Risk Management in the Current Banking Environment

by Vic Berbano, Senior Consultant, Regulatory Advisory Services

The FDIC Industry Analysis shows that from 2001 – 2023 there have been 564 bank failures. 465 failures occurred during the 5-year span from 2008 – 2012 amid the real estate crisis. In just the 1^st quarter of 2023, three banks have failed- collectively nearly a half trillion dollars in total assets. The industry must examine the way risk management is approached and face the issues head-on in today’s banking environment.

Federal Reserve States that the US Banking System is Sound  

In light of the recent bank failures, the Fed stated that the U.S. banking system is sound. While the capital and liquidity levels are strong, there are industry challenges of credit, liquidity, interest rate risks, and concentrated funding sources.  The May 2023 Board of Governors’ Supervision and Regulation report actually shows positive trends in 2022 with improvements in bank earnings performance, increasing return on assets (ROA), return on equity (ROE), and strong net interest income that more than made up for increasing loan loss provisions and falling noninterest income. However, net interest income will likely not experience strong growth in 2023 as assets on the balance sheets were booked when rates were lower, much lower.  

Asset Liability, Interest Rate Risk, Liquidity Management Challenges

The issue is that assets, loans, and investments tend to be longer-term than expense liabilities, i.e., deposits.  Thus, while much of the assets were placed on the books when Fed rates were 0.25% and fixed-rate mortgages were earning 3.0%, customers expect deposit earnings based on today’s 5.00% Fed rate. Thus, the net interest margins will continue shrinking, and fixed-rate bonds have lost significant market value in this rapidly rising interest rate environment.  One might argue that investments are not going to experience losses unless they are sold at a loss and that argument is indeed correct.

However, under current accounting rules, investments held as available for sale must be marked-to-market and unrealized losses must be shown on the financial statements for all the public to see for any public company. News spreads lightning-fast in today’s media-rich environment. Perception became reality at certain institutions when depositors responded to seeing significant unrealized mark-to-market losses and resulting income statement losses by making huge deposit withdrawals, creating a liquidity crisis that resulted in banks having to sell securities, resulting in realized losses, leading to increasingly fast panic withdrawals.  The ultimate liquidity crunch – a deposit run.

Federal Reserve Governor Michelle Bowman Gives a Well-Thought-Out Response

On May 19, 2023, Federal Reserve Governor Michelle Bowman called for a “targeted” regulatory response to the recent bank failures, pushing back against broader reforms that “appear to advocate a shift away from tailoring and risk-based supervision.” She cautioned that broad regulatory changes could do more harm than good.  Bowman said a targeted solution would instead focus on actual risks, on the improvement of supervision and risk management, and on prompt remediation of supervisory issues. She also said that in times of stress, regulators need to be forward-focused on bank preparedness so that banks are positioned to address issues of concern.

How can Your Financial Institution be Forward-Focused and Prepared to Position Itself?

In today’s banking environment, it is imperative that each financial institution have an intentional, forward-focused risk management process that considers the current banking environment.  Risk modeling is a discipline that should involve all key managers meeting on a regularly scheduled basis.  In many institutions, Compliance Managers are relied upon as key managers to develop and facilitate the risk management process.  While the task can appear daunting, developing an effective risk management system begins by:

1. Identifying the source of risks to your institution. In the current environment, examples of risks to consider include various rate increases from 50 – 500 basis points over various time periods from 1 month to 3 years; deposit level decreases over various time periods; slowing loan prepayment speeds; decreasing loan demand; and decreasing collateral values. 

2. Measuring the impact of those risks

3. Controlling and mitigating risks to lessen their impacts   

4. Monitoring risks on a continual basis and identifying new threats

A strong risk management process provides management and the board of directors with the tools to ensure that your financial institution remains strong and well-positioned for the challenges that face our banking system.

How Capco Academy Can Assist with Risk Management

A robust risk management system is key to identifying, measuring, mitigating, and monitoring risks. Our team of experts is here to assist you to develop a robust risk management system. We offer direct access to our team of compliance experts to submit compliance questions via live chat and ticketing system. Our online compliance learning platform has over 120+ courses of comprehensive live and recorded webinars to keep you up to date with the latest developments in the financial industry.