Evolving key risks in the banking sector

Brunella Bruno, Elena Carletti and I recently wrote a paper for the European Parliament's Committee on Economic and Monetary Affairs on evolving key risks in the banking sector and related priorities for the SSM. In this short note, we point to a few new sources of risks, challenges posed to supervisory actions, but also make the important case that traditional risk management tools might face limitations in the current situation.

First, there are significant geopolitical and related risks, including (i) credit risk and effects on corporate and consumer lending business, (ii) market risks and effects on trading, (iii) fiscal policy support result resulting in sovereign debt increases and a renewed doom loop between bank and sovereign fragility, (iv) climate risk including the risk of backtracking on commitments with stranded asset risks materialising even more strongly later, (v) risk of cyber-attacks against financial institutions and critical infrastructure, (vi) geopolitical tensions beyond Ukraine and consequent negative effects on international trade and economic recovery. Beyond these geopolitical risks, there are (i) the risk of financial market disruptions related to increasing interest rates and imbalances in asset holding, (ii) spill-over effects from fragility in the crypto-market, and (iii) risks arising from financial sanctions against Russia.

The challenge for banks will be to be prepared for such extreme scenarios. New approaches to risk management are needed, combining quantitative and qualitative assessment. Scenario analysis seems to be a more effective way to address tail risks that are multifaceted in nature. The challenge for banks (and thus, for supervisors) will be to be prepared for such tail-risk scenarios, for example in the form of back-up solutions in the case of cyberattacks Banks’ strategic plans need be to set towards long-term objectives, but also have to be flexible enough to allow for the possibilities of tail risks. In terms of supervisory actions, these considerations call for a very-bank specific monitoring approach.