Four Steps for Building an Effective Risk Appetite Framework


risk-appetite-12-7-16.pngRisk appetite is a key component of a bank’s risk management framework. Effective risk management is fundamental in ensuring there is an appropriate balance between risk and reward.

Good risk management does not involve avoiding risk at all costs. Instead, it allows taking on more risk as long as the bank is making informed choices and has measures in place to mitigate risks. Having a strong risk appetite statement and well established policies and procedures is important, but equally important is the effective implementation of this framework.

Based on discussions with a number of credit risk executives at small and large banks, we have identified four steps for implementing an effective credit risk framework.

1. Ensure data quality and integrity.
Clean, standardized data is essential to making fair, timely and accurate credit decisions. The bank also needs to see its complete exposure to ensure it’s not over-exposed at the time of origination.

Regulators are increasingly demanding that a solid risk governance framework include policies and processes to provide risk data aggregation and reporting capabilities. In order to accomplish this, banks should have the IT infrastructure to store data and support risk aggregation and reporting in order to capture material risks, concentrations and emerging risks in a timely manner.

Technology can significantly improve data quality and aggregation. Current systems offer a single source of truth and gather all the risk data in one system that is easy to view and access. So there’s no need for checking multiple systems, tracking exposure in spreadsheets, or adding up numbers. These systems can also aggregate exposures across products, industries, regions, and so forth.

2. Set appropriate limits.
At most banks, the limit-setting process falls to the risk management team. But setting limits is as much an art as a science in many institutions.

One way to ensure appropriate limits is to align compensation with risk culture and take an approach to limit setting that is well articulated, tied to business objectives, and clearly sets out the consequences of breaching limits. In addition, banks can leverage the funding and resources that have already been allocated to conduct regulatory stress testing to help set risk appetite limits.

We have worked with clients to define their risk appetite limits through a well defined analytical and quantitative approach. Ultimately, this approach can help risk management set appropriate limits, adjust limits as the market environment changes, obtain business buy-in, and improve the bank’s overall risk culture.

3. Implement and enforce limits.
Effective risk appetite can be thwarted by integration challenges between risk, business and other functional areas at banks. Lack of cultural alignment and faulty processes often prevent the risk appetite framework from being adopted by the business units at the point of origination, rendering it ineffective.

At many banks, the process is still manual–checking reports and spreadsheets to ensure compliance where automation could save time and increase accuracy. Solutions now exist that let bank officers see at the point of origination where a potential deal is going to breach risk appetite limits. At that point, before moving forward, the red flag is raised and originators can decide to continue the approval process and seek an exception, escalate it to management, or even decline the deal.

4. Monitor limits and manage breaches.
Identifying limit breaches and near-breaches in a timely manner is critical to a dynamic risk appetite monitoring process. Limits should be reviewed and updated frequently, as changes in market conditions, risk tolerance, strategy, or other factors arise. Having ready access to customer and portfolio data, and where various exposures stand against limits, is essential to make timely decisions.

Breaches must be identified as they occur, automatic alerts sent to the right decision-making individuals at the bank, and the breach and resolution must be well documented so it can be audited in the future. Manual calculation and spreadsheets cannot guarantee this; only a strong IT infrastructure with limits and management capabilities can achieve this desired state.

Conclusion: The Way Forward
Technology can deliver significant value to the overall risk appetite process. Automated systems provide efficiency gains, better data quality and enhanced analytics. And these factors, in turn, drive the ability to measure, monitor and adjust risk taken against established risk appetite.

For more on this topic, see our white paper.

Successful Tech Implementations Are About People, Not Platforms


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To set the stage for a successful technology implementation, it takes more than just training your staff or setting up a platform. You also need to understand your firm’s strategy, culture and people—and know how the new technology will enhance all three.

Increased competition, shifting customer expectations and more diligent enforcement of expanding regulation are making the commercial lending space a tougher place to do business.

It’s true that commercial loan growth is expected to hit 11 percent in 2016. That impressive growth belies a challenging market environment. In truth, lower interest rates and higher costs of doing business are squeezing lenders’ margins. To paraphrase an old joke: Financial institutions need to avoid losing money on every loan, while “making it up in volume.”

Financial institutions that want to avoid becoming a punchline are responding strategically, investing in core technologies and leveraging the new analytical capabilities of solutions to drive product-level profitability.

Due to the increased cost of doing business and the need to operate in a leaner environment, most financial institutions do not possess the internal expertise needed to properly plan and execute enterprise-wide process change. This lack of experience leads to longer success rate times and reduced buy-in by end users and management.

According to the technology and consulting firm CEB, a vast portion of business-led technology adoption happens without the input of information technology, with nearly half of originators saying they are willing to forgo quality for speed. This lack of planning is showing up in the final output. Eighty-five percent of the “stall points” in the adoption of new technology result from a lack of planning, with just 15 percent related to issues around the implementation itself.

So, what are the steps that your financial institution needs to take to ensure the success of your implementation?

Identify What Change is Needed: The institution needs to have a clear idea of what needs to change, and the metrics by which the success of the change will be measured. To make this happen, it’s important to have an executive steering committee, to get senior-level buy-in around a common goal.

Organize the Core Team: Next, it’s important for the institution to assemble a wide variety of cross-functional teams to allow free-thought around how paradigms at the firm could change. Effective tech implementations mean new processes, not just swapping one platform for another. To ensure that those paradigms work across the organization, everyone who will interact with the new system needs representation. For a commercial implementation, this means including representatives from the front line, such as relationship managers, all the way to the back-office, such as loan processors.

Choose a Champion: Financial institutions have to make a careful choice of the person who will be the face of change. The final candidate should be a strong communicator who can explain the benefits of the change to everyone in the organization.

Thoroughly Scope Business Requirements: Conduct a full scoping and planning session with your technology provider to understand business rules, as well as the existing systems and processes that need to change as a result of implementation.

Identify Key Implementation Resources: The financial institution needs to allocate the correct resources to maximize productivity and efficiency throughout the implementation. The creation of an implementation steering committee (separate from the executive steering committee we discussed above) can also help minimize design changes that need to occur after the implementation begins. This steering committee should also ensure that the changes have no unintended consequences for the organization.

Create Program/Project Plans: Will the project be an enterprise-wide implementation or focused on a specific area? Is the organization better suited to a waterfall or agile implementation methodology? (A waterfall implementation tends to be linear and sequential, while an agile approach is incremental and iterative, with processes occurring in parallel.) Will the rollout of the new technology be a “big bang” or phased? These issue need to be addressed in advance, along with the standard project timeline.

Most importantly, financial institutions need to work deliberately and efficiently, and avoid hurrying the process. Rushing into a mistake will delay the outcome longer than working slowly and effectively. As they say in the Navy SEALS: “Slow is smooth, and smooth is fast.”

Careful planning can significantly reduce the amount of time that a financial institution requires for the implementation, and speed up the time to realize the benefits. The key is planning right—from the beginning.

Bank Compensation: How Banks are Changing Bonus Plans


compensation-10-26-16.pngThe problem with creating an incentive plan is that your employees just might do whatever you incentivize them to do. If you pay bonuses based solely on earnings growth, then you might not only get growth in earnings but also really bad loans that eventually sink the bank. If you don’t include the quality of the bank’s ratings with regulators in the performance metric for your CEO, then you might end up with a bad regulatory rating.

During Bank Director’s Bank Executive and Board Compensation Conference on Amelia Island, Florida, yesterday, it became clear that many banks in the wake of the financial crisis are beginning to incorporate a variety of mechanisms to incentivize the behavior they want from their employees and management.

  • Fifty-nine (59) percent of banks in a Blanchard Consulting Group 2016 survey of more than 200 public and private banks have some kind of formal performance-based incentive plan for management. Only 22 percent have a bonus plan that is solely discretionary, according to the survey. This is of increasing importance for publicly traded banks as well. The shareholder advisory group Institutional Shareholder Services recommends that at least 50 percent of a CEO’s shares be tied to performance, said Gayle Appelbaum and Todd Leone of consulting firm McLagan.
  • Sixty-eight (68) percent use net income as one of the metrics in their performance-based incentive plan for the CEO. Seventy percent use it as a metric when evaluating the senior management team. It is more difficult for management to manipulate net income in their favor compared to return on assets or return on equity, said Mike Blanchard, CEO of Blanchard Consulting Group.
  • In a survey of the audience at the conference, which consisted of roughly 225 attendees, 35 percent used asset quality as the primary non-profitability metric in their incentive compensation plan. Regulators want to see other metrics besides profitability in bank incentive compensation schemes. “Be careful if you have profits only,” Blanchard said. Building in a little bit of discretion for the board in setting senior management pay is a wise idea, rather than basing incentives solely on metrics, Blanchard said. That could give the board more flexibility when something has gone wrong.

Banks are increasingly using clawback measures or deferral of pay to reduce the risk of their compensation plans. A clawback measure could be similar to one used by Wells Fargo & Co.’s board recently when departing CEO John Stumpf forfeited $41 million in unvested stock and Carrie Tolstedt, the former head of consumer banking, forfeited $19 million, following a fraudulent account opening scandal. Clawing back unvested stock is helpful because it’s difficult to clawback pay when the executive has already received it, and presumably, spent it. Some banks are adding clawback provisions to their incentive compensation plans that allow the board to clawback for unethical behavior or reputational damage to the firm.

With Wells Fargo in the headlines, questions about incentive pay and motivating the right behavior were a big focus of the conference, although not the only one. Most speakers thought Wells Fargo’s crisis was more related to its culture and how management responded to problems, rather than its incentive plan.

Chris Murphy, the chairman and CEO of 1st Source Bank in South Bend, Indiana, a $5.4 billon asset institution, talked during a panel discussion at the conference about building integrity and character among staff. If someone violates the basic values of the company, he wants other employees to know why that person was let go. A reputational crisis could hurt the bank financially but it’s an even bigger deal than that. “We now understand a little better the impact of little things building up over time,’’ he says. Lying is a nonstarter. “You can’t have anyone lying in any way, shape or form in your organization.”

Bank Compensation and Wells Fargo: The End of an Era


compensation-10-21-16.pngOne of the biggest scandals among big banks in years is still unfolding as Bank Director heads into its annual Bank Executive and Board Compensation Conference Oct. 25 to Oct. 26 on Amelia Island, Florida. Wells Fargo & Co. announced last week the immediate retirement of CEO John Stumpf, with Chief Operating Officer Tim Sloan taking on the CEO job, as the board struggled to deal with public outrage over accusations that the bank’s employees had opened more than two million fraudulent accounts on behalf of customers to game aggressive sales goals.

The case raised questions about compensation and governance at the most basic level: What impact did the bank’s incentive package have on employee behavior, if any? What impact did the bank’s sales culture and sales goals have on the behavior of employees? What did the bank’s management know about fraudulent account openings and what did it do to stop it? If management failed to stop the fraudulent activity and benefited financially from it, should compensation be adjusted for those individuals, and if so, by how much?

These are all issues of extreme importance to Wells Fargo’s board, whose independent members are conducting an investigation, but also, to any board. No one wants to have a scandal of this magnitude take place while they serve on a board. If employees are complaining about bad behavior and bad culture, how does your bank handle it? How are you ensuring that complaint patterns from employees and customers are recognized and reported to upper management? Should the board also get these reports? What types of behavior are your incentives and sales goals motivating?

Wells Fargo’s board and now, Tim Sloan, are in the unenviable position of having to change the bank’s consumer banking culture even as they try to assess what went wrong. The pressure is strong to show the public and government officials that it is taking action quickly. Wells Fargo has said that as of Oct. 1, it had ceased all sales goals for branch-level employees and instead will start a new incentive program based on metrics related to customer service and risk management.

Since the sales culture had been very much a part of Wells Fargo’s identity, and higher than average profitability, investors are wondering how this will impact the bank’s financial performance. Keefe, Bruyette & Woods analysts Brian Kleinhanzl and Michael Brown downgraded the stock to market perform and wrote last Friday that “Wells’ management doesn’t know what the consumer bank will look like in the future.”

The stock price has fallen to $45 per share as of Wednesday afternoon from $50 per share at the start of September, before the announcement of a $185 million settlement over the issue with regulators and Los Angeles officials, who had sued the company. Is this the end of an era for Wells Fargo? I think so, as major changes will need to be made.

Community bankers tend to point to scandals like this as a way to differentiate themselves from the big banks. Many of the community banks I know don’t have an aggressive sales culture, let alone sales quotas. It’s also easier to know what’s going on in a small bank than one with more than $1 trillion in assets. Still, many bank boards in the wake of the scandal may be asking questions about their own sales culture, their incentive packages and compliance with company policies and ethical standards. Regulators are certainly asking these types of questions of banks, and I expect this to continue in the wake of the scandal. For more on the topic of culture, and determining your bank’s culture, see Bank Director magazine’s fourth quarter 2015 issue.

When we talk about compensation, we may talk about salaries, stock grants, deferrals and clawbacks. But what we’re really talking about is how to motivate employees to do a good job for the bank. And if you don’t have the culture to match what’s good for the bank and your shareholders, you don’t have much.

FinTech Day Recap: Rapid Transformation Through Collaboration


Over the next few years, the financial services industry will continue to undergo a major transformation, due in part to the speed of the technology movement. With continuous pressures to innovate, how can banks leverage these new technologies to stay relevant and competitive over the next five years? Filmed during Bank Director’s annual FinTech Day in New York City at the Nasdaq MarketSite, industry leaders in the banking, technology and investment space share their insights and perspectives on the challenges and opportunities facing traditional banks.

FinTech Day Recap: The Times They Are A-Changin


Over the next few years, the financial services industry will continue to undergo a major transformation, due in part to the speed of the technology movement. With continuous pressures to innovate, how can banks leverage these new technologies to stay relevant and competitive over the next five years?

Filmed during Bank Director’s annual FinTech Day in New York City at the Nasdaq MarketSite, Al Dominick, president and CEO of Bank Director, shares his thoughts on how banks who are looking for partnerships and opportunities to develop new technologies, may find fintech companies eager to collaborate.