Financial markets experienced increased volatility in 2023 and were driven by economic uncertainty, geopolitical tensions and technological disruptions against the backdrop of digitalization. As the impact of bank failures and rising defaults continues and continues to impact risk management, one question remains: what lies ahead?
The committee
- Tony JohnsonSenior Director, Product Management, SS&C Algorithms
- Nicholas SilitchFormer Chief Risk Officer, Prudential Financial
- Dimitrios PapathanasiouHead of Global Funding Concentration and International Treasury Risk, UBS group
- Host: Luke ClancyEditor-in-Chief, Risk.net
In an exclusive Risk.net webinar in collaboration with SS&C Algorithmics, a panel of experts discussed the underlying causes of recent bank failures, how risk management best practices can protect against future failures, and the role of mission-critical technology in staying ahead of demanding and ever-evolving regulatory changes. This article presents key takeaways from the webinar discussion.
Protect yourself from failure
The collapse of Credit Suisse, the Silicon Valley bank (SVB) and Signature Bank has undoubtedly raised concerns about the health and stability of the entire financial sector – particularly regional banks across the country US.
While this recent series of bank failures was idiosyncratic in nature, it once again highlighted the deficiencies in risk management practices – particularly 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 time of market disruption. The panel emphasized that while concentration risk played a role, it was also a factor in the challenges faced by Credit Suisse with its clients Archegos and Greensill Capital SVBalthough the circumstances were different in each case.
Tony Johnson, SS&C Algorithms
“[SVB] has been heavily focused on the technology sector, both from a loan book and depositor base perspective. With the additional concentration of Treasuries and Treasuries in its hedge book, the overall system could not handle such a large concentration risk,” said Tony Johnson, senior director, product management at SS&C Algorithms. “If concentration risk had been better managed, some of this reputational risk may have been mitigated.”
In addition, exposure to riskier real estate and corporate bonds may continue to impact banks’ vulnerability in the future.
“What is your exposure to these asset classes? The good news is that on the banking side, many of these risks have been eliminated through collateralized loan obligations,” said Nicholas Silitch, former chief risk officer at Prudential Financial.
He added: “But there are banks with exposure to the corporate side, and there are still many regional banks with exposure to the real estate side.”
Likewise, poorly managed interest rate risk can have serious consequences for banks in the future. “That is very clear SVB “It 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 would not have sought such high interest rate risk as they would have been required to hedge risks.
Implementing best practices in dynamic risk management that address new and different levels of risk is essential to protect against possible future bank failures.
Risk managers must prioritize an informed and measured response to not only protect balance sheets but also stimulate business growth while maintaining a competitive advantage and mitigating these risks.
Regulatory change
This spate of bank failures has also highlighted the need for a change in supervisory sentiment away from a siled approach toward a broader range of financial intermediaries, panelists warned.
“Regulators must consider the broader universe of capital intermediaries, including credit rating agencies and the ratings regulatory construct,” Silitch said, particularly to minimize or eliminate opportunities for capital arbitrage.
Given the global rise in private credit, already estimated at $1.5 trillion to $2.5 trillion, as well as a growing market for structured credit and a resulting diverse investor base, a broader regulatory net is essential, he emphasized.
In addition, extending deposit protection to all deposits at large and regional commercial banks can avert liquidity shocks and resulting bank runs.
“If we want banks to continue to be financial intermediaries, the system should expand the guarantee to significantly increase the number and form of deposits it takes under its wing,” Silitch said.
Different systems
But why do banks find it difficult to manage and measure the different concentration risks?
Johnson explained that disparate systems and legacy infrastructure made it difficult to obtain a consistent view of risk across the organization, making it difficult to manage and establish a robust risk appetite framework.
Additionally, a poorly defined risk framework that is either too narrow or too broad can create the potential for undesirable risk accumulation across the portfolio. On the other hand, Johnson warned that an overly conservative risk framework could lead to missed profit opportunities.
Where a particular concentration is a choice, as with niche banks such as SVB Due to the chosen concentration in the technology sector, it is becoming increasingly important to have an overall view of risk appetite to avoid unwanted accumulation of risks in sectors that are not monitored or measured.
Mission critical technology
Efficiently consolidating risks from disparate systems and improving risk controls and metrics are critical to measuring credit risk on a consolidated basis and in real time. “Having a place to consolidate and layer your risk appetite in real time is critical, especially when markets are under stress from both a systemic and policy perspective,” Johnson said.
Next-generation risk analytics and a robust, multi-layered risk framework enable organizations to measure risk appetite from both a risk and reward 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.
In addition, the frameworks should be comprehensive, covering both banking and trading books, with a focus on addressing credit and market risks to ensure that potential risks are identified in a timely manner.
Papathanasiou stressed the importance of describing concentrations in detail and involving senior management: “Every bank should have a funding concentration framework – and that does not mean that the risk manager has to apply restrictions based on existing exposures.” It works about having a discussion at board level.”
Most importantly, financial institutions need early warning systems to remain proactive, Johnson said. “It’s all well and good to have a framework within which to measure all of these elements, but you need to know early enough to do something about it.”
In summary
Ultimately, financial institutions need an integrated risk management approach that is not only based on robust, business-critical analysis, but can also provide early warning signals, especially when volatility is unknown.
Risk managers need to accurately measure credit risk in a consolidated, real-time manner and stay ahead of regulatory requirements, especially as new and diverse shocks disrupt markets.
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