11 Key Risks Faced by Financial Institutions Today
Whether a small consumer lender or a major financial institution is involved, maintaining stability across the enterprise is key to the viability and longevity of a business. But while most laypeople consider financial institutions (FIs) to be among the most stable organizations out there, this stability is no accident, requiring significant resources to maintain.
All FIs face existential threats, and these are often numerous and highly complex. This is why financial services risk management takes a central part in the day-to-day activities of all FIs. In recent years, financial services risk management activities have become increasingly sophisticated, leveraging next-generation artificial intelligence (AI) and machine learning (ML) capabilities to counter increasingly complex external and internal threats. From legal and regulatory risks to wider market and industry risks, here are just a few of the biggest risks faced by financial institutions today:
1) Default and Bankruptcy
In recent years, digital lending has become a burgeoning vertical in the financial services industry, with borrowing becoming easier for debtors of all types. Both traditional financial institutions and nonbank financial companies (NBFCs) have benefitted from this boom, but when it comes to repayments and collections, many financial institutions continue to rely on paper-based documentation and other outdated processes. Consequently, many of them have become delinquent in following through with their debtors’ financial obligations, resulting in defaults and even bankruptcies.
To reduce these risks, many FIs are turning to software. Nonbank financial companies (NBFCs), in particular, are increasingly adopting NBFC software solutions to issue legal notices to debtors, removing many of the human factors involved in debt collection. Software solutions like these are essentially allowing NBFCs and other FIs to speed up collections and remove red tape and human error from collections, enabling the recovery process to become more efficient and thus also improving the FIs’ cash flow and reducing delinquency risks. With the rise of such cloud-based legal management platforms, lawyers and legal teams, as well as the financial institutions they work with, are able to navigate complex legal ecosystems in order to recover loans from debtors with greater ease and agility.
2) Credit Risks
All FIs have to handle a degree of risk whenever they take on a lending role. Smaller lenders, however, have to take on more credit risks simply because they do not have the resources to mitigate these in the same way bigger FIs could.
Fortunately, things are changing for smaller lenders, thanks to the wider availability of AI-enhanced risk management and legal management software. These solutions permit a much more accurate assessment of each borrower’s credit risks, allowing optimal lending strategies to be taken and thus minimizing default risks, losses given default, voluntary prepayment risks, and other elements of credit risk.
These software solutions can not only help financial institutions improve how they measure, manage, mitigate, and report risk across the enterprise, they can also help these institutions’ lawyers or legal teams in terms of automating operations, streamlining workflows, and improving the FIs’ bottom lines.
3) Regulatory Risks
A shift in prevailing laws or regulations that can impact businesses like banks, fintechs, NBFCs, and digital lenders. Whether they originate from government agencies or internationally recognized regulatory bodies, these standards and regulations for financial institutions continue to grow year after year. If FIs want to avoid potentially expensive fines and sanctions, keeping up with all of these is mandatory. Thankfully, modern financial services risk management software solutions usually incorporate a range of functionalities that allow for automatic compliance on every transaction.
4) Market Risks
The world’s financial markets are more intertwined than ever before. Today, there are so many processes and players involved in each transaction that it’s no longer possible for any single human to consistently make confident long-term financial market predictions.
AI and ML modules have proven invaluable for helping FI analysts surmount this problem. The capabilities of new systems also allow them to draw data from more sources, including marketing software and enterprise resource planning (ERP) solutions, making it possible to create highly accurate models of likely market events within moments.
5) Liquidity Risks
FIs can also face significant liquidity risks when they take on the role of borrower. In particular, being able to pay off short-term debts is extremely important if an FI wants to be able to draw from a wider range of sources for future borrowings. Again, software can be the solution for avoiding liquidity risks by enabling the FI to effectively manage its collections and increase its liquidity.
6) Internal Management Issues
Despite all the discussions on how artificial intelligence is changing FIs, it’s still extremely important for banks to be able to hire and retain top financial talents. Banks and other FIs that focus on customers without thinking of the welfare of their employees are likely to have issues retaining clients or capturing new markets.
By choosing employees that share the FI’s vision, seriously focusing on professional development, and offering competitive compensation, most FIs should be able to mitigate most of these types of risks.
7) Political Risks
Markets with high political uncertainty are a double-edged sword. On one hand, political uncertainty often presents numerous opportunities to make profits. On the other hand, it could lead to market failure. Those that do choose to take on these risks may want to invest in keeping their systems resilient from systemic shocks.
8) Tech Disruption
In the 2010s, financial tech companies started posing a serious challenge to traditional FIs, causing many to lose their market shares, particularly in the exploding global ecommerce market. The late adoption of finance technology platforms had forced FIs to play a game of catch-up, and many were not able to cope.
To avoid tech disruption risks, FI policymakers may have to develop a more grounded understanding of the potential of new and emerging technologies, perhaps engaging with fintech companies to find mutually beneficial opportunities.
9) Cybercrime
Cybercriminals run the gamut from teens working on a hand-me-down computer to entire rogue governments with state resources at their disposal. All of these parties are incredibly resourceful and innovative.
Without contemporary cybersecurity systems, FIs are almost always at the mercy of these malicious actors. Taking their activities seriously and investing in both tech and human systems is the only way to mitigate their potential damage.
10) Reputational Risks
Because FI’s have to be stable to be viable, they are vulnerable to serious threats to their reputation. As such, not only do FIs have to perform to their advertised standards, but they also have to actively manage their image.
11) Competition
Just two decades ago, the biggest competition traditional FIs had were other traditional FIs. As mentioned earlier, financial tech companies, alternative financing businesses, and card providers have all taken over some of the traditional roles of FIs in recent years, putting many traditional lenders in a bind.
While there is no one-size-fits-all solution for improving competitiveness, it’s clear that FIs need to invest more in finance automation as well as in the human systems needed to maximize it. Investment in these areas will enable FIs to be more agile and resilient, allowing them to consistently avoid risks and effectively pivot to new markets if needed.
What Can Financial Institutions Do?
It’s impossible for FIs to completely eliminate any of these key risks. However, by consistently investing in the appropriate financial services risk management solutions, they could mitigate the possibility of these risks becoming catastrophic. Furthermore, investing in human systems and keeping sight of the fundamentals can help to further insulate FIs from existential threats.