Amidst the backdrop of an apparent increase in highly publicized banking failures, Silicon Valley and Signature Bank, to name a few, financial advisors, economists and investors alike are beginning to share plausible concerns regarding the possibility of a significant recession approaching in 2023.
There are warning signs there for all to see, with the Federal Reserve acting to raise interest rates to a range of 4.75-5% in an effort to combat high inflation. But, for professionals working in the financial sector, it remains unclear as to whether the economy will continue to trend in the wrong direction.
Above all else, it’s important that banks strive to enact positive measures and considered policies to prevent long-term damage from being done. Provided that our financial institutions continue to approach these uncertain times with an eye to measured risk management and controlled resistance, the banking sector should be appropriately protected from serious harm. To explain these ideas in a little more detail, here’s a short overview and guide to effective risk management in the banking and finance sectors.
Common Risks Faced by Financial Institutions
Before enacting measures to resist the effects of difficult economic times, it’s crucial to understand the common risks that financial institutions can expect to face during periods of recession and inflation.
When a bank lends out financial resources, there’s always a chance that the loan recipient will not be able to pay back the funds within a preapproved timeframe. This discrepancy will be measured as a credit risk, which if not addressed, can lead to an interruption of cash flows as well as increased costs for collection.
All financial investments made by banks are subject to a potential decrease in value as a result of combined market factors, including inflation and economic recession, market risks such as these must be factored into wider risk management policies by acting to diversify or hedge existing investments.
Operational risks describe financial losses that occur as a direct result of operational events. For example, insufficiently trained employees making ill-advised decisions, critical systems and processes suffering breakdowns or malfunctions as well as information theft that could result in financial harm.
These risk factors refer to the possibility that financial institutions may be unable to pay back liabilities upon request due to unexpected claims or an unforeseen obligation to sell long-term assets below market value. Liquidity was a major risk factor in the recent financial failure and collapse of Silicon Valley Bank.
Risk Management Strategies to Shore up Financial Resilience
Credit Risk Management
Banks and financial institutions can never be fully protected from credit risks as lending funds will always be central to their operations. However, there are a few risk management strategies that should be explored to reduce the likelihood of exposure to potential credit risks. Primarily, it’s advised that banks look to diversify investments across unrelated categories to mitigate the impact of a credit downturn.
This means that if unexpected losses are imposed on one asset class, serious financial harm can be offset by the stability or even gains in another. Enacting a risk management policy that instructs financial officers to monitor and diversify active portfolio resources across unrelated investments can help to prevent institutions from becoming overexposed to specific markets if they should suffer large losses.
In addition, it’s essential that financial institutions ensure that they’re only loaning money to clients with good credit histories, as well as transacting with high-quality and low-risk counterparties, with efforts made to back up loans with stable collateral to reduce exposure risks associated with credit defaults.
Market Risk Management
Market risks will be mostly tied to a bank’s activities in capital markets, any unpredictability in terms of commodity prices, credit spreads or interest rates will factor into increased risk exposure. Institutions investing in companies that produce commodities are likely to experience an elevated risk posed by economic instability, as fluctuations in supply and demand will have an impact on commodity values.
Just as with credit risks, effective market risk management strategies will involve the diversification of financial investments. Provided that major portions of an institution’s collected assets are not invested entirely in commodity producing entities, they should be shielded from market shifts and large losses.
Together with diversification of investments, risk management policies can involve related hedging strategies such as arbitrage, whereby financial officers purchase products in a lower demand market and immediately sell these assets in an opposing market for a higher value. Provided traders possess a good understanding of their chosen asset class, small, steady profits can be made without a great deal of risk.
Operational Risk Management
Operational risk management strategies involve dedicated efforts to improve internal processes and installed systems. For example, institutions can reduce several risks associated with human error by developing automated technologies. AI-informed automation tools can be leveraged to perform bank teller duties, carefully monitor customer transactions and verify accounting services to minimize risk exposure.
Automated alert systems should also be implemented to protect financial institutions from any potential cyber threats that could lead to instances of fraud or data theft. By working with security integrators and IT teams, banks are able to create converged security systems capable of monitoring and responding to multi-platform attacks with smart password protections like multi-factor and biometric authentication.
Operational risk management strategies should take a holistic approach to cyber and physical security whereby on-site security teams and IT staff are equally involved in designing protocols to limit attack surfaces. These policies should be enacted alongside frequent staff training and guidance to reduce the likelihood of human error events and ultimately lower the institution’s exposure to financial risk factors.
Liquidity Risk Management
Liquidity issues commonly come as a result of an over-reliance on short-term sources of monetary assets, such as customer funds and guaranteed investment contracts, so an effective liquidity risk management strategy will involve carefully planned efforts to support liquidity with more stable long-term investments.
The major liquidity risk faced by banks, however, is a potential loss of customer trust leading to mass requests for withdrawals that cannot be matched by available liquid funds. During times of economic uncertainty, this risk factor may be elevated, meaning banks must enact risk management policies designed to ensure that they hold enough liquid assets to survive without an influx of external funds.
The mismanagement of asset-liability duration may also contribute to liquidity problems, so it’s vital that risk management policies are designed to ensure that banks always have enough short-term assets available to reliably cover the expense of all short-term liabilities such as debts and deposits.
Though there are definite signs that significant market risks may occur in the immediate future, banks and financial institutions have ample time to prepare themselves for economic uncertainty. By taking the time to develop risk management strategies intended to cover all likely capital, market, operational and liquidity risks, banking organizations can shield themselves and their account holders from financial harm.