3 Ways to Solve for Credit & Deposit Concentration Risks Even When They’re Not Obvious

Sometimes risk in lending or funding is easy to recognize — or at least 'hiding in plain sight,' as JPMorgan Chase's Jamie Dimon said about the recent banking crisis. But sometimes concentrated exposures aren't as obvious as they may seem in retrospect. Here are some strategies that'll help spot problems while they're gestating.

No financial institution can be all things to all people. So, it’s natural to specialize, and many do so successfully. But specializing comes with risks.

So, the question remains: How do you deliver niche banking while managing concentration risk appropriately?

Even more challenging is managing risk concentration that doesn’t fit the usual mold. Spotting emerging trends today demands thinking beyond traditional patterns. Understanding the dynamics at play is critical.

Credit Concentration Alone Won’t Kill You — But ‘Credit Correlation’ Might

Correlated risks are like fish in a school. When one swims in a particular direction, the rest tend to follow. Take the first bank collapse that set off the recent crisis as an example. It had a depositor base dominated by cash-hungry tech firms and venture capital-backed startups, most of which had high-ticket uninsured deposits. The bank also had an investment strategy concentrated on long-duration assets vulnerable to inflation and interest rate hikes. A tech downturn, higher interest rates, rising inflation and an ill-timed announcement of a capital raise sent Silicon Valley Bank into a spiral.

By itself, the bank’s concentration on tech firms and startups wasn’t the issue. Nor were its investment choices. Nor was the fact that most of its depositors were commercial clients (rather than retail), with large, uninsured deposits. Each of these risk concentrations was, on its own, known, indeed, sometimes part of a deliberate, legitimate strategy.

One danger that flares up with surprising speed: If risks are correlated, they can — under certain conditions — work together to quickly wipe out a financial institution’s liquidity.

Instead, the issue was that, because these risks were correlated, they would — under certain conditions — work together to quickly destroy the bank’s liquidity. Unfortunately, Silicon Valley Bank was not alone in its approach to risk management. To prevent contagion from taking hold and to protect both customers and the economy, executives must find out now if their financial institution is overexposed in correlated areas and, if so, how to fix it fast.

The correlated risks that recently troubled banks faced certainly may present themselves again in the commercial lending and leasing or auto finance space, for example. Investors may sour on these assets, driving down the actual value. So, it behooves banks to diversify outside of such asset classes and conduct scenario planning around potential volatility of these risks as well as correlated ones.

Every financial institution has dashboard instruments in place that measure certain indicators, such as liquidity, capital and market risk. But as any driver knows, a speedometer and an odometer alone are not enough. If banking executives want a true picture of risk, they need to add more comprehensive, sensitive, real-time gauges to their instrument panel.

Here are three steps banking executives can take to decrease the chance of getting their institutions into a pickle when it comes to concentration and correlation risk:

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Risk Buster #1: Know Your Customers Better

In a digital age, it’s critical for banks to go beyond standard, demographic “know-your-customer” data sets. Instead, banks and credit unions must develop a rich understanding of their clients, including their psychographics, and identify whether there are correlated risks in their deposit base. Specifically, as institutions seek to manage and mitigate risk, customer personalities, values, attitudes, interests and behaviors are important for institutions to understand and proactively address.

For example, customers of recently troubled banks were highly networked and communicative with one another. Warnings about recent events simmered on private channels — such as the messaging platform WhatsApp, email threads, texts, chat rooms — and then boiled over into wider view online. Really knowing your customer includes understanding characteristics that might make them, say, more lemminglike, more jumpy or less loyal.

More data is available these days to help financial institutions understand the complex characteristics of their customers. The advanced technology to analyze it is readily available too.

Increasingly, more data is available to help banks and credit unions understand these less-traditional characteristics of their customers. For example, alternative data streams now include everything from web-scraped social media streams to satellite imagery and Internet of Things sensors. Where applicable financial institutions need to use this data to augment conventional data sources. For example, collecting and analyzing social media data can help institutions stay on top of emerging risks arising from “chatter.”

Today’s leaders also have greater access to more (and more advanced) technologies, which they can use to harness this alternative data and convert it into insight. For example, alternative data often comes either as aggregated data sets or as a straight data feed, through application programming interfaces, or APIs. The alternative data obtained through APIs can then be included in any of the scenarios and stress testing that are part of many financial institutions risk management modeling practices.

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Risk Buster #2: Try to ‘Break the Bank’ in the Stress Test

Financial institutions also need to introduce stress testing in areas where it isn’t yet in use and improve it in areas where it is. This is critical for assessing the impact of the inherent and correlated risks they face in their own environments alongside external risks that emerge from evolving market dynamics and broader events. (Consider how the Covid crisis led to much wider working from home trends and the population movements that resulted, and the impact on commercial real estate that is still playing out, creating challenges with commercial real estate lending and other forms of credit.)

Stress testing should be holistic and integrated. Results from tests across risk, finance, and treasury departments should inform management actions and help enhance the institution’s recovery and resolution planning.

In addition, executives should ensure these stress tests consider factors such as interest rate decisions, concentration risk, deteriorating credit conditions, unusually high cash burn for certain sectors, and impact on large depositors.

Ongoing management of risk factors must be frequent, comprehensive, nimble and aggressive.

Finally, financial institutions should create severely adverse shock scenarios that go beyond those required by financial regulators. If they really want to measure and monitor risks effectively, these scenarios should include “break the bank” events or “living will” events that model a convergence of all risks at once.

Beyond that, the yellow lights or even red lights resulting from this testing should cycle back to functions of the institution that produce fresh business. When an institution already has too much of a given type of loan, for example, somehow the message must be received by lenders and by marketing. Why bring in more of something already setting off alarms?

New ways of monitoring risk — and risk concentrations — should be considered, and adopted, where applicable. Ongoing management of these factors must be frequent, comprehensive, nimble and aggressive. Financial institutions should take advantage of the wide range of advanced technologies and approaches including models to simulate liquidity events and even consider forms of customer sentiment monitoring.

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Risk Buster #3: Use Teamwork to Fill in the Gaps

If a spark is threatening to ignite a fire and going it alone isn’t a viable option, financialcan consider ways to use partnerships, and even mergers and acquisitions, to acquire new customers at scale as a means of diversification.

Harnessing the power of partnerships: Financial institutions can join with others to sell each other’s products in different markets. If one bank services only commercial clients, for example, it may be able to engage in joint marketing initiatives with a bank that services retail clients. If a bank has a ton of uninsured depositors, who are far more likely to pull their cash out at the first sign of difficulty, it can partner with a mass-market bank with a highly insured base for an alternate funding stream.

Partnerships and even mergers can be an effective way to shore up areas of weakness.

Alliances can be a rapid and effective way of taking the pedal off the metal. Fintechs are masters of this art. Banks can learn from them when looking to partner with other institutions to offset risk.

Banking-as-a-service relationships can be seen in this light. For example, neobank Chime does not possess a banking license. Instead, it teamed up with The Bancorp Bank to protect its accounts against any type of default and insure them for up to $250,000 through the Federal Deposit Insurance Corp. In turn, by partnering with Chime, The Bancorp Bank was able to address new market segments, ensuring a symbiotic and mutually beneficial relationship.

Acting on the urge to merge: Another option to manage correlated concentration risks is to merge with or acquire another bank. This strategy may take more time to execute, but it’s a good way of compensating for weaknesses, as well as diversifying and elevating strengths.

Several recent deals illustrate these benefits. In February 2023, BMO Financial completed its acquisition of Bank of the West, further diversifying BMO’s revenue stream away from Canada and expanding into new U.S. markets where it previously had no branches. And in December 2022, U.S. Bancorp completed its acquisition of Japan’s MUFG Union Bank, in part to boost its presence in California. So while there is, of course, a business growth objective associated with these acquisitions, the buyers are also using acquisitions to diversify geographically.

There might be some regulatory speed bumps along the way. But even announcing a well-chosen M&A strategy can help to offset risk. It says, “We see the gaps, and we’re addressing them.”

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