Three hidden risks below the waterline bank boards should be aware of

Iceberg
  • Posted on Juli 11, 2022 by Dr. Andreas Ita

Navigating a bank safely through uncertain times requires expertise, experience and intuition which goes far beyond reviewing standard risk and financial reports. In the current challenging economic, political and social environment, it is crucial that bank board members understand the mechanics, risks and dependencies of a bank’s business model. This is a pre-requisite to raise the right questions to ensure that also risks which are unobvious, infrequent and elusive are appropriately managed. Effective supervision by the board is important, since management and key risk takers may have a tendency to underestimate, neglect or even downplay tail risks. This is because such infrequent risks could call into question certain businesses which are profitable in normal times, but which can be fatal for shareholders in the long run. 

In this article, we discuss three imminent risks which board members should have on their radar, although they are difficult to grasp from standard risk reports because they cannot be reliably quantified and therefore require a qualitative discussion with management. We believe that board members need to raise the following questions.

1. Do we have a hidden ALM gap due to wrong modelling assumptions for client deposits?

Due to the unusually low and even negative interest rates in the last two decades, clients shifted their bank deposits almost entirely from fixed-term products into sight deposits. At the same time, the average duration of loans and in particular mortgages have materially increased. As a consequence, banks face a significant ALM gap risk which is due to internal model assumptions not fully visible in commonly used interest rate risk and funding risk reports. 

Orbit36 sees a risk that with raising interest rates banks may be forced to reprice their deposits faster than assumed in their models. The effective duration of the liabilities is likely shorter than assumed, so that the banks could experience a material decline in Net Interest Income (NII). This impact could come as a surprise to some banks, because it is concealed by a duration assumption which might turn out to be wrong in the current market situation. 

Most interest rate risk and funding and liquidity risk models are based on a static balance sheet assumption. While this assumption is convenient and often appropriate, it might be fallacious in an environment of rapidly increasing interest rates and with potential new players like Fintechs/Neobanks entering the market. Unless the banks swiftly adapt their deposit interest rates to attractive levels, clients could shift their sight deposits quickly in higher yielding or more tax efficient investment products. This could lead to material deposit outflows which the banks need to cover with alternative and typically more expensive funding, resulting in lower NII. We would not even rule out a scenario in which some banks could face significant liquidity challenges if they fail to timely replace withdrawn sight deposits with external wholesale funding. 

Board members need to make sure they understand the main assumptions behind reported interest rate and funding risk numbers, as well as the consequences if these assumptions should be wrong. 

2. How much uncollateralized derivatives counterparty exposure do we have in a market crash?

Some hedge fund and family office clients use synthetic financing to fund their leveraged trades. Since these structures are complex and involve derivatives, it is not fully transparent how much the bank effectively lends to these clients and how much the bank could lose in a market crash if a counterparty fails on a margin call. 

Archegos has shown that some banks were exposed by a multiple of what risk models and regulatory frameworks predicted. Even the recently revised Basel III Standard Approach for Counterparty Credit Risk (SA-CCR) – which is commonly believed to be stringent – materially underestimated the risk and resulted in too low risk-weighted assets.  Stress tests can reveal the real loss potential, but it is crucial that they are well designed and based on realistic assumptions. Notably, even regulatory stress tests failed to detect the Archegos exposures of some banks.

Due to their different structure and because of the credit mitigation through daily re-margining, synthetic financing transactions are not necessarily subject to the normal loan approval process with graduated approval authorities (e.g., approval by Group CEO, Group Executive Board and Board of Directors above certain thresholds). Consequently, some banks could enter without the knowledge of the board indirect credit exposures significantly in excess of normal loan approval limits, as some bank’s large exposure to Archegos has shown.  

Board members need to understand how much counterparty exposure their bank could have in a sudden market crash, despite sophisticated netting and collateral arrangements. Moreover, the board needs to ensure that synthetic financing is subject to similar limits as the traditional lending business, albeit such transactions are structured in a different way and often done in different business units. 

3. How robust are the processes for collateral management and the timely liquidation of positions?

The use and regular exchange of collateral with counterparties plays a crucial role in the repo, securities financing and derivatives business. Daily mark-to-market valuation and recalculation of collateral requirements are often standard. Yet, not all banks are equally well organized regarding the handling of collateral. If a counterparty defaults, it can make a huge difference by how fast additional margin is posted by a counterparty and how quickly unmet margin calls are detected and escalated. Also, the swift liquidation of collateral and the unwinding of the hedge positions can be a crucial factor to avoid or reduce losses from the default of a counterparty. For instance, in the repo business the unexpected default of a counterparty could possibly go along with the concurrent liquidation of similar collateral by other market participants.

Board members should understand how the processes for collateral management and the timely handling of a counterparty default are organized. In addition, they need to ensure that the responsibilities for escalation and timely decision making are clearly ruled. 

Orbit36 offers education and support to boards or individual board members in their demanding task of supervising management. Our profound knowledge and experience in risk management and the efficient usage of scarce financial resources allows us to quickly identify those business areas with non-evident risks and a potentially suboptimal risk return profile. 

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