landscape. They must
understand risk concentrations and proactively address vulnerabilities to
fortify their institutions. By providing effective governance as a strategic
tool, directors can steer their institutions towards long-term success and
resilience.

Rafael DeLeon is SVP for industry engagement at Ncontracts, a risk and
compliance management software firm, which he joined following a 30-year career
as a national bank examiner at the OCC. He is also a director of MainStreet
Bancshares in Fairfax, Virginia. Dave Coffaro is principal of Strategic Advisory
Consulting Group, where he works with services firms to accelerate growth and
generate more favorable economics. His most recent book is Leading from Zero:
Seven Essential Elements to Earning Relevance.

Artificial intelligence Business continuity Directors Risk management
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