The Six Big Bank Risks for 2017

SMITH BRAIN TRUST — The risk landscape for banks has changed since last year. For starters, Congress and the Trump Administration have started discussions on a regulatory overhaul. And, meanwhile, interest rates are on the rise, and the Federal Reserve is shifting its focus toward maintaining economic gains made in the past few years. 

All this should further compel banks to embrace enterprise risk management — a relatively nascent strategy that seeks to to identify, assess and prepare for any potential dangers to an organization's operations and objectives as both a day-to-day routine and long-term strategic planning process, says Clifford Rossi, Professor of the Practice in the finance department at the University of Maryland’s Robert H. Smith School of Business. Moreover, bankers should think strategically about the near-term with a focus on the horizon for risk trends that could emerge.

Rossi recently discussed six associated risks — excerpted from this American Bankers Association Banking Journal article. 

Rossi also will be a featured presenter in an ABA-Smith School co-hosted Enterprise Risk Management Advanced Professional Development Program, May 22-26, 2017, at the Reagan Building in Washington, D.C.

Credit risk, loan losses: Lagging data structures are likely challenges from a credit risk perspective as banks prepare to implement the new Current Expected Credit Loss standard for loan loss accounting. Subsequently, data integrity is increasingly significant, says Rossi. “We should be striving to make sure that those data sets that we’re using for our analytics are as clean and consistent as possible.”

Banks gradually have compiled data scattered through systems across the organization, he says. "We end up creating a series of different credit views that then makes it hard to stitch a consistent story together around these disparate credit metrics,” he explains. “I’m a big fan of looking at the big picture. Step back from what we do on a day-to-day basis and [ask]: How do we get greater integration around credit risk measurement than we currently have?”

The past two recessions, for example, were preceded by a strong expansionary run, during which loan volumes swelled, followed by a period in which many borrowers defaulted and credit tightened again. With that in mind, bankers should ensure that they have a concentration risk policy in place and closely monitor concentrations in their portfolios. Rossi advises paying particular attention to geographic concentrations, and warns lenders to beware of what he calls “product morphing,” in which loan products over time change shape as underwriting standards are relaxed.

Interest rate risk: The economy appears to have finally hit a turning point with respect to interest rates, with the Fed forecasting a rise in the federal funds rate to 3 percent by 2019. It is currently at 1 percent. Bankers “need to be bolted down and ready for a rising rate environment,” Rossi notes. One potential danger point here, he says, is that during the last decade, banks have stretched for yield by moving to longer-duration assets that could hurt them more in a rising rate environment. Now is a good time to revisit the bank’s strategy for reducing exposure in that particular area and for clearly defining appetites for market risk, he says. He also recommends stress-testing loan portfolios under different interest rate scenarios.

Liquidity risk: In a rising-rate environment, bankers must also pay close attention to deposit behavior, which can be effected by reputational issues, Rossi says. For example, he says, Washington Mutual during the financial crisis suffered a $5 billion deposit drain over a two-week period as a result of reputational issues surrounding its subprime mortgage lending portfolio. “You need to ask yourself: ‘What are your backup plans? What are your liquidity contingency plans?’” he says. “Do you have backup lines of credit or sources of wholesale funding available to you? Do you have access to a Federal Home Loan Bank advance?”

Operational risk: When it comes to operational risk, Rossi says, process risk and succession planning are among related hot topics for this year. As regulations are expanded or revised, bankers often find themselves “bolting” new compliance procedures onto existing procedures. This can have tangible consequences for the organization, he says, particularly as loan production increases — research has shown a statistical relationship between credit loss and process quality. “If the same loan was originated by an institution that had good process quality and by another that doesn’t, you would find a statistically higher credit loss associated with the institution that had a lower quality process.” That’s why it’s critical to prioritize “infrastructure ahead of growth,” he says. Boards and senior management must also give consideration to succession planning, Rossi points out. “At the end of the day, banks are only as good as the human capital they have in place. Making sure you’ve got people in the jobs with the right skill sets is hugely important.”

Reputation risk: In an increasingly high-speed, digital world where content can go viral in an instant — take the United Airlines overbooked-passenger fiasco as an unfortunate example — reputation risk is becoming a central focus for businesses across all industries. For bankers, the key to safeguarding the institution’s reputation is by ensuring that ethical standards and business processes are consistent across the enterprise, says Rossi. Everyone — from the chairman of the board to the tellers — need to be singing from the same song sheet when it comes to employee conduct. “Going forward, there’s not going to be a lot of latitude for missteps here,” Rossi says. “Process matters. How you interact with your customers throughout the process matters. Getting that message across is imperative, and making sure that executive compensation plans and sales compensation plans are aligned with the long-term interest of the shareholder are critical to maintaining… the company’s good reputation.”

Strategic risk: For Rossi, strategic risk is the risk category most likely to keep him up at night. With more nonbank players entering the picture each day and new generations clamoring for new and innovative products and services, banks are being constantly challenged to move quickly, which can make strategic planning a particular challenge. Added to that are new market challenges as interest rates rise, and the need to balance all of these factors against the strategic objective of growth. The key, Rossi says, is not to become complacent and to embrace new technologies. “You’ve got to look at automation as your friend, not your enemy.”