Bank stress — Implications for model development and governance

Improving risk management in banks with better model development and governance

In March 2023, US consumers and companies were reminded of the importance of bank liquidity, strong balance sheets and effective interest rate risk management practices.

While the rapid actions taken by governments and banks, both domestically and internationally, helped to instill some confidence and preserve stability in the US and global financial system, the full ramifications of this most recent stress event will take some time to play out. 

From a regulatory perspective, supervision will likely intensify. Treasury Secretary Janet Yellen’s recent speech highlighted the “need to reexamine our current regulatory and supervisory regimes'' and Fed Chair Jerome Powell has pledged support for recommended changes. Upcoming Congressional hearings will likely shed further light on changes. 

Regulators may require institutions to undertake more frequent and detailed liquidity reporting and engage in more rigorous stress testing. Regulators will also likely increase their supervision of risk management practices and their scrutiny of internal audit coverage of a bank’s financial risk management processes. At a policy level, they’ll likely re-evaluate the risk management requirements levied on banks with less than $250 billion in assets, particularly with regards to liquidity and capital ratios, risk management and reporting.

At the same time, the industry could see more consolidation among smaller and mid-sized banks as institutions join forces to create stronger organizations. If that happens, organizations that may not have been subject to the current regulations may suddenly be forced to undergo stress testing. Even more institutions may become subject to those requirements if parts of the Dodd-Frank Act that relaxed reporting requirements on smaller institutions are rolled back to pre-2018 rules, when stress testing covered institutions with at least $50 billion in total consolidated assets.

If regulators implement new stress testing requirements, they will closely scrutinize a company’s models, including around credit risk, market risk, financial crime, capital and stress testing - as stress testing is primarily driven by models. The problem? Many smaller banks don’t have sophisticated models, either because they have small internal modeling teams (if they have a team at all) or they have a limited amount of internal data with which to develop models. They then have to rely on vendor models that come with limitations.

Ready to grow

The recent stress events in the US banking system will likely have a significant impact on companies of all sizes. Whether it’s smaller organizations needing to comply with stricter rules or larger ones having to deal with an influx of safety-seeking clients, banks should be ready to withstand additional pressures––and seize new opportunities to expand their business. 

Maintaining a strong risk management and compliance posture in a disruptive environment might be daunting, but solid model development and governance can help give banks a competitive advantage, while a tool like Model Edge can help management effectively manage its model development while also managing time and costs.

To learn more about Model Edge, visit us here.