Governor Speak: Michelle Bowman on the future of banking

7 Feb 2024 , 02:56 PM

THE CHANGING BANKING LANDSCAPE GLOBALLY

If there is one sector that has changed drastically in the last 30 years, yet intrinsically remained the same, it is the global banking sector. Technology has changed the face of banking and made it more customer friendly and customer centric. However, banking still remains a very conservative industry when it comes to regulation and risk management. It is in this context that the recent speech delivered by Fed Governor, Michelle Bowman, on the future of banking assumes importance. Speaking at the Southwestern Graduate School of Banking, Bowman highlighted the changes in the banking sector from a regulatory perspective and also from the technology perspective. 

As Michelle Bowman aptly put it, “Normally, when we think about the future of banking, we focus only on today’s most pressing issues and problems, some of which will be fleeting and may not have long-term impact on the banking system.” That is especially true in a crisis, when the entire focus shifts to the problem at hand. Known in banking circles as a hawk, Bowman focused her speech on the higher-level view on how the future of banking was changing from a long term perspective. 

WHY THE FOCUS ON FUTURE OF BANKING? 

That is because the world economy, in general, finds itself in a state of flux. As Michelle Bowman put it very eloquently, “Today we find ourselves at an interesting juncture in the evolution of the banking system. Some traditional risks like interest rate risk and liquidity risk have become a higher priority concern for banks and regulators. At the same time, other risks like cybersecurity and fraud continue to evolve and pose challenges.” Banks have multiple challenges at the current juncture as they need to balance growth and risk. One obvious change is that banks, like cars, are becoming less of a service product and more of a technology driven product. It is now a service that has to be built around technology. It is the integral nature of technology in banking that makes it interesting and also challenging. Banking regulation last evolved around 30 years back when capital adequacy, asset quality and income recognition started to get regulated. It is, perhaps, time for the next round.

HOW TO ADDRESS THE ISSUE OF BANKING COMPLACENCY?

There are two diverse experiences that have been seen with respect to banks and regulators in the past. When there is a banking crisis of a certain magnitude, the regulators move in on a war footing and the tightening of regulation is almost immediate. These normally pertain to traditional risks like liquidity risk, interest rate risk, asset liability mismatch etc. However, when there is a long period of stability, it has been observed that banks tend to get too complacent. For example, banks were relatively stable in the period post the sub-prime crisis implosion. This triggered of a misplaced sense of complacency among the banks that nothing really could go wrong. 

The interesting part is that, complacency stems from false assumptions. Take the example of the sub-prime crisis of 2007-09, which set the tone for the implosion of several banks globally. In the run-up to the sub-prime crisis in the US, the tacit assumption was that housing values would continue to appreciate. It is one thing to have an assumption but another thing to act irrationally based on these assumptions. When the crisis struck, it became a mutually destructive phase when housing was destroying banks and in turn bank delinquencies were destroying housing prices. 

Similarly, another case of complacency was seen post the global financial crisis. The central banks cut rates rapidly and infused trillions of dollars in liquidity. Most banks and other investors assumed that rates would stay low for ever and that pushed investors to other asset classes that were riskier by nature. However, the equations changed rapidly when rates started rising rapidly from 2022 onwards. The sharp hike in the rates forced a lot of small and medium sized banks into bankruptcy, although it was addressed on time and nipped in the bud. However, it would have been still better if banking had the in-built buffers to pre-empt such a crisis rather than just managing the crisis. 

What is the outcome of such complacency? In a sense, complacency can result in overlooking risks even on basic issues like asset quality, interest rates, maturity mismatches etc. Globally, many banks face significant challenges when planning effective leadership succession. They just don’t have a second line of defence with the result that these banks have to be sold at an unremunerative price to other buyers who have the necessary bandwidth to handle the complexities. In fact, technology protection measures have resulted in lower degree of cybercrimes on secured servers. However, this may not stay on for ever. There will be significant risks if the banks fail to devote sufficient resources to maintaining and updating systems, or if a bank fails to integrate and update legacy systems.

This has serious implications for regulators. For instance, the only cure that regulators can offer for complacency is eternal vigilance. The regulator needs to have the systems and wherewithal to focus on the apparent risks and also the dormant risks. In many cases, banking complacency may not just arise from inattention, but could also arise due to wrong prioritization. An example is when regulators focus on risks that are tangential to statutory mandates and critical areas of responsibility. This can raise a priority issue and can eventually increase the risk that regulators overlook areas that require immediate attention. Concentration risk often does not get adequate attention in banking and that is normally a loose end. For instance, during the banking stress of early 2023, several banks that experienced particularly acute stress had concentrated exposures or monoline business models. For example, the focus would have been very deep in the IT industry, or to venture capitalists or even to crypto-asset industry.

RISKS EVOLVE, RISKS MUTATE; AND THAT IS THE REAL RISK

Mutation is one of the biggest risks in banking; quite often as it goes unnoticed. For instance, when changes are introduced in banking, the assumption is that some of the risks have been addressed for good. However, these risks do not actually go away. Instead, they mutate and assume forms that are more complicated and also less predictable. Even as banks focus on the well defined risks like credit risk, interest rate risk, liquidity risk, cyber risk, and mismatch risk; the bigger risk is that such risks also mutate over time. The advent of the automated teller machine (ATM)s and electronic banking were two of the most significant paradigm shifts in banking. However, these also opened up new risks wherein hackers could hack into a particular bank account and through that account access the banking servers. It has often happened that the data of many customers has been compromised in this process. Here it is a case of risks mutating.

Most banks today focus on the core banking operation and many of their tasks are outsourced to specialists. Many buys have tied up with other NBFCs or MFIs for co-loan origination. There are a number of banks that are relying on third parties to provide Banking As a Service (BAAS) on a contract basis so as to be able to better manage costs and scalability. However, such external dependence also poses new risks to the banking system. The risk of third party involvement in niches of the banking business, is a risk that cannot be underestimated. 

The moral of the story is that there is a need for a different way of thinking about the long-term challenges and opportunities in the banking industry. It does not only pertain to the banks, but also to the regulators.