Risk and Regulatory Insights: Are Banks Prepared for 2017’s Risks?

Dr. Cliff Rossi

A post-election market euphoria may be masking a set of forces with the potential to unleash extreme volatility here and across the globe in 2017. After the financial crisis, attention to strengthening risk management practices across the industry grew, largely from intense regulatory focus embodied by such rules as heightened standards for risk governance. However, the economic environment of the last 5 years has not tested the resilience of risk management under anything approaching stress conditions. The question is whether the industry can maintain risk vigilance at a time when a long-awaited economic expansion may just be around the corner and as a host of other potential risks stalk financial markets.

 

Fed Chairman Yellen in her post-FOMC press conference remarks reiterated concerns about bank culture given a string of high profile compliance breakdowns over the last few years. While regulators have continued to shine a light on this topic at banks, they admit that ultimately regulation cannot establish and maintain good risk culture. If there has ever been a time since the crisis to ensure risk practices and culture are at their highest level it is now. The incoming Administration has signaled a number of major shifts in economic and foreign policy that could generate a range of very different outcomes for which banks need to be prepared. Expansionary fiscal policy coupled with a more aggressive foreign trade and policy agenda along with regulatory easing raises the level of economic and political uncertainty heading into 2017. How Brexit is resolved, further potential unravelling of the EU, rising trade and military tensions rising between China and the US, and major trade agreement renegotiations, are just a few of any number of issues that could also spark major destabilization of markets across the globe.

 

Closer to home, bank boards and risk management teams must be on guard if expansionary policies and regulatory softening takes off. The rising specter of interest rate risk that the Office of Financial Research has flagged as a concern on its Financial Stability Monitor, continued cyber intrusions into secure data and systems, and foreign exchange risk, are key risks facing banks heading into the new year. Economic expansion puts significant pressure on existing bank business and risk infrastructure to handle higher asset production levels which can expose the bank to greater credit and operational risks as we witnessed during the mortgage boom. This is where banks that have spent the last several years transforming their cultures and risk infrastructure to adapt quickly and respond to any number of potential threats will be well-served in this period of growing risks. What are the essential elements required to be ready for what risks might be lurking next year?

 

Risk transformation entails rethinking the banking model across lines of business, core activities and personnel. It begins and ends with bank strategy. In this framework products and services are developed using a bundled risk-adjusted framework that directly assesses tradeoffs among financial and nonfinancial risks and optimizes risk and return within the contours of a bank’s long-term portfolio strategy taking into account the larger political, social and technological events unfolding around it.

 

The core attribute of a risk transformative institution is one that operates at an entirely different strategic level than other firms across the enterprise as shown in the table below. Such firms adopt a holistic approach to viewing product and service offerings as an integrated set of risks and return tradeoffs and opportunities over the long-term. Specialization and compartmentalization has been a hallmark of banking that separated risk and business management activity long ago and in so doing unwittingly fostered an excessive level of tension between the business and risk functions that was unwarranted in the process and often led to suboptimal outcomes.

Risk Transformation Enables Banks to Better Handle Market Uncertainty

 

From a human capital perspective, risk transformation requires people to be problem solvers and not specialty thinkers. Bundling risks and business outcomes forces bank staff to take ownership for the success of the product in totality and not just an isolated piece.

 

Processes and controls used to build the balance sheet must be rethought in terms of their flexibility to adapt to changing markets and customer preferences. This continues to plague many firms whose fortunes are tied directly to unyielding platforms and systems. These rigidities have been observed by a host of new entrants that have realized that they can compete favorably on this dimension against traditional banks. The customer engagement model of banking which has relied on brick and mortar operations is undergoing a sea change in how customers prefer to do their banking as millennials and nontraditional bank customers increase their presence in the market. Creating opportunities for virtual banking experiences via web-enabled technologies and mobile apps is a trend that is not going away. Certainly some banks have been moving in this direction, however, the speed and degree of adoption of such capabilities depends on the extent that they have embraced risk transformation.

 

Other signs of bank risk-taking rigidity come in the form of regulation and compliance. Massive regulation following the financial crisis severely handicapped banks from making the risk transformation leap. First, it forced firms to become regulatory-centric, putting banks in a defensive rather than offensive posture, which facilitated nonbank entrants to the market. The second effect of heightened regulation related to the first was to generally relegate transformative investments for the future to a lesser priority. Technology, data and analytics are years behind where they should have properly been in banking. Developing data repositories and analytics to support various regulatory reporting requirements rather than viewing them as strategic inputs to bank production prevents risk transformation from taking place.

 

Despite the regulatory and market upheaval of the financial crisis, the banking model has not changed significantly over the years. Much attention has been given to elevating the risk management processes in banking, but where regulatory edict has tried, market-leading firms will find that elevating the level of strategic risk in the organization provides a way forward to forming a more integrated and adaptive approach to navigating an environment of unusual uncertainty.