Managing risk profile in times of economic uncertainty

Banks benefit from understanding how risks unique to any unit affect others, defining how risks interact and ensuring that no risk program is executed in isolation.

By Michael Aiyetan

Consumer prices are rising, inflation is at a record high, and signs of recession are heating up. This outlook makes it imperative for banks to prepare, as changing economic conditions may affect their risk profiles. While many banks have implemented robust processes to reduce the risk of adverse economic shocks, here are a few additional steps they can take to ensure their risk profiles stay within their board-approved risk appetites:

Identify risk relationships. Banks typically have separate risk programs managed by different teams for each risk category. As a result, risks may be managed in silos. Banks would benefit from understanding how risks unique to one unit affect others, defining how risks interact and ensuring that no risk program is executed in isolation. A sound risk program manages risks within the unit where it resides and also identifies links between risks.

Identifying risk relationships drives a centralized risk management approach and ensures a comprehensive view of risks. It allows risk exposures to be managed as a portfolio of interrelated risks and risk program delivery to be transparent. In addition, it helps link all the activities of the bank, the risks associated with the activities, the existing controls, the effectiveness of these controls and the applicable policies or regulations.

Track key risk indicators. By creating key risk indicators and putting the right resources and controls in place, banks can be prepared for and react to unexpected events. They can monitor trends and adjust risk strategies, filter out the noise and isolate the signal in changing economic conditions, and gain clear visibility into vulnerabilities. In a changing economy, an effective KRI system can provide timely information on risk exposures as well as an analysis of issues and opportunities.

Assess concentration risks. In uncertain economic times, intra-risk concentrations (concentration risks within a risk type) and inter-risk concentrations (concentration risks across different risk types) can be particularly acute. Hence, it is beneficial to identify and mitigate concentration risks, as exposures with a common sensitivity to economic developments can be a significant source of distress. It is also beneficial to implement business strategies that promote diversification and keep risk concentrations at bay.

Pay attention to all risk types. It would be inappropriate to prioritize one risk category over another in uncertain times. Just as it is crucial to manage the risks that may arise from an obligor who does not meet the terms of a contract due to the changing economic environment, it is also crucial to manage the risks that may arise from inadequate internal processes or misconduct. In other words, both financial (credit, market, liquidity) and non-financial (operational, compliance) risks are to be taken seriously.

In sum, risk profiles may change rapidly during times of economic uncertainty, resulting in a threat to earnings, liquidity or capital. Banks would benefit from strengthening internal processes capable of identifying risk relationships, tracking KRIs, mitigating concentration risks and monitoring all risk types to effectively manage changing risk profiles.

Michael Aiyetan, CERP, served as a risk analysis specialist at Bank of America. Most recently, he served in risk strategy, planning and governance roles at Wells Fargo.