Mission-critical risk frameworks vital for navigating volatility

Financial markets in 2023 have been marked by heightened volatility, and driven by economic uncertainty, geopolitical tension and technological disruption against a backdrop of digitisation. As the repercussions of bank failures and rising defaults persist and continue to impact risk management, one question persists: what lies ahead?

In an exclusive Risk.net webinar convened in collaboration with SS&C Algorithmics, a panel of experts discussed the underlying drivers of recent bank failures, how best practices in risk management can guard against future failure and the role of mission-critical technology in staying ahead of demanding and ever-evolving regulatory changes. This article presents the key takeaways from the webinar discussion.

Guard against failure

The collapse of Credit Suisse, Silicon Valley Bank (SVB) and Signature Bank has undoubtedly raised concerns about the health and stability of the entire financial sector – particularly that of regional banks across the US.

This recent series of bank failures, while idiosyncratic in nature, once again highlighted subpar risk management practices – notably in asset-liability and interest rate risk departments, as well as concentration risk management.

Concentration risk – the level of risk in a bank’s portfolio resulting from exposure to a single counterparty, sector or country – has come to the fore during this period of market upheaval. The panel emphasised that – while concentration risk played a role in the challenges faced by Credit Suisse with its clients Archegos and Greensill Capital – it was also a factor at play with SVB, even though the circumstances of each case varied.

“[SVB] was highly concentrated in the technology sector, both from its loan book and depositor base perspectives. With the additional concentration of treasuries and the treasury bonds in its hedge book, the overall system couldn’t handle that much concentration risk,” said Tony Johnson, senior director, product management at SS&C Algorithmics. “If concentration risk was better managed, some of that reputation risk might have been mitigated.” 

In addition, exposure to riskier real estate and corporate bonds can continue to have implications on the vulnerability of banks in the future. 

“What is your exposure to those asset classes? The good news is that, on the banking side, a lot of those exposures have been taken away by collateralised loan obligations,” Nicholas Silitch, former chief risk officer at Prudential Financial, said. 

He added:“But there are banks with exposures to the corporate side, and there are still plenty of regional banks with exposures on the real estate side.”

Similarly, poorly managed interest rate risk can also have dire consequences for banks in the future. “It’s very clear that SVB was not a small bank, and there was a lack of regulation on how interest rate risk should have been managed,” said Dimitris Papathanasiou, head of global funding concentration and international treasury risk at UBS Group. He added that regulated banks wouldn’t have sought such high exposure to interest rates as they would have been be obliged to hedge risks.

Implementing best practice in dynamic risk management, covering new and varied levels of risks, is imperative to safeguard against potential future bank failures. 

Risk managers must prioritise an informed and measured response to not only protect balance sheets but also spur business growth, while maintaining a competitive edge and mitigating those risks.
 

Regulatory shift

This spate of bank failures has also stressed the need for a shift in supervisor sentiment, away from a siloed approach, to cover a wider range of financial intermediaries, panellists warned.

“Regulators need to consider the broader universe of capital intermediaries, including rating agencies and the ratings regulatory construct,” Silitch said, especially to minimise or eliminate opportunities for capital arbitrage. 

As global private credit balloons – already estimated to be between $1.5 trillion and $2.5 trillion today – in addition to a growing structured credit market and subsequent varied investor base, a wider regulatory net is essential, he emphasised.

Furthermore, expanding deposit guarantees to all deposits across large and regional commercial banks can shield against liquidity shocks and the resulting bank runs.

“If we want banks to continue to be financial intermediaries, the system ought to expand the guarantee to substantially increase the number and form of deposits it takes under its wing,” Silitch said.
 

Disparate systems

But why have banks struggled to manage and measure varied concentration risks? 

Johnson explained that disparate systems and legacy infrastructure have made it challenging to obtain a single view of risk across the organisation, making it difficult to manage and establish a robust risk appetite framework.

Furthermore, a poorly defined risk framework either too narrowly or too broadly focused can leave potential for unwanted risk accumulation across the portfolio. On the other hand, Johnson warned, having an overly conservative risk framework could result in missed opportunities for profit. 

Where a specific concentration is a choice, as with niche banks such as SVB and their chosen concentration in the technology sector, it becomes increasingly vital to have an overall view of the risk appetite to avoid unwanted accumulation of risk in sectors that aren’t monitored or measured.   
 

Mission-critical technology 

Efficiently consolidating risks from disparate systems and improving risk controls and metrics are critical for measuring credit exposure on a consolidated and real-time basis. “Having one space to consolidate and overlay your risk appetite in real time is mission-critical, especially as markets go under stress, both from a system and a policy perspective,” Johnson said.

Next-generation risk analytics and a robust, multilayered risk framework allow organisations to measure risk appetite from both a risk and return perspective. This approach covers multiple dimensions across industry, country and granularity within an industry – particularly in non-homogeneous asset classes such as commercial real estate, the panel said.

Frameworks should also be comprehensive, covering both banking and trading books, with an emphasis on addressing credit and market risk, to ensure potential risk is captured well ahead of time.

Papathanasiou underscored the importance of detailing concentrations and involving senior management: “Every bank should have a funding concentration framework – and this doesn’t mean the risk manager must apply restrictions based on existing exposures. It’s about having a board of director-level discussion.”

Most importantly, financial institutions need early-warning triggers to remain proactive, Johnson said. “It’s all well and good having a framework where you measure all of these items, but you need to know early enough to be able to do something about it.”
 

In summary

Ultimately, financial institutions require an integrated risk management approach that is not only powered by robust, mission-critical analytics, but also one that can provide early-warning signs, especially during uncharted volatility. 

Risk managers need to accurately measure credit exposure on a consolidated and real-time basis, and stay ahead of regulatory demands, especially as new and varied shocks disrupt markets. 
 

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