Since the aftermath of the financial crisis banking leaders and regulators are heavily focused on improving risk management practices in order to avoid another dramatic downturn. Nevertheless, in 2023 the collapse of Silicon Valley Bank in the US again highlighted the consequences and impact poor risk management can have on a banking operation.
Hence, for banks, effective risk management is of utmost importance to guarantee stability and success in the face of uncertainty inherent to their business model. Our article gives you an overview of the key elements of risk management and the best practices that leading banks are adopting for 2024 and beyond.
Adopting an Integrated Approach to Risk Management
In the past, risk management in banks tended to be siloed, with different departments handling specific risk types independently. However, today's increasingly complex and interconnected risks require a more holistic approach. Leading banks are now taking an integrated view of risk management that encompasses credit, market, operational, liquidity, regulatory and other risks.
This integrated approach allows banks to identify correlations between different risk types and develop a more coordinated mitigation strategy. It also provides a complete picture of the bank's overall risk profile rather than just individual slices of risk exposure.
Key Elements of an Integrated Risk Management Framework
- Enterprise-wide risk governance with involvement from senior management and the board of directors. This ensures alignment between the bank's business objectives and risk management priorities.
- Consolidated risk analytics using advanced data aggregation and quantitative modelling to get an enterprise-wide view of risk. This is facilitated by investments in risk data architecture.
- Risk identification and assessment processes that span across departments and risk types. The goal is to recognize emerging risks and measure exposures more accurately.
- Risk controls and mitigation strategies that tackle multiple risk dimensions across the organization. This aims to efficiently optimize capital allocation and improve loss prevention.
- Continuous monitoring of the risk environment and performance tracking of risk management processes. It enables banks to keep enhancing their risk management frameworks.
Adopting these core elements allows banks to manage risk from an integrated perspective rather than within departmental silos.
Prioritizing Compliance amid Regulatory Changes
The regulatory landscape for banks is continuously evolving to address new challenges and risks. This exposes banks to heightened compliance risks as they struggle to keep pace with heavy regulatory burdens and supervisory expectations. Recent years have seen a significant uptick in regulatory fines and sanctions globally.
To tackle this, leading banks are making compliance a top strategic priority and deploying several mitigation strategies:
Proactive Approach to Regulatory Change Management
Banks are improving change management processes to quickly detect and act upon new regulations. Dedicated regulatory monitoring teams armed with regulatory technology (RegTech) tools can systematically track updates across jurisdictions and proactively adapt compliance programs and systems.
Comprehensive Compliance Risk Assessments
Periodic assessments across business lines help banks measure their compliance risk exposures more accurately. Risks related to money laundering, consumer protection, data privacy etc. can then be prioritized for mitigation. Assessments also diagnose weaknesses in compliance programs.
Increased Investment in Compliance Resources
Adding compliance staff, increasing training budgets, purchasing compliance technologies — all these initiatives help establish the strong compliance foundations needed today. Banks are also trying to change the perception of the compliance function from a cost center to a value-creating function.
Customer Due Diligence and Surveillance
Enhancing CDD procedures and customer screening against sanctions lists has become vital for Know Your Customer (KYC) compliance. Advanced analytics techniques can help screen billions of transactions for money laundering red flags. Automation also aids compliance without compromising customer experience.
Testing and Monitoring Compliance Controls
Banks are adding rigor to compliance testing programs to validate control effectiveness and adherence to policies. This is combined with management information system (MIS) dashboards for monitoring key risk indicators on an ongoing basis.
Proactive Engagement with Regulators
Maintaining open communication channels with regulators and involving them during key compliance initiatives reduces ambiguity and enhances compliance. Some regulators also provide compliance testing tools and resources for banks.
By embracing compliance as a value creator and core business function, banks can achieve superior regulatory outcomes amid evolving compliance demands.
Managing Climate and Sustainability Risks
With rising concerns around climate change and social issues, banks are facing increasing scrutiny of their own environmental, social and governance (ESG) records. There is growing stakeholder and regulatory pressure on banks to actively manage climate and sustainability risks as part of their portfolio management.
Leading banks are responding by taking concrete steps:
Incorporating ESG in Risk Frameworks
Banks are enhancing risk management frameworks to incorporate climate and social risk factors. This includes building methodologies for climate and social risk identification, measurement and mitigation. ESG is now an integral part of risk governance and reporting.
Conducting Climate and Social Risk Assessments
Scenario analyses, stress testing, and other assessment tools are being developed to gauge portfolio vulnerabilities against climate and social risk factors. This allows strategic steering of portfolio mix towards greener, more socially responsible assets.
Tightening ESG Client Selection and Lending
Banks now increasingly screen and monitor client ESG performance as part of due diligence and credit approvals. Stricter ESG lending policies are also being implemented for high-impact sectors like oil and mining. ESG-linked loan features are also on the rise.
Aligning with ESG Reporting Standards
Adoption of sustainability reporting frameworks like TCFD (now under IFRS) is increasing to showcase alignment with global ESG reporting standards and practices. This boosts brand reputation and stakeholder confidence.
As ESG considerations become integral to banking, proactive management of climate and social risks is no longer optional but an urgent priority. Those outpacing peers in this area can gain a competitive edge.
Harnessing Advanced Technologies for Risk Management
Technology is disrupting the landscape of banking and risk management. Incumbent banks are pursuing digital transformation by deploying advanced technologies to enhance risk management capabilities:
Cloud Migration
Cloud infrastructure enables scalability, data security and faster deployment of applications including risk management systems. Cloud also allows easy integration of AI and data analytics. Cloud migration is a precursor for many banks’ digital strategies.
Implementation of Automated Risk Management Platforms
Many banks are increasingly adopting automated risk management platforms like OnBoard by MVSI. These platforms allow banks to set customized credit and risk criteria which are then used to automatically process customer checks and due diligence. It reduces manual processes and enables banks to manage more accounts with higher efficiency.
Open Banking through APIs
Open banking through APIs allows smooth data exchange between a bank’s systems and third-party applications. This facilitates integration of risk management systems with core banking systems and data aggregators. APIs enable quick product development and innovation.
Digital Advisory Tools
Chatbots, mobile apps and data visualization platforms help relationship managers provide highly customized risk management advice to customers, thus boosting engagement. They also improve internal access to risk analytics.
While full-scale transformation takes time, incumbents are steadily embedding technology into risk management for the future.
Adopting Agile and Data-driven Approaches
Traditional risk management used to rely on backwards-looking models and rigid processes. However, risk environments are extremely dynamic today. Banks are thus embracing agile and data-driven approaches to enable more responsive and predictive risk management:
Transitioning to Agile Risk Management
The agile approach breaks large initiatives into smaller chunks through sprints and continuous development. This brings flexibility, accelerated feature delivery and the ability to quickly incorporate new data. Banks increasingly use agile methods for risk IT projects and model development.
Developing High Quality Risk Data Strategies
Robust data quality frameworks and governance provide the foundation for advanced analytics. Banks are also rationalizing redundant systems and migrating data to centralized data lakes.
Building Risk Management Data Science Teams
Specialist teams of data scientists, engineers and translators coordinate data management and advanced analytics initiatives for risk functions. They collaborate closely with business teams in an experimental, iterative manner to solve complex risk issues.
Testing Model Robustness
Banks actively validate model performance through out-of-sample testing, benchmarking, and sensitivity analysis. Regular independent reviews of models also help verify model suitability before adoption and prevent over-reliance.
With superior data and analytics capabilities, banks can achieve more accurate and nimble risk management.
Reinforcing Risk Culture
Risk management relies heavily on human judgement in designing frameworks, analyzing output, and decision making. Thus, robust risk cultures play a pivotal role in effective risk management. Risk culture refers to the norms, attitudes and behaviors surrounding risk-taking and management within a bank.
Leading banks are actively nurturing strong risk cultures by:
Tone from the Top
Senior leaders underscore the importance of risk management through messaging, incentives and personal conduct. This shapes how the bank’s employees approach their duties related to risk.
Comprehensive Training Programs
Investments in specialized risk management training ensure employees across the three lines of defense have adequate expertise for their risk responsibilities. Training helps disseminate risk management objectives across the organization.
Incentives Alignment
Compensation structures and performance management frameworks are aligned to promote accountability for risk control and deter excessive risk taking. There is a careful balance between risk and reward built into incentive schemes.
Encouraging Sound Risk-Taking
Banks are clarifying risk appetite statements and operationalizing guardrails to guide prudent risk-taking. Employees are empowered to take informed risks while upholding the bank's risk standards.
Promoting Open Communication
Forums for open discussion of risk management issues help teams share knowledge and candidly escalate concerns. Psychological safety facilitates critical evaluation of existing practices.
Independent Risk Function
The independence of dedicated bank-wide risk oversight functions and committees ensures objective assessment and management of risks across business lines.
Embedding Risk Management
Common risk metrics are incorporated into regular business reviews across the organization to reinforce risk discipline at all levels. Risk management is positioned as a shared business responsibility.
With robust risk cultures, employees internalize risk management principles and help translate frameworks into action. This provides a critical line of defense.
Conclusion
As the banking sector continues to operate in a global and less certain economic environment, old approaches to risk management are proving insufficient for the challenges ahead. Leading banks are responding by fundamentally transforming risk management using the strategies discussed:
- Adopting integrated risk frameworks to get an enterprise-wide view of exposures.
- Making compliance a top priority and value creator amid regulatory changes.
- Incorporating emerging risks like climate and sustainability factors.
- Harnessing advanced technologies such as cloud and AI.
- Enabling agile and data-driven risk management.
- Reinforcing strong risk cultures across the organization.
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