The financial sector is currently navigating an intricate web of regulatory and political challenges. With the rise of new technologies and recent high-profile bank failures, regulatory bodies have increased their oversight, demanding more stringent compliance measures.
Concurrently, political pressures are pushing for greater accountability and consumer protection. Without addressing these risks proactively, financial institutions risk facing severe consequences, including regulatory fines, lost business, reputation damage or even criminal charges. Furthermore, individual banks’ compliance efforts are essential in maintaining the stability of the entire financial system.
The current landscape: heightened risks
Regulatory pressures
In 2023, the collapse of major financial institutions like Silicon Valley Bank underscored the critical need for effective risk management. These incidents have led regulators to tighten their oversight and introduce more rigorous requirements. For example, the Basel III “endgame” proposal is set to significantly change how banks manage risk-based capital, potentially increasing risk-weighted assets for larger banks and necessitating enhanced risk data capabilities for smaller ones.
Deloitte’s 2024 regulatory outlook addressed the Basel III proposal in addition to the Dodd-Frank Act Section 1071, which also imposes extensive data collection and reporting requirements on small business lending, similar to those required for consumer credit. While these regulations aim to enhance transparency and protect consumers, they present significant compliance challenges, particularly for smaller banks. The updated Community Reinvestment Act (CRA) final rule further complicates matters by pushing banks to meet specific metrics, potentially increasing credit risk.
Political pressure
Banks are facing mounting political pressure to reform fee-based revenue models, particularly overdraft fees, which have been criticized for disproportionately impacting vulnerable customers. This political backlash is driving banks to seek alternative revenue streams and explore cost management strategies. Discussions at the 2024 Bank Director Risk & Audit Conference highlighted the need for banks to address the political pushback against overdraft fees and resulting revenue loss.
Cybersecurity and technological risks
The rapid commercialization of artificial intelligence and the persistent threat of cyberattacks add another layer of complexity to the risk landscape. Cybercriminals are increasingly using AI to enhance their capabilities, posing significant threats to banks’ cybersecurity defenses. Regulators are prioritizing cybersecurity oversight, further complicating compliance requirements. Banks must continuously invest in advanced technologies to stay ahead of these evolving threats.
Strategies for managing and mitigating risks
To navigate this challenging environment, financial institutions must adopt a multifaceted approach to risk management. Here are several strategies that can help banks future-proof their operations:
- Enhanced risk assessment and monitoring
Banks should invest in advanced risk assessment technologies to identify and mitigate potential risks proactively. AI-driven analytics can provide real-time insights into emerging threats, enabling banks to respond swiftly and effectively. Enhanced risk monitoring can help institutions stay ahead of regulatory changes and ensure compliance with new requirements.
- Strengthening cybersecurity defenses
Given the increasing threat of cyberattacks, banks must prioritize investments in practical and scalable cybersecurity measures. This includes implementing multi-factor authentication (MFA) to enhance security for user access, regularly updating and patching software to close vulnerabilities, and conducting frequent security audits to identify and address potential weaknesses.
Additionally, employee training programs are essential to raise awareness about phishing and other common cyber threats. By fostering a culture of cybersecurity awareness and vigilance, banks can significantly reduce the risk of cyber incidents and protect sensitive data.
- Regulatory engagement and advocacy
Active engagement with regulators and policymakers is crucial for staying ahead of regulatory changes. Banks should participate in industry forums, contribute to policy discussions and build strong relationships with regulatory bodies. By doing so, institutions can influence the development of regulations and ensure their interests are represented.
- Diversification of revenue streams
To mitigate political pressures and reduce reliance on fee-based revenue models, banks should explore alternative revenue streams. This could include expanding into new markets, offering innovative financial products and leveraging digital platforms to reach a broader customer base. Diversification can help institutions maintain profitability amid regulatory and political challenges.
- Captive insurance
Traditional commercial insurance, while essential, often falls short in fully addressing the unique and evolving risks faced by financial institutions today. Commercial insurers may not provide the specialized coverage needed for certain regulatory fines, emerging cyber threats, or politically-driven risks. Moreover, commercial policies can be inflexible and costly, with premiums rising in response to market conditions and claims history. This can lead to coverage gaps and increased financial strain on banks, especially smaller institutions.
One of the most effective strategies for managing these regulatory and political risks is the use of captive insurance. Captive insurance allows financial institutions to create their own insurance subsidiaries to cover specific risks unique to their operations and offers the following benefits:
- Tailored coverage: Captive insurance enables banks to design customized policies that precisely match their risk profiles and operational needs. This ensures comprehensive protection against the specific regulatory and political risks they face.
- Cost savings: By self-insuring through a captive, banks can achieve significant cost savings compared to traditional insurance premiums. Captives allow for greater control over insurance expenses, providing financial stability and predictability.
- Flexibility: Captives offer enhanced flexibility in policy design and claims management, allowing banks to adapt quickly to changing regulatory requirements and emerging threats. This is crucial in a dynamic risk environment where traditional insurance products may not keep pace.
- Risk management: Captive insurance enhances overall risk management by encouraging a proactive approach to identifying and mitigating risks. This can lead to improved governance, risk assessment processes, and a stronger culture of risk awareness within the institution.
- Coverage for regulatory fines and penalties: Captives can be structured to cover regulatory fines and penalties, providing a financial safety net that bolsters a bank’s resilience against compliance failures. This coverage is often difficult to obtain through traditional commercial insurance policies.
Additionally, it should be known that commercial insurance policies exclude cyberattacks that occur from foreign countries, and that the majority of cyberattacks come from foreign countries. For example, this year, Lloyd’s of London Ltd., a marketplace where around 75 syndicates of underwriters congregate to provide insurance coverage for businesses, began requiring its insurer groups to exclude catastrophic, state-backed cyber hacks from its standalone cyber insurance policies, according to the Wall Street Journal. This fact has led to companies to insure cyber liability in their wholly owned captive insurance company, whereby the policy language is written to the owner’s interest (and not the commercial insurance company’s interest).
To see how captive insurance would work in regards to one of the stated political or regulatory threats, let’s use the example of political pushback on overdraft fees, which has forced banks to reconsider their revenue models. Overdraft fees have traditionally been a significant source of income, but political backlash has made it increasingly difficult for banks to rely on this revenue stream. Captive insurance can play a crucial role in addressing this issue.
By setting aside capital to self-insure, banks can better control their insurance expenses, thereby offsetting revenue losses from politically pressured fee reductions. The profits retained by a captive insurance company can be significant. Unlike premiums paid to commercial insurers, which are lost as an expense, premiums paid into a captive can be retained as profit if the claims are lower than anticipated. This retained profit can be reinvested into the bank or used to cover other financial needs, effectively making up for the revenue lost due to reduced overdraft fees.
Conclusion
The financial sector is at a pivotal moment, facing unprecedented regulatory and political pressures. To navigate this complex environment, banks must adopt a comprehensive approach to risk management, incorporating strategies like enhanced risk assessment, strengthened cybersecurity, regulatory engagement, revenue diversification and captive insurance.
By doing so, they can safeguard their operations, protect their customers, and contribute to the stability of the entire financial system. The time to act is now, as proactive measures taken today will determine the financial sector’s ability to thrive in the face of tomorrow’s uncertainties.
A risk manager, Christopher Gallo joined Knoxville, Tenn.-based insurance company CIC Services in 2020, and directly consults with business owners, CEOs and CFOs in the formation, and as a regulatory liaison, of captive insurance programs for their businesses. He is leading CIC’s launch of BankInsure this year, which will provide comprehensive insurance for small to mid-sized banks.
