Risk trends involving financial institutions

The current condition of inflation and market volatility affects us all, but given their pivotal economic role, it is the chief concern of financial institutions. We examine the main risks banks and investment firms are facing in 2023, the potential impact to operations, and how to best respond to today’s unprecedented challenges. 

Risk 1: global recession 

Research has found that companies that take bold moves in anticipation of a potential crisis outperform others. It’s especially true in banking. 

Managing macro-scale outcomes 

While the world is more connected than ever, international alliances can also increase risk. The World Bank slashed its 2023 growth outlook to 1.7 percent from its earlier projection of 3 percent, citing that to tame inflation, tighter monetary policies from central banks around the world have contributed to a worsening of global financial conditions. 

Facing the third-weakest pace of growth in nearly three decades, projections indicate that rising interest rates will lift short-term revenues but then lead to difficult conditions for banks and fund managers. Tightening capital markets will challenge startups and fin-techs needing cash as they seek profitability. Lastly, analysts anticipate higher costs, greater delinquencies, and declining revenues across most segments. 

 

The impact to financial institutions 

The banking sector will head into a potential downturn in a strong position. Over the past 10 years, the industry has built substantial capital reserves. On the other hand, mortgage originations plunged 13 percent in the third quarter of 2022, and applications hit a 25-year low as mortgage interest rates climbed to 6.94 percent. 

Domestic hardship is accelerating, with total household debt now $2 trillion higher than at the end of 2019. A 13 percent rise in credit card balances since Q2 2021 represents the largest increase in more than 20 years. And with all types of consumer debt except student loans seeing a rise in overdue payment, Fitch Ratings projects the delinquency rate will increase at least 4 percent by year-end 2023. 

Help with a way forward 

Economic volatility presents challenges in business planning, which could lead to mismanagement claims. A smart course of action is to review Directors and Officers (D&O) coverage terms and increase limits of liability. It is also a good time to review limits on mortgage impairment insurance against the heightened possibility of foreclosures. 

Risk 2: cybersecurity 

At least 79 U.S. financial services companies reported data breaches affecting 1,000 or more consumers in 2022. 

Cyberthreats on the rise 

Because of the sheer amount of information they store, financial institutions of all types are prime targets for ransomware attacks and data breaches. In ransomware crimes, hackers infiltrate a network and shut it down to extort payment. There has also been an increase in the number of security threats coming from insiders. In many instances, they are inadvertent, reflecting a lack of security training or oversight. 

Federal Reserve Chairman Jerome Powell warned last year that cyberattacks are the number-one threat to the global financial system. 

The impact to financial institutions 

According to a 2021 IBM Cost of a Data Breach report, the average cost of a financial services data breach was $5.72 million. In recently released data, cybersecurity firm Flashpoint said that the financial services sector experienced the second-highest number of data breaches in 2022, behind only government. 

At least 79 financial services companies reported data breaches affecting 1,000 or more consumers in 2022, and the largest breaches affect millions of consumers each. The public is taking notice. In fact, Cap Gemini’s Top Trends in Banking 2022 declared cybersecurity is becoming a competitive differentiator for banks. 

Help with a way forward 

Financial institutions should be defining their cyber strategy for when a cyberattack will happen, and not if a cyberattack will happen. Foundational cybersecurity capabilities such as (but not limited to) identity and access management; security monitoring and analytics; vulnerability management; incident response and recovery; and security awareness and training should be core to their cybersecurity programs. 

Cyber insurance can also play a key role in helping to not only provide liability coverage, but also in helping to mature a financial institution’s cyber program. Having cyber insurance coverage can help to provide extended resources to support financial institutions’ cyber programs pre-breach by providing cybersecurity maturity assessments, incident simulation workshops, cybersecurity training, and broader consulting services, and post-breach through incident response capabilities, ransomware facilitation, and public relations and crisis management. As the landscape for cybersecurity rapidly changes and increases in complexity, cyber insurance should continue to move from a “nice to have” to a “must have” product for financial institutions. 

Risk 3: environmental, social, and governance (ESG) 

Finance and ESG are an increasingly interconnected proposition. 

Contending with a changing climate 

In March 2022, the SEC announced proposed rule changes to standardize climate-related disclosures for investors. This new push to provide robust disclosures and data on climate-related risks can help inform investor decisions and allow businesses to forecast emerging challenges. 

Meanwhile, climate change is intensifying natural disasters at the same time people are moving to more disaster-prone areas such as Florida, Texas, and Arizona. As of now, 10 million properties across the U.S. face major or extreme wildfire risk, while on the East Coast, new homes are being built two to three times faster than average in areas vulnerable to flooding. 

Today’s customers follow their conscience, as 76 percent of consumers reported they would discontinue relationships with organizations that treated employees, communities, or the environment poorly. 

The impact to financial institutions 

Banks and other financial firms must be prepared to comply with new regulations, and make sure that all business partners honor their ESG commitment to avoid regulatory and reputational risks. 

While insurance carriers are paying out larger sums, the increase in natural disasters impacts all financial institutions, as extreme weather events put real estate at risk and cause significant business interruptions. 

Help with a way forward 

Simply put, it is essential for financial firms to have a strategy around ESG — one that should include standards for the institution as well as business partners.  

As for environmental concerns, an imperative next step is to reassess property exposure for risk of flood and wildfire. It is also recommended to review mortgage impairment limits and consider flood coverage. 

Lastly, as a governance measure, it is advised to consider D&O terms and limits of coverage.