The Future of Bank Risk Management with FRM

By 2025, risk functions in banks will likely need to be fundamentally different than they are today. As hard as it may be to believe, the next ten years in risk management may be subject to more transformation than the last decade. And unless banks start to act now and prepare for these longer-term changes, they may be overwhelmed by the new requirements and demands they will face.

So, what will the risk function look like in 2025? It is likely to have broader responsibilities, to be very engaged at a strategic level, and to have much stronger, collaborative relationships with other parts of the bank. At the same time, its talent pool will probably have experienced a massive shift in expertise toward better analytics and greater collaboration, and away from operating processes. Most of the latter can reasonably be expected to be automated, real-time, and paperless by then. IT and data will likely be much more sophisticated, often employing big data and complex algorithms. As a result, the risk function may be able to make better risk decisions at lower operating costs while creating superior customer experiences.

The six structural trends that will transform bank and financial risk management over the next ten years:

Trend 1: Continued expansion of the breadth and depth of regulation

The scope of regulation will continue to expand, propelled by four drivers. First, public and hence government tolerance for bank failures has shrunk since the global financial crisis, and the appetite for interventions using taxpayers’ money to save banks has evaporated.

Second, governments are policing illegal and unethical behaviour much more tightly. This has been driven by a general shift of attention toward financial crime, the vanishing tolerance for tax avoidance, and the perceived increased threat of terrorism from individuals and countries since September 11, 2001, attacks in the United States.

Third, governments are increasingly demanding both domestic and global compliance with their regulatory standards. They want “good banks,” not just “good banking practice within their borders.” As a result, laws, and regulations are increasingly applied with extraterritorial effects.
Lastly, we expect the regulation of banks’ behaviour toward their customers to tighten significantly, as the public increasingly expects improved customer treatment and more ethical conduct from banks.

Trend 2: Changing customer expectations

Over the next decade, shifts in customer expectations and technology are expected to cause massive alterations in banking and give it an entirely different profile. By then, widespread technology use is likely to be the norm for customers. The current tech-savvy younger generation will be the major revenue contributor to banks by 2025 because banks make most of their money with customers over 40. Simultaneously, older bank customers are expected to adopt technology at a much higher rate.

Customers will likely expect intuitive experiences, access to services at any time on any device, customized propositions, and instant decisions. To deliver on the customers’ expectations, banks will probably require redesigning the whole organization from a customer-experience perspective and digitizing at scale.

Trend 3: Technology and analytics as a risk muscle

Technology will not only change customer behaviour but also enable new risk-management techniques, often coupled with advanced analytics. The proliferation of new technologies provides cheaper, faster computing power and data storage, which enable better risk decision support and process integration.

Trend 4: Additional (non-financial) risk types are emerging

Although management of financial risks has advanced significantly over the last 20 years, this is not the case for other risk types, particularly nonfinancial ones. The tremendous increase in fines, damages, and legal costs related to operational and compliance risks over the past five years has forced banks to pay much more attention to these risks. This will probably increase even further, due to the regulatory trends discussed earlier and given the expected rise in capital requirements for operational risk.

Trend 5: Better risk decisions through the elimination of biases

Another risk is that of making wrong decisions due to unrecognized biases. Over the last 30 years, enormous strides have been made in understanding how real humans, not the Homo Economicus of traditional economic theory, make economic decisions. We have learned that even when people attempt to approach a problem rationally and diligently, their decisions are often suboptimal, due to various conscious and unconscious biases.

For example, some energy utilities that have to make multibillion-dollar investments that can make or break the company (e.g., building a nuclear-power plant) have completely redesigned their major investment-decision processes. These are very relevant for banks, which make thousands of risk decisions every day; every bias that affects each decision can lead to an incorrect underwriting decision or poor pricing. Not only that, but a cascade effect can set in, with multiple biased decisions having a cumulative effect on the bank’s overall risk levels.

Trend 6: Need for strong cost savings

The banking system has suffered from slow but constant margin decline in most geographies and product categories. Banks have worked very hard and used operational cost improvements to compensate for these declines, resulting in a constant return on equity at the lower end of the long-term average, which is in the upper single digits. While there will probably be substantial regional differences, the downward pressure on margins is expected to continue across all geographies.

As a result of these disruptions, banks will possibly need to rethink their operating costs so they can deliver more value at lower costs. Once banks have exploited traditional and incremental cost-cutting approaches such as zero-based budgeting, value-added analysis (i.e., demand management), and outsourcing, we believe that simplification, standardization, and digitization will likely be the only sizable avenues left for substantial cost savings.

This article is an excerpt from a McKinsey&Company report.