How Banks Manage Risk: Everything You Need to Know
Banks face risks from every angle. Read this guide to learn how banks manage risks in a digital era, the challenges they face, and what the future looks like.
Banks face risks from every angle—changing customer behavior and expectations, digital fraud, cybercrime, unpredictable markets, and regulatory compliance.
Many risks can be hard to anticipate, discover, and respond to. Stakeholders also expect financial institutions not to make any missteps that would cause fines and sanctions.
Successful banks embrace risks while developing powerful mechanisms to prevent or manage risk and stay ahead. This guide will cover how banks manage risks in a digital era, the challenges they face, and what the future looks like.
Why risk management is important to banks
In a 2021 Global Risk Management Study by Accenture, 77% of risk leaders—particularly in the software and platforms and utilities and energy sectors—raised concerns over operational and financial risks emerging more rapidly than ever before.
The risk landscape is even more fast-paced, volatile, and complex.
Accenture’s report also found that operational risks mainly resulted from supply chain disruption and a spike in remote work during the global pandemic.
Economic uncertainty and credit risk further aggravate financial risks as fraud and cyberattacks increase.
However, no amount of preparation can keep away disasters—they’re bound to happen. Leaders in the banking industry need robust and flexible plans to respond when such disasters strike.
Manage the deluge of financial and other data they receive, send, or manage
Streamline coordination of and control over their business processes
Improve how they measure performance
Get an enhanced understanding of their profit sources
So, what type of risks do banks grapple with in a digital era?
8 types of risks banks face today
Today’s banking environment presents a unique set of demands for risk management.
Heightened uncertainty and volatility in business, regulatory, and geopolitical environments leave business leaders deciding whether to keep their traditional banking system frameworks or rethink their risk management approach.
Foremost on their minds: their survival and building resilience. This starts with knowing the risks they’re up against, the main ones being:
Credit risk: This is the biggest risk for banks, which happens whenever they lend money to customers with no guarantee that they’ll repay their loans. Such agreements—which can occur on mortgages, fixed-income securities, credit cards, or derivatives—may cause banks to incur more debt.
Operational risk: Any risk a bank incurs because of inadequate or failed systems, processes, policies, and people is an operational risk. Examples include a security breach or service interruption.
Market/Systematic risk: Changes in the global financial market may lead to losses in the banking sector, also referred to as market or systematic risk. An example is the housing market crash, which brought the financial system to a standstill in 2008. Other sources include political unrest, natural disasters, or economic recessions.
Liquidity risk: When a bank can’t meet its obligations, it jeopardizes its financial standing or existence. In such cases, the bank can’t convert assets to cash to meet funding obligations so customers can withdraw their deposits. It’s mainly caused by over-reliance on short-term funding sources, mismanaged asset-liability duration, or customers’ loss of confidence in the bank.
Cybersecurity risk: Financial services providers grapple with cybersecurity risks, which involve safekeeping private electronic information from theft, misuse, or damage. Factors increasing this risk include poor password policies, lack of transaction business and logical access controls, and personal vetting shortcomings.
Reputational risk: Refers to the potential damage to a bank’s reputation or brand, caused by employee and organizational behavior or actions, resulting in a negative perception and subsequent loss of confidence by the public in the bank. Potential causes include customer records manipulation or mismanagement, poor customer support or after-sales services, the inability of the bank to honor regulatory or government commitments.
Business risk: A bank’s strategy may also threaten its profitability, especially if it doesn’t align with the digital era. The bank risks market share loss, acquisition by other financial institutions, or closure.
Compliance risk: Failure to comply with industry or federal laws and regulations leads to compliance risks and eventual reputational damage, legal penalties, legal or regulatory sanctions, and financial loss. For instance, if a bank has a faulty anti-money laundering program or violates the Bank Secrecy Act.
Risk management: How it works in the banking industry
How do banks manage all the risks they face? By having a clear, formalized risk management plan, which:
Reveals key dependencies and control effectiveness
Brings additional visibility
Simplifies identification of systemic issues that affect the bank
Banks develop risk management programs like this by creating a risk identification process using a root-cause approach.
Then banks determine the risks relevant to their organizations and why those events occur. Banks can also design risk mitigation strategies to neutralize those risks and prevent them from re-emerging.
For example, a bank can leverage advanced analytics and machine learning data to screen its operations automatically and continuously.
The insights from this ongoing tech-enabled risk surveillance help the bank develop and adapt key risk indicators (KRIs) to warn its risk management teams early enough of any potential problems.
When something looks unusual or suspicious, the automated surveillance flags risk managers of such activities. The bank can then direct its risk management teams to focus on high-risk, high-value areas instead of conducting narrow, random, and time-intensive audits.
Specifically, banks follow these steps when implementing a risk management plan:
Identification: Identify the root cause of the risk. For example, inappropriate assessment by lenders is the primary cause of credit risks associated with borrowers.
Assessment and analysis: Assess risk uniformly to determine its likelihood and prioritize remediation efforts.
Mitigation: Reduce risk exposure, minimize the likelihood of an incident, and continually address top concerns to protect the bank.
Monitoring: Test, collect metrics, and remediate incidents to ensure the controls are effective and address emerging trends to determine progress made on risk management initiatives.
Create relationships: Connect the dots between risks, business units, and mitigation strategies to recognize dependencies, identify systemic risks, and design centralized controls.
Reporting: Generate reports about the progress of the risk management program to give a dynamic view of the bank’s risk profile and show the plan’s effectiveness.
Challenges banks face when managing risk
Managing risk isn’t without obstacles.
Advancements in business models, disruptive technologies, cultural shifts, and regulatory changes have reshaped how financial companies address risks.
Risk management teams in banks and financial institutions must stay updated on the latest market developments and regulatory outlooks to be ready for the future.
And they must navigate several broad challenges, including:
Consumer expectations: Customers today use their mobile devices to perform multiple tasks, including banking. They desire solutions as functional as their banks’ branch operations or online platforms, which leaves banks struggling with security risks and platform design issues.
Evolving regulatory obligations: New regulations or amendments to existing ones respond to public sentiment, political turmoil, and other factors. Banks must comply or expose themselves to compliance risks.
Cybersecurity threats: An increasingly tech-based banking and financial services industry faces constant cybersecurity attacks through malware, phishing, and other threats.
Identity theft and fraud: These are detrimental to bank operations, pose security risks to banks and their customers, and affect the overall customer experience, eventually costing banks more money.
Stiff competition: Local and regional banks face increasing competition from tech companies breaking into the financial services industry and internet banks.
Inefficient processes: Banks spend many resources on operation costs to prevent business or liquidity risks. Without stringent practices in place, these costs can rack up quickly, leading to credit, operational, and compliance risks.
How banks can overcome risk management obstacles
Banks and financial institutions must embrace change and champion it to overcome these challenges and manage risks.
Organizations that adapt and become flexible by implementing innovative technologies and managing governance, risk, and compliance will grow.
Some quick steps banks can take include:
Automating risk management: Reduces costs and the adverse impact of implementing frequent regulatory changes to banking operations.
Investing in customer-centric technologies: Acquire tools that provide the level of personalization and technology customers desire to avoid business risk and remain competitive.
Solving cybersecurity tasks through smart technologies: Artificial intelligence (AI) and other smart technologies rapidly identify and resolve fraud and identity theft problems, while streamlining security efforts and saving resources.
Using cloud technology: Cloud computing introduces efficiencies that save banks money. For example, leveraging analytics can reduce the time and costs of marketing new products.
Refresh existing offerings: Rethink customer engagement strategies to interact with customers and meet their expectations.
Start the risk management journey for your bank
The risks banks and financial institutions face contribute to different levels of uncertainties, making it hard to expect what lies ahead.
Leaders in banks and financial institutions need to be vigilant in scanning the horizon for emerging issues. The focus should be on building resilient organizations and cultures to pivot the speed of change, mitigate emerging risks, and ensure the continuity of their businesses.
If you’re looking to manage risk better in your organization, Inscribe can help. Inscribe’s Fraud Detection and Automation software is powered by AI and machine learning.