The recent string of bank failures and associated financial crises has brought the importance of risk management in banking into sharp focus. As banks facilitate the creation and management of money, unnecessary risk-taking can cause significant financial losses that can slow down or even stall local and global economies.
So, what is risk management in banking? What does it look like, and what kinds of threats is it designed to handle? Additionally, what can banks do to optimize their financial risk management programs? This guide has the answers to the following:
- What is Risk Management in Banking?
- How Does Risk Management in the Banking Process Work?
- The 6 Types of Risk Management in Banking & How to Mitigate Them
- 5 Best Practices for Risk Management in Banking
- The Tools You Need for Risk Management in Banking
- FAQs About Risk Management in Banking
What is Risk Management in Banking?
Risk management in banking is the process of a bank identifying, evaluating, and taking steps to mitigate the chance of something bad happening from its operational or investment decisions. This is especially important in banking, as banks create and manage money for others.
Typically, risk teams separate fraud and compliance operations, resulting in distinct teams for fraud risk management, which is responsible for managing risk associated with fraud operations, and compliance risk management, which is responsible for managing risk associated with compliance operations.
The Importance of Risk Management in Banking
Banks are cornerstone institutions of national and global financial systems. While they are allowed to take some risk, they are typically afforded much less risk than other industries. If they fail, the creation and exchange of money slows or halts, which has far-reaching impacts on the rest of the economy.
Risk management is crucial in the banking sector for several key reasons, including its role in helping banks to:
- Avoid wasting or needlessly losing the money they need to stay in business
- Avoid disruptions to their operations
- Maintain confidence from investors and customers to continue doing business with them
- Comply with laws and regulations to avoid paying non-compliance fines
How Does the Risk Management in the Banking Process Work?
The banking risk management process involves six components:
- Identification: Defining the nature of financial risks, including where they originate from and why they pose a threat to the bank.
- Assessment and Analysis: Evaluating how likely a risk will pose a threat to the bank and how grave that threat will likely be. This helps a bank prioritize which risks deserve the most attention.
- Mitigation: Designing and implementing bank policies and processes that limit the chance that risks will become threats and minimize the damage threats may cause.
- Monitoring: Gathering data on threat prevention and incident response to determine how well a bank risk management strategy is working. This also involves researching emerging risk trends to determine if a bank’s risk management framework needs (or will need) updating.
- Cooperation: Establishing relationships between enterprise risks and mitigation strategies across different areas of the bank’s operations to create a more centralized and coordinated threat response system.
- Reporting: Documenting and reviewing information related to the bank’s risk management efforts to gauge their effectiveness. This is also used to track how the bank’s overall risk profile changes over time.
These components of the banking risk management process need to be carried out together and repeated regularly to give banks the greatest protection against risk.
The 6 Types of Risk Management in Banking & How to Mitigate Them
Banking risk management has a number of different threat areas to cover. The challenge isn’t just how many different types of risk there are; it’s also about how much control an organization actually has over these factors. Below, we explore the different types of risk management in banking to help your organization navigate these types effectively:
1. Credit Risk
Credit risk is one of the most common types of risk in banking. Put simply, it’s the risk of a bank lending money to a customer and not having it paid back. This can decrease the amount of assets a bank has available to meet its financial obligations. It can also cost the bank extra money if it deploys methods of trying to recoup the money it’s owed.
How to Mitigate Credit Risk
Mitigating credit risk boils down to knowing two things. First is the bank’s overall financial position in terms of how much losses it can take while still being able to operate effectively within its banking risk management framework. Second, it is important to know your customer, such as understanding their financial history and situation, as well as their general financial behavior, to evaluate the amount of risk they pose of defaulting on a loan. A bank can then tailor a customer’s lending agreement to have tighter or looser terms, depending on their level of risk.
2. Market Risk
Market risk, also known as systematic risk, is the chance that an adverse event outside the banking industry will negatively affect a bank’s investments. This could be an issue in a single industry—such as the US housing market collapse in 2008 or a general national or international economic downturn. Other types of risk in banking, such as political instability or natural disasters, can also increase market risk.
How to Mitigate Market Risk
In some cases, market risk can be mitigated by diversifying a bank’s investment portfolio. However, there are other times when this strategy won’t work because a crisis will affect multiple interdependent industries. Effective banking risk management involves exploring other tactics, such as investing in staple industries (like utilities or consumer packaged goods), employing a long-term investing strategy, or keeping more of a bank’s assets in liquid form.
3. Operational Risk
Operational risk refers to risks incurred based on how a bank is run day to day. For example, if employees are poorly trained, they may make more errors that cost the bank time and money to correct. If the bank has an inadequate IT infrastructure, its systems may break down, disrupting customer service.
A component of operational risk is cybersecurity risk, which measures how likely cybercriminals are to successfully attack a bank’s digital systems. The theft or destruction of digital money or sensitive information can significantly hinder a bank’s ability to operate effectively. It can also put customers and stakeholders at risk, highlighting the importance of an effective banking risk management operation to protect against these vulnerabilities.
How to Mitigate Operational Risk
Operational risk can be limited in several ways. One is to hire the right people and properly train them on the bank’s processes and ethical culture. Another is to secure the bank’s tech stack, including thoroughly vetting third-party service providers and staying up-to-date with critical types of risk in banking, such as cybersecurity threats and trends.
Automating processes with technology, such as customer onboarding, can help reduce human error. Implementing feedback and data collection programs can help address any updates needed as the bank’s risk profile changes over time, ensuring that types of risk management in banks evolve with these shifts.
4. Reputational Risk
Reputational risk refers to the risk that a bank will lose the confidence of its investors and customers and thus lose funding or business (respectively). It’s basically a side effect of any other risk a bank encounters, but that doesn’t mean it’s any less threatening. It can be caused directly by the bank’s business practices or employee conduct or indirectly by the bank being associated with a person or group with a negative reputation.
For example, reputational risk might result from a client receiving poor customer service from the bank and then telling others about it through word of mouth or social media. Or a news outlet may publish a story revealing corruption among some of a bank’s management staff.
How to Mitigate Reputational Risk
Reducing reputational risk begins by clearly defining the bank’s core ethical values. These values should be developed with input from stakeholders and communicated to employees through proper training, ensuring everyone understands the expected standards of behavior. Managing reputational risk is a vital part of risk management in banking, as it helps maintain trust and stability. Banks should also monitor their reputation in the news and on social media, proactively addressing concerns and taking responsibility for any mistakes.
The bank should also develop a contingency plan in case a reputation-affecting incident occurs. It should focus on quick and transparent communication, outlining what controls are being used to help minimize the damage, as well as how the bank will determine what it will do differently in the future to avoid the same mistake happening again. A bank may want to hire a public relations firm or use specialized reputation management software to assist with risk management in banking and other reputational risk management processes.
5. Liquidity Risk
Liquidity risk refers to the chance that a bank will run out of physical money, including if it can’t convert its other assets into cash fast enough. Thus, it cannot meet its short-term obligations to creditors or customers.
A recent trend that threatens to elevate banks’ liquidity risk is an increase in the number of bank runs. A bank run happens when rumors that a bank may fail in the near future cause its customers to panic. They then try to withdraw as much cash as possible from the bank before they potentially lose access to their money.
Banks run rapidly, decreasing the amount of liquid assets available to meet their short-term debts. So, while rumors of the bank failing may not have been completely accurate, the bank run still caused a spike in its liquidity risk, making it much more likely that the bank will actually fail.
Bank runs can also damage consumer confidence in the entire financial system, especially if they result in bank failures. This can lead to a domino effect of further bank runs and potentially more bank failures as a consequence.
To make matters worse, bank runs are becoming more threatening than ever with the advent of the Internet. Rumors of a bank’s financial troubles can spread very quickly over online communications, especially social networks. The ability to make electronic funds transfers means that customers can withdraw money almost instantaneously without actually setting foot in a bank, making it difficult for the bank to control how fast it drains its available cash.
How to Mitigate Liquidity Risk
Banks can manage their liquidity risk by more regularly forecasting their cash flow—that is, how fast liquid assets are coming into a bank versus leaving it. Effective banking risk management involves understanding the potential risks associated with the different ways a bank is funded, from investing to customers. One key aspect of risk management in banking is that a bank should also have a contingency funding plan (CFP) in place to address liquidity shortfalls.
Banks can also conduct stress tests, creating hypothetical risk scenarios that would cause a loss of liquidity and estimating how much liquidity would be lost in each instance. This can allow a bank to create baseline liquidity rates, helping to ensure it has enough working capital in the event of a crisis.
6. Compliance Risk
Bank compliance risk involves the risks a bank takes by not fully complying with applicable government laws or industry regulations. These can include punitive fines, civil lawsuits, criminal charges, and even economic sanctions.
Compliance risk also includes a reputational risk component. Banks exposed as non-compliant often lose the trust of their investors and customers, which hurts their ability to make money. They can also cause a downturn in consumer and investor trust in the entire banking industry or financial system.
How to Mitigate Compliance Risk
A bank can manage compliance risk by having employees on staff familiar with applicable laws and regulations. For most organizations, this is an AML compliance officer. These teams play a vital role in implementing types of risk management in banks, equipping them with the right tools to automate processes where possible, quantify and analyze activity patterns, and keep on top of any other obligations.
One of these obligations should be to understand the other types of banking risks and assess how likely they are and how impactful they would be. This allows a bank to identify areas of residual risk where it may not entirely be meeting compliance requirements and strengthen controls there.
Finally, a bank should make compliance part of its overall banking risk management culture. This means educating employees outside of the compliance and risk management teams on what laws and regulations the bank has to comply with and why they can play important roles in ensuring this happens. It can also mean proactively addressing reputational risk. A bank can do this by summarizing what it’s doing (in a practical sense) to remain compliant and how that protects the interests of customers and other stakeholders.
5 Best Practices for Risk Management in Banking
In addition to the tips above for managing specific types of risks in banking, there are certain things a bank can do to have an overall more effective risk management program. Here are five best practices for risk management in banking:
1. Establish a Finance Institution-wide Risk Governance Framework
This is another way of saying that it is important to involve everyone who works at the bank, not just risk and compliance team employees, in the bank’s risk management operations. Department leaders should brainstorm with their teams and then collaborate with executives to develop an overall risk profile for the bank. This profile should be shared among all bank stakeholders so they understand the types of risk in banking and why it’s important to control them.
The identified risks should then be delegated to the appropriate departments. Team leaders should work to develop risk management strategies and ensure that they’re properly understood and implemented within each department. Decentralizing banking risk management like this helps to make it an institution-wide priority while limiting confusion over risk management roles in banking.
2. Prioritize Identity Verification & Authentication
People not dealing honestly with a bank can drastically increase the risks it faces. That’s why a bank should make a point of investing in identity verification and authentication techniques for both customers, whether individuals or businesses and its own employees. These are crucial components of risk management in banking, especially important during onboarding (whether gaining new clients or hiring new staff), but they should be applied regularly afterward to ensure everyone is acting in their own capacity.
Know Your Customer (KYC) helps to ensure individuals aren’t impersonating others to cheat the system or acting unlawfully to another party’s benefit. Know Your Business (KYB) is essential for knowing who’s really in charge of a business and making sure the business itself is legitimate (and not, say, a shell company used simply to hide illicit dealings). And, Know Your Employee (KYE) is important for ensuring all bank employees are acting in the bank’s best interests, as misuse of privileged information by employees can lead to significant types of risk in banking, including sharing it with illegitimate outside parties.
3. Automate Tasks Related to Banking Risk Management
Checking transactions manually to see if they pose a threat to a bank or its stakeholders is tedious, if not impractical. Not only does this cost extra time and money, but it can also introduce more types of risk in banking in the form of human error. The key to effective risk management in banking is to balance catching transactions (or patterns of them) that are likely risky with filtering out false positives that unnecessarily take up a risk management team’s time.
Unit21’s Transaction Monitoring solution helps with banking risk management in two ways. First, it looks beyond strictly monetary data streams to other activities that may be deemed suspicious. This allows banks to create complete and accurate risk profiles for customers and transactions.
Second, it employs machine learning in banking risk management to create “alert scores”. These are ratings based on a customer’s transaction history, the bank’s case history, and other factors that indicate how likely a suspicious activity alert will be a true positive. This allows a bank’s risk management team to better prioritize which alerts actually warrant a manual investigation.
4. Keep Up with Both Individual Cases and the Overall Financial Risk Reporting
When incidents occur that present heightened types of risk in banking, it’s important not to try to deal with them as a single group. Instead, compartmentalize them based on the relevant information and then delegate them to separate teams or team members. This allows for handling more incidents at once while still allowing each team to have a greater focus on data analysis and pattern visualization for each incident. This strategy is known as case management, and it is a key component of risk management in banking.
Writing and filing reports about incidents regularly is equally important. This reduces compliance risk by documenting the practical steps the bank is taking to address types of risk in banking. Over time, these reports create a comprehensive view of a bank’s overall banking risk management profile, highlighting areas of greatest vulnerability and assessing how well the bank’s controls are mitigating risks effectively.
5. Continually Assess, Analyze, and Act on Risk Metrics
Risk management in the banking sector isn’t a static process. A bank’s staff or clientele can grow and change. New technological standards are developed, which can lead to both better banking security and new avenues for risk. And new regulatory requirements are put in place to address the evolving landscape of threats to banks.
That’s why the risk management process in banking has to be dynamic. Banks need to assess how well their current controls are handling risk and what areas of risk may need further attention. They also need to consider the types of banking risks they may face in the near financial future and determine whether their systems can adapt to manage those risks properly.
Above all, a bank has to take action, creating and updating risk management plans based on its analysis and implementing governance structures to ensure all employees are on board and doing their part.
The Tools You Need for Risk Management in Banking
The future of risk management in banking will likely shift more and more to digital spaces as customers demand faster and more convenient ways to bank. The emergence of decentralized virtual currencies, neobanks, and banking as a service (BaaS) functions will likely prompt banking regulatory changes in an attempt to address the potential for such technologies to be exploited by cybercrime.
Unit21 helps streamline this process by providing flexible, automated tools for monitoring and identifying suspicious activities across both traditional and digital banking platforms. With real-time risk analysis, advanced fraud detection, and customizable workflows, Unit21 empowers banks and financial institutions to stay ahead of evolving threats, ensuring robust compliance risk management in banking while maintaining a seamless customer experience.
Transform Your Risk Management in Banking with Unit21!
The banking sector is constantly evolving, with new regulations, technological advancements, and
sophisticated fraud tactics emerging every day. As we navigate this dynamic landscape, traditional banking risk management methods often fall short, leading to missed opportunities and heightened exposure. As regulatory landscapes shift, Unit21’s suite of tools makes banking risk management and regulatory compliance easy. Contact us for a demo of what we can do for your bank!
Frequently Asked Questions About Risk Management in Banking
Below, we address some of the most common questions surrounding the key aspects of banking risk management, offering insights into how institutions navigate and mitigate financial risks.
How do banks handle technology failure risks in their banking risk management strategies?
Banks mitigate technology failure risks by investing in reliable IT infrastructure, conducting regular system updates, and implementing disaster recovery plans. These efforts, along with robust cybersecurity measures, ensure the continuity of banking operations and reduce technology-related financial risks.
What are the best practices for managing data privacy risks in banking?
As banks handle vast amounts of sensitive customer data, data privacy risks are increasingly critical. To prevent data breaches and protect customer information from cyber threats, best practices include implementing strong data encryption, conducting regular privacy audits, and complying with regulations like GDPR.
What is the role of third-party risk management in banking risk management?
Third-party risk management involves assessing and mitigating risks that arise from outsourcing services to external vendors. Banks manage this by conducting due diligence, setting clear contractual obligations, and monitoring the performance of third parties to ensure they do not introduce new operational, cybersecurity, or compliance risks.
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