Six ways for board directors to reduce the ‘unknown unknowns’

By Rafael DeLeon and Dave Coffaro

The late Donald Rumsfeld described them as “unknown unknowns.” Economist Nassim Nicholas Taleb calls them “black swans.” But whatever memorable expression one chooses for the old adage that we don’t know what we don’t know, the statement begs for action: Now is the time to ask!

The velocity of change in the financial services industry—from technology to economic forces to geopolitical turbulence–amplifies the need for bank directors in particular to expand their scope of inquiry. Looking ahead through the rest of 2024, here are six areas of inquiry for directors to deepen their understanding for the benefit of the bank and the board.

1. How will evolving earnings pressure (revenue contraction, market decline) affect the bank’s activities?

Expense reductions are the first go-to step to address earnings pressure. With personnel expenses the largest line item on most banks’ P&L statements, staff reductions are often the first cut. Many banks have taken this approach and concluded also the same time compromise the quality of customer service. Reducing staff may also increase the risk of processes and controls not being properly maintained.

There are alternatives to navigate earnings pressure in challenging economic environments. For instance:

• Take an “anything but staff” approach to surfacing cost savings opportunities.
• Opportunistically hire displaced customer-facing, revenue-generating talent from other firms (grow through the downturn).
• Invest in training and upskilling to help the bank adapt to rapidly changing market conditions or downturn.
• Ask: What will our staffing need to be in one, three, and five years to fulfill our strategic goals?
• Ask: How can we capitalize on opportunities our competitors will forego due to their expense reduction activities?

2. How are we using AI today? How do we plan on applying AI over the next 12 months? What risks should we monitor in our applications of AI?

The industry is in the early stages of integrating AI into financial services. It is likely that AI is already being used in your operations to streamline processes and improve decision-making. A recent McKinsey report states that “[a]cross the banking industry, for example, the technology could deliver value equal to an additional $200 billion to $340 billion annually if the use cases were fully implemented.” Over the next 12 months, we expect the rapid advancement of AI to focus on generative technologies, potentially revolutionizing how banks work.

As institutions integrate AI into their systems, it’s crucial for directors to monitor several risks:

• Data privacy and security: AI applications often require vast datasets, posing a risk to data privacy and potentially leading to unauthorized data access.
• Bias and fairness: Machine learning models can inadvertently learn biases present in their training data, leading to unfair or discriminatory decisions.
• Operational risk: Over-reliance on AI can lead to operational disruptions if AI systems fail or produce inaccurate outcomes.
• Deepfakes: AI-generated deepfakes can produce convincing false images, audio or video, posing a risk to an organization’s reputation and integrity and compromising some of today’s authentication protocols.

Navigating these challenges necessitates robust risk management strategies for bank leaders and directors, incorporating elements like ethical guidelines and contingency plans to ensure the responsible deployment of AI technologies.

3. What differences do we anticipate across each segment of our client base in a slowing economy and what do we think the impact will be?

Each segment of a bank’s client base is affected differently by a slowing (or accelerating) economy. Therefore, headline numbers need to be deconstructed to fully understand the impact of various economic change scenarios. Most banks do a good job of deconstruction in their reporting, but there may be more for directors to understand.

For instance, according to a recent LendingTree study, baby boomers led generations as the group that paid off the most credit card debt between 2021 and 2023, decreasing credit card balances by 35.4 percent. Gen X decreased their card balances by 7.2 percent. However, Millennials and Gen Z experienced significant growth in their credit card debt between 2021 and 2023, increasing their balances by 26.2 percent and 174 percent, respectively. Headline: Credit card debt is increasing. Anticipated impact to the bank: Varies by borrower segment.

Trends differ by bank, geography and target markets. That said, the takeaway for directors is to go below headline numbers (in the example above, increasing credit card debt levels), and understand the composition of assets, liabilities, and fee-based business drivers to get a bank-wide view of existing, emerging, cyclical and counter-cyclical risks. Directors are not expected to be the bank’s risk managers. However, they do have strategic oversight responsibility, which includes testing management’s readiness for changing operating conditions and asking hard questions about their assumptions and forecasts.

4. What macro trends or one-off events are we aware of that have not yet shown up in our serving area, but we should be aware of?

This line of inquiry for directors is intended to engage the CEO and management in real-world scenario-based conversations with the board. What is happening globally, nationally, and locally in the economy and business operating environment? Are trendlines similar to the macro picture or different within the bank’s serving area? If conditions differ locally, what is the reason for the variance?

For example, if job cuts at technology firms are being reported nationally, but have not yet taken place in a particular bank’s serving area, what is unique and nonsystemic about that bank’s market? Is the bank’s technology clientele working with government contracts that may account for countercyclicality? Or are local tech firms simply suppliers at a different point in the end-user value chain and likely to experience economic contractions later in the cycle?

Professional boxer Mike Tyson once said “Everyone has a plan until they get punched in the mouth.”
This type of conversation helps directors demonstrate agility as conditions change, guiding the evolution of the bank’s strategic plan — and avoiding getting a surprise punch. Engaging in this area of inquiry can stimulate valuable “what if” conversations between directors and bank leadership.

5. How should we review and evaluate business continuity planning in the context of the many devasting wildfires, 100-year floods and changing hurricane paths?

The keyword for any effective business continuity plan is “resilience.” This isn’t just about bouncing back. It’s about bouncing back better and stronger, especially in the face of environmental calamities like wildfires, floods and hurricanes. Resiliency is your organization’s ability to adapt and respond, not just recover. These questions will help guide directors’ conversations with bank leadership:

• Is the plan updated regularly? A resilient BCP is continually updated. Changes in climate patterns and environmental risks necessitate constant adaptation.
• How comprehensive is the risk assessment? For resilience, you must factor in every conceivable natural disaster relevant to your geographical location.
• Are response strategies realistic? Ensure management conducts a tabletop exercise to test response mechanisms for agility and adaptivity in handling real-world disruptions.
• Is there a communication protocol? Resilience requires clear, quick communication during a crisis to adapt to changing circumstances.
• How quickly can operations resume following an unexpected event? Assess the speed of restoring functions. In a resilient system, not only is recovery quick but improvements are made to avoid future vulnerabilities.

Remember, a resilient BCP isn’t a one-time task. It’s an ongoing commitment to adaptability and foresight.

Lastly, the speed at which operations can resume is another indicator of a resilient BCP. Faster recovery coupled with lessons learned for future improvement is a hallmark of resiliency in business continuity planning.

6. What are our risk concentrations, and how are they changing?

Monitoring concentrations of risk, particularly in real estate or liquidity, is essential to directors’ oversight duties. Concentrated risks can lead to large-scale financial losses, compromise the bank’s ability to meet its obligations and may even result in regulatory sanctions or failure.

For instance, a significant investment in real estate could expose the bank to market volatility, potentially reducing asset value. Similarly, liquidity risk could leave the bank without sufficient funds to meet short-term commitments, severely impacting its operational functionality and market reputation. Effective management of these concentrations involves implementing appropriate policies and strategies along with comprehensive risk analysis. Directors should actively monitor and control these risks across business lines, which aids in decision-making and ensures alignment with the bank’s risk appetite.

Here are key questions bank directors can ask:

• What is our current exposure to real estate and liquidity risk?
• Do we have adequate policies and strategies in place for managing these concentrations of risk?
• How often are we reviewing our portfolio mix and risk limits?
• What contingency plans do we have for adverse market conditions affecting real estate and liquidity?
• Are we in compliance with regulatory guidelines for risk concentrations, and how are we preparing for potential regulatory changes?

Bank directors play a crucial role in today’s financial landscape. They must understand risk concentrations and proactively address vulnerabilities to fortify their institutions. By providing effective governance as a strategic tool, directors can steer their institutions towards long-term success and resilience.

Rafael DeLeon is SVP for industry engagement at Ncontracts, a risk and compliance management software firm, which he joined following a 30-year career as a national bank examiner at the OCC. He is also a director of MainStreet Bancshares in Fairfax, Virginia. Dave Coffaro is principal of Strategic Advisory Consulting Group, where he works with services firms to accelerate growth and generate more favorable economics. His most recent book is Leading from Zero: Seven Essential Elements to Earning Relevance.