By Scott Van Voorhis
For banks in the Big Apple and across New York State, the near-meltdown of the global financial system in 2008 was a wakeup call.
Once a backwater, risk management has vaulted to the forefront of bank operations in the years since. Along with a prudent desire to improve in this crucial area, financial institutions are also now scrambling to meet a myriad of new demands issued by state and federal regulators and Congress, say risk management consultants who work with the financial industry.
Many Empire State banks are now coming to the painful realization that becoming more aware of potential risks is one thing, but designing effective programs to guard against what can be a bewildering array of threats may be an even greater challenge, experts say.
Worse still, banks across New York may not have that much longer to fine-tune their efforts before their new and improved risk management systems face their first major test.
The debt crisis in the Euro zone has already begun to make banks in New York and across the world increasingly nervous. A debt meltown in Europe, in turn, could send a 2008-sized shock wave that would not only shake the financial behemoths on Wall Street, but also rattle community and regional banks across the state, industry consultants say.
“Most of the banks are struggling to comply with all the risk management guidelines,” said Pat Trendacosta, financial services attorney with Frandzel Robins Bloom & Csato. “A lot of banks I don’t think understand fully the concept and philosophy behind the risk management being pushed by the regulators.”
Behind the drive to minimize risk is the understanding that the banking industry’s quality control measures were lacking in the years leading up to the 2008 crash.
Alan Morley, a consultant with the ForwardThink Group, compared the shoddy mortgages that were funneled through the banking system in the bubble years to a chocolate factory that winds up in trouble after using bad ingredients.
“We haven’t really done as good a job as we could have done,” he said. “That allowed poor production, poor raw ingredients to go through the system and get [sold].”
As a result, “operational risk and compliance risk has suddenly become the absolute focus for banks,” he said.
Meanwhile, federal and state regulators are doing more than just tyring to ferret out potentially questionable lending practices – they are often taking a deeper look at a bank’s approach to risk management. In particular, regulators are increasingly focusing not just what a bank’s policies and guidelines are as related to risk, but, crucially, whether the bank’s own employees are following the rules.
“Where the rubber meets the road is how you are doing things, how you are running your bank,” Morley said. “What safeguards have put in and are they being adhered to. If you failed to follow your own policies and procedures, there can be a compliance issue.”
On top of that, there is a new generation of tougher bank examiners who can shut down banks that are found to be out of compliance.
“The government has recruited many new examiners,” Morley said. “They have teeth.”
And even as they scramble to meet post-2008 requirements, banks are also faced with complying with an earlier wave of post-9/11 edicts aimed at cutting off financing for terror groups and preventing money laundering, Morley notes.
Both are complicated and time-consuming, forcing the bank to verify that customers are truly who they say they are.
“It is a lot of background checking and verification,” Morley said. “Every couple of years they have to go through the process all over again.”
While there has been a rise in interest by banks in overall risk management concepts, the number of financial institutions with full-blown programs is still in the minority.
John White, chief executive and founder of New York-based ICS Risk Advisors, cites numbers that show just 25 percent of banks with formal risk management programs.
“That is not a lot, considering all the problems that have occurred,” White said. “That is something that has to be changed.”
The nation’s largest banks, including those with New York headquarters or a substantial presence in the state, have had the resources to beef up their risk management programs. In fact, many of the industry’s best practices come from these heavyweights. The larger banks may already have risk management chiefs and risk management committees in place, notes Cory Gunderson, managing director at Protiviti, who works in the firm’s New York office.
“They are largely in an enhancement mode, continuing to improve their capabilities to manage risk,” he said. “They are focusing a great deal these days on really tactical issues.”
By contrast, smaller banks are typically more skeptical of the benefits of a rigorous risks management program, with thinner margins and less money to spend on such initiatives.
“The smaller the bank, the less interested they are,” White noted.
As tough as it can be to devote the kind of resources necessary to adequately analyze and monitor risk, it is essential for banks, whatever their size, to make the commitment.
To be effective, banks need to do more than just hire a knowledgeable consultant. Financial institutions also need to internalize the changes, putting some of their best and brightest staff to work in an area that has not always been attractive to rising talent, according to White.
“They need to gain public confidence, the banking world needs to gain momentum,” White said. “One way to do that is to show they have the systems in place.”
Financial institutions also need to learn how to weild data effectively when analyzing potential risks. In hopes of staying one step ahead of the regulators, banks are producting ever larger quantities of data, but too often, bank risk managers are simply becoming overwhelmed in a sea of data and are unable to step back, feeling that since the data is there, it should be used.
“With so much data at your fingertips, it’s really hard to see what this really means when I blow it all up,” Gunderson said.
The big test for small banks – say under $5 billion in assets – is to build as robust a risk management program as possible without putting a big dent in the bank’s bottom line, Morley said.
“The challenge is making the investment without killing the bank,” he said.
But with the growing debt crisis in the Euro zone, the urgency for having an active risk management program is only growing. New York’s largest banks are some of the most exposed to the debt crisis, with complex interrelationships with other major global and European banks. The big banks are already doing various stress tests to see what the impact of various Euro zone debt disasters might have on their financial footings, industry experts say.
But community and regional banks across New York State could also take a significant hit should the European debt crisis become another, 2008-style global meltdown, Gunderson warns.
While the smaller banks may not have direct links to big European banks, they more likely do have financial links to major U.S. banks in New York City.
“You need to understand what the impact would be if something happened to your counterparty, if they were shut down for a few days,” he said.
But that’s just for starters. As they weigh the impact of a European debt debacle, all banks, including smaller banks seemingly far from the action, need to understand their liquidity position, and, if it is lacking, take steps to shore it up, Gunderson advises.
“If you don’t have strong liquidity and things turn in the world, if you can’t meet your obligations, banks and go away almost overnight,” he said.
Community and regional banks also have to examine their loan portfolio carefully. Given their narrower geographic footprints, there is likely to be more of a concentration in one business sector or another, such as extensive lending agreements with a major local business.
While this is natural, bank executives then need to ask the tough questions of what would happen should that plant or firm face a severe setback or shut down, according to Gunderson.
“You tend to have aftershocks or indirect impacts of something happening in Europe,” he said. “They have to have an awareness of what their exposure can be. There is just a domino affect that can go pretty far down the chain.”
In the short-term, the commitment of cash and executive talent can seem formidable, but the good news is that becoming better at judging and weighing risk is likely to pay off for banks in bottom line returns and stability, albeit over the long run, industry experts say.
“Those are the organizations that tend to do better in the ups and downs of the economic cycle,” Gunderson said. “It can be a competitive advantage.”