Risk Management & Analytics: Three myths in financial services risk management

Three myths in financial services risk management

When it comes to financial services risk management, many financial institutions seem to have risk management nailed down, from system implementation through processes and governance. However, when analysts at MountainView Financial Solutions, a Situs company, dive deep into risk management discussions with industry partners, we find that even the most well-organized and well-staffed institutions require regular self-evaluation to determine whether their approach to risk management is both tactical and strategic. While many of the challenges we see are unique to a specific risk function, often such challenges are a byproduct of broader risk management myths that cause financial institutions to make costly errors. Here are three key myths to avoid when developing your risk management approach:

Myth 1: Risk management comes down to a specific person, function, process or technology

An occasional mistake made by many institutions is to treat risk as highly specific and the result of singular functions. While it is critical to identify specific risks within a financial institution, it may create new risks if the institution’s risk audits and resulting corrective actions are limited in scope. Often, specific risk is either a) a byproduct of another risk, or b) will result in one or more new risks if not properly evaluated.

It is important to keep in mind that the industry continues to learn the lesson that risk is interconnected and trickles down from factors both outside and within your organization. For example, data management impacts the accuracy of financial models, and the assumptions and outcomes of those models feed other models. This in turn impacts the accuracy of information on which stakeholders make business decisions. By looking at specific risk within the context of systemic risk (including data, technology, functions, processes, policies and regulations) and thinking through how risk cascades, financial institutions will be able to capture risks earlier, prevent them later and do it more efficiently.

Myth 2: Risk management responsibilities are owned by risk management professionals

Of course, risk management professionals are hired to manage risk and when something goes wrong, they will surely be the first to answer the hard questions. But, as the saying goes, “point one finger and three will point back at you.” When something goes wrong at a financial institution, it is rarely the fault of one individual. Even in the cases of fraudulent activity or insider trading when the big arrow points to one bad apple, other factors come into play, such as the effectiveness of policies, communication and ethics training.

Some institutions mistakenly view risk management through the lens of regulatory compliance alone and hire individuals based on the premise that passing the audit is the core risk management objective. This narrow risk management narrative is rapidly becoming outdated within financial services. Of course, passing an audit is important so long as it is not the only risk management objective. There is a fundamental shift in how financial institutions approach risk management — and that is to drive a culture of risk management and compliance from the ground up. Establishing a risk philosophy and building a risk-aware culture will reinforce how leaders, managers and employees perceive and account for risk in day-to-day activities.

Myth 3: With better tools and technology, fewer audits, validations and analyses are required

Systems, artificial intelligence (AI) and machine learning all offer amazing, groundbreaking developments in financial services risk management. Exploring and implementing such tools will most definitely increase efficiencies in your risk management approach and will likely capture more errors. That said, since some of these tools are fairly new, and others are still subject to human error, overreliance on systems, automation and AI may pose a risk.

The learning curve associated with many new systems can sometimes result in modeling errors, data integrity challenges and additional work. While we advocate for modernizing and automating risk management, third-party, objective reviews are still required, and the frequency of third-party reviews may even increase as new tools are embraced. The takeaways are to evaluate your systems and technology options thoroughly, choose tools and technology strategically and in a way that won’t disrupt your institution, and look for forward-thinking risk analytics partners that understand modeling software and watch tech advancements closely.  As systems and technology evolve, so too should your third-party partner.

If your institution requires comprehensive model validation, loan analytics or deposit studies, reach out to Andrew Phillips, Andrew.phillips@situs.com


FDIC chief: Spare small banks the burden of complex capital rules

Days before the Federal Deposit Insurance Corp. is set to propose a new leverage ratio for community banks, the agency’s chief said she wants to do even more to simplify capital requirements.

The FDIC’s board will meet today to propose a “community bank leverage ratio,” or CBLR. Under the regulatory relief law enacted in May, banks below $10 billion of assets that exceed the ratio — measuring their tangible equity to average assets — can avoid other Basel-related capital requirements if they meet certain criteria. Regulators can set the new ratio between 8% and 10%.

“The Basel III standards, which may be appropriate for internationally active banks, are unduly complex and unnecessary for community banks,” FDIC Chairman Jelena McWilliams said last Friday in prepared remarks at a community bank conference hosted by the Federal Reserve Bank of Chicago. “We do not need 15 pages of regulatory reporting requirements for simple community banks to demonstrate capital adequacy. It is time to go back to basics.”

Read more: American Banker


Banks are more profitable than ever, but risks abound

In a report published on November 15 by Moody’s Investors Services, Moody’s analysts confirmed what has been suspected for a few months. U.S. banks’ Common Equity Tier 1 (CET1) has been decreasing. The fact that common equity and retained earnings are decreasing is concerning, because they are what help banks sustain unexpected losses.

U.S. banks’ median Common Equity Tier 1 (CET1) ratio decreased by 40 basis points. The decrease in capital is primarily due to banks paying out dividends, since their capital plans were approved in the most recent Comprehensive Capital Analysis and Review (CCAR). A few banks front-loaded their dividend distributions. In its report, Moody’s analysts stated that they “still expect payouts in excess of 100% of earnings to prevail over the next three quarters.

Read more: Forbes


Why hedging credit risk is getting easier in China

A record pace of bond defaults and increasing corporate-funding strains have spurred China’s regulators to re-energize efforts to provide investors with ways of hedging risk in the world’s third-largest debt market. While credit-default swaps (CDS), which allow traders to place bets on a company’s — or a collection of companies’ — creditworthiness have been around for decades in developed nations, such securities are rare in China. Regulators are now actively supporting financial contracts that let investors make bets on risk. The thinking: that might make them as a group more comfortable buying bonds.

Up until recent years, it didn’t. The country first started letting companies default on bonds in 2014. Regulators have come round to the idea that only by allowing insolvent borrowers go under can they achieve the objective of pricing credit on the basis of risk, rather than relationships — which ultimately will limit the build-up of bad debt. What started as a trickle has become more of a steady stream: There has been some 75.6 billion yuan ($11 billion) in defaults this year. But now that defaults are becoming a regular feature of the landscape, investor appetite for bonds could be dented, and all the more so with the economy slowing. An active market for debt insurance could help sustain demand for the underlying bonds.

Market players say credit risk mitigation warrants are the most commonly used of the four main types of instruments in China. They offer a kind of insurance linked to a specific bond or loan obligation, and can be traded on the secondary market. (That makes them different from the Chinese version of credit-default swaps, which were introduced in 2016 but cannot be transferred from one investor to another.) A drawback is that the warrants only cover one specific obligation. CDSs by contrast provide protection against multiple credit events from a single borrower. CDSs in China involve genuine bilateral contracts, with the seller and buyer negotiating price and other terms privately — limiting their availability.

Read more: Bloomberg


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