Non-bank financial intermediation: in turbulent times, how can incumbents manage risk?

By Muzammil Shabudin, UKI Risk CxP Advisory Lead at SAS UK & Ireland

 

It’s safe to say the banking industry has faced some challenges over the last few years. From prominent bank collapses to continued economic uncertainty, those within the sector are taking stock and re-evaluating the threats facing the industry.

This has led some to question the risks of higher capital requirements driving interest towards non-bank financial intermediation (NBFI) – previously referred to as shadow banking – and what this might mean for the sector long term.

Given that non-bank financial intermediaries are generally unregulated and not subject to the same risk, liquidity, and capital restrictions as incumbents, they have been a risk to the banking sector for as long as the latter has been in existence.

In response, banks’ key priorities must revolve around improving operational resilience and minimising risk – and keeping up with the latest trends in the economic climate to do so effectively.

The current climate

Back in 2022, the Bank of England was forced to intervene in the long-dated bond market after a steep sell-off of UK government bonds threatened the country’s financial stability.

Muzammil Shabudin

In response, analysts flagged lingering stability risks in the UK’s shadow banking sector, with former Prime Minister Gordon Brown urging regulators to tighten their supervision of shadow banks.

As debates on regulation continue, the NBFI sector continues to grow. According to the most recent data from the Financial Stability Board (FSB) from December 2022, the global NBFI sector grew by 8.9% in 2021, higher than its five-year average growth of 6.6%, and reached $239.3 trillion in total global financial assets.

While we await this year’s data, one trend which is clear is that the NBFI sector cannot be ignored, but instead, the level of risk posed needs to be accurately judged so incumbent banks can take any necessary action in a timely manner.

Economic uncertainty

It’s recognised that incumbent financial institutions may face increased risk due to a more volatile economic and geopolitical climate.

For example, if the rising cost of living forces more consumers to turn to the NBFI sector, those already in financial distress risk exacerbating their situation.

This could lead to accelerated financial delinquency, insolvencies and write-offs, while also calling into question the steps banks take if consumers feel a lack of support, access or options are responsible for pushing them toward NBFI alternatives. There is a heightened focus on the risk of harm caused by financial institutions due to the new Consumer Duty legislation – whilst firms should already be mindful of the principles of this regulation, the spotlight means more purposeful attention is required by the industry.

Effective steps banks can take to prevent this scenario include enhancing customer experience considerations and widening access to digital services. Both of these can be accelerated through developments in artificial intelligence (AI) which allow banks to personalise each customer interaction and strengthen trust, so long as the risks to responsible AI are identified and mitigated.

Banks should also look to diversify product offerings and provide customers with clear educational information – helping customers make informed decisions about their finances, meeting a key cross-cutting rule of the Consumer Duty.

The rise of crypto currencies

Another key change in recent years is the rise of cryptocurrencies.

According to Forbes Advisor, 9% of the UK population currently have money in cryptocurrency, and the UK crypto user base is estimated to reach 22.2 million by 2027.

For incumbent banks, there are some associated risks, including:

  • Compliance risk – ID&V is more complex, easier to circumvent and harder to provide assurance.
  • Asset volatility risk – valuation is subject to broader, more spontaneous risk drivers meaning risk weights will need to be materially higher to capture more of the potential swing.
  • Reputational risk – given the difficulty to confirm source of funds and the legal owner of funds, the risk of doing business with criminal, sanctioned or politically exposed persons is much greater and likely outside incumbent banking institutions’ risk appetite.

The way forward

While the cost-of-living crisis and the rise of cryptocurrencies are external factors, incumbent banks have the ability to proactively build up their own operational resilience through a few important actions.

Firstly, banks can reduce the ‘garbage in, garbage out’ risk by seeking to improve their operational process, data provision, analytical intelligence and auditability.

Incumbent banks should also ensure operational resilience policies and procedures align to regulatory standards as a minimum, and seek a higher level of compliance with the firm’s internal expectations which should be driven by strategic objectives and values.

New technology – including AI – is paving the way forward here. Banks can now manage critical operational risk and compliance processes more efficiently, such as through self-documenting solutions which ensures auditability and traceability.

The NBFI sector may be trending towards further growth and therefore increased risks to consumers, but the above considerations can help to reduce the potential impact traditional financial institutions seeking to support consumers’ financial needs. Overall, developments in data management, advanced analytics and responsible AI should be part of boards’ and executives’ strategy execution plans to ensure risk remains within approved appetite over the long term.

Find out more about how analytics and AI can support financial institutions meeting their strategic goals.

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