The state of financial institutional risk in 2024
Threats to today’s banking and finance organizations range from old-fashioned to futuristic.
The financial-services industry is emerging from a tumultuous year marked by five bank failures in 2023 including the Silicon Valley Bank collapse.
Now, the sector is heading into an unpredictable future with questions surrounding the economy, the political landscape, regulatory changes, evolving technologies and the unclear role of artificial intelligence.
Financial institutions face many of the same risks that businesses across industries face, as well as some unique to banking. For those with a significant property and casualty exposure, inflation continues to be a challenge thanks to higher costs to rebuild properties, says Eileen Yuen, managing director in the Financial Institutions Practice at Gallagher. Soaring medical costs affect coverages such as workers’ compensation and general liability. And there are some exposures that are ubiquitous across most financial institutions such as lawsuits arising from the mismanagement or theft of funds.
But exposures can vary greatly from one financial institution to the next.
“For example, you can have a large regional bank with 100-plus branches visited by customers and vendors all throughout the day. This creates a fair amount of exposure to traditional general liability claims such as trips and falls,” Yuen says. “On the other hand, you can have a hedge fund with hundreds of millions of dollars under management that operates out of a small office or even fully remote, in which case they have little to no exposure to the risks covered by your traditional property and casualty programs.”
The Federal Deposit Insurance Corporation 2024 Risk Review breaks financial institution risk into five broad categories, including market risks like liquidity and interest rate risk; credit risks related to lending in several vertical markets; operational and cybersecurity risks; climate-related financial risks; and crypto-asset risks.
Fraud and cyber risk
Banks and credit unions are seeing increasing instances of check fraud despite a decrease in consumer utilization of checks with the ongoing shift to a digital environment, Yuen notes. Fraudsters steal mail and sort through envelopes to look for checks intended to pay bills, according to the FDIC. They then use chemical and electronic tools to alter the amounts and payees on the checks and deposit them using mules.
“Fraudulently altered checks can cause significant losses to financial institutions and disrupt bank operations,” FDIC says in its risk report. It noted the nationwide surge in check fraud schemes targeting the U.S. mail prompted the Financial Crimes Enforcement Network to issue an alert to financial institutions to be vigilant in identifying and reporting such activity.
Meanwhile, cybersecurity continues to rank as a top risk concern across corporate America, and the rapid rise of artificial intelligence has provided cybercriminals with even more tools both to break into banks’ systems and to perpetrate scams. This includes generating phone calls that use AI-created voices to circumvent identity- and authentication-based defenses and using AI to create fake or altered documentation, audio files and video recordings.
The U.S. Treasury Department underscored that artificial intelligence is becoming a powerful weapon for fraudsters and cyberattackers targeting the financial services market and warned they will outgun defensive efforts for a while. In addition, cyber-attacks tied to geopolitical events like the Israel-Hamas conflict and the war in Ukraine have increasingly targeted critical infrastructure. In 2023, there was an observed increase in politically motivated, distributed denial of service (DDoS) attacks against financial sector participants and others, according to FDIC.
Real estate lending
The financial sector also is seeing significant headwinds in the commercial lending space due to the downturn in commercial real estate. Although still low, delinquencies for consumer and commercial debt are rising and a few sectors are facing shifts in the post-pandemic world. Office space, for example, is experiencing high vacancy rates as enterprises grapple with return to office strategies following the pandemic. Malls and other retail properties have been under increasing pressure as consumers turn more to online shopping. This could lead to foreclosures and loan modifications.
On the residential side, home insurance is becoming costly and sometimes difficult to purchase, causing some homeowners to forgo coverage. According to the Financial Stability Oversight Council, increasing climate-related losses and decreasing insurance coverage for these losses could increase financial institution exposure to disaster risk and may have financial stability implications, FDIC noted.
Regulatory changes
“One risk trend that impacts every type of financial business is regulatory change, which can lead to claims against directors & officers, cyber and professional liability policies,” says Yuen. “This is something that we are continually monitoring, especially given that it is an election year and we face a potential change in party.”
One such regulation is Small Business Lending Under the Equal Credit Opportunity Act (Regulation B) which requires covered financial institutions to collect and report data on applications for cred it for small businesses, including those that are owned by women or minorities. The banking industry has expressed concerns that the rule will require them to collect sensitive personal information, impose significant compliance obligations and related costs on banks, and open them up to class-action lawsuits.
Another regulatory development the financial industry is watching is Basel III, which purports to improve the resilience of the global banking system by strengthening capital, liquidity and leverage requirements for banks, as well as introducing new risk management and transparency measures. The proposal would eliminate the practice of relying on banks’ internal risk models
Mitigating risk
FDIC deposit insurance is perhaps the most well-known protection in the financial services space.
“While providing protection for the depositors, deposit insurance also provides a free put option to the borrower which, in theory, makes demand deposits more stable,” says Stas Melnikov, head of quantitative research and risk data solutions at data and AI company SAS.
“That, in turn, enables greater risk-taking behavior on the side of the banks.” Melnikov notes that perhaps the most important risk banks need to guard against is their own credit risk.
“The most effective way to do that is via a multi-period simulation framework that connects depositor behavior, interest rate simulation and credit risk calculation as well as the asset side of the balance sheet,” says Melnikov.
A strong coverage portfolio with broad policy language is one of the most effective means of risk transfer, but best-in-class financial institutions will have a strong emphasis on preventative controls, compliance and other risk management practices, says Yuen.
“One practice that we find helpful with our insureds is an enterprise risk management survey,” she says. “These surveys are completed by a variety of individuals with different job functions across the organization and they help the institution better identify current and emerging risks, as well as the impact they would have on the organization, should they occur. We then review the results of the survey and identify which risks are insurable and uninsurable, making recommendations as to how the company can improve their risk management program to address these risks.”
There are a number of areas in which the insurance ecosystem could better support financial institutions.
“Front of mind are insurance products more tailored to address the exposures of the modern financial institution,” Yuen says. “Today’s financial institutions tend to not fit in a box and are truly diversified, thus requiring insurance programs customized to address their exposures. In order to achieve this, it is crucial for insurance brokers and carriers alike to have a strong financial literacy. This understanding enables them to thoroughly grasp the operations and risks faced by each insured, which then can effectively be conveyed to the marketplace where creative programs can be developed.”
Kristen Beckman is seasoned business journalist based in Colorado.
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