At a recent investor conference hosted by Bernstein Research, the CEOs of JPMorgan Chase, Wells Fargo, and Morgan Stanley predicted a difficult economic environment in the face of inflation and rising interest rates. Their forecast is based on a combination of factors, including fiscal stimulus during the pandemic, Federal Reserve policy, and the war in Ukraine.

While the Federal Reserve’s increase in interest rates (raised by another 0.75% on July 27) is designed to slow inflation, it is also likely to slow consumer spending and weaken businesses. Speakers at the conference compared the coming economic conditions to a hurricane on its way – but were uncertain how severe the storm will be.

Uncertainty drives the biggest concerns

Jamie Dimon of JPMorgan Chase reported that “the bank is bracing for turbulence and bad times.” However, the real issue with the economy may be uncertainty. ABA economists predict both upside and downside in the months ahead.

On the upside, the group expects real consumer spending to continue rising, with 2.5% growth this year and 1.8% next year, supported by low unemployment and exceptional wealth gains over the previous few years. They expect inflation to drop from the current 9.1% to as low as 2.4% next year.

On the downside, inventory accumulation is expected to slow. Consumer and business sector growth will be counterbalanced by international trade weakened from military conflict, COVID-19, and high energy prices. And continued inflation, supply chain problems, or a housing correction could tip the economy into a downturn.

Conflicting economic conditions introduce risks for banks as they ride out the uncertainty. Brian Moynihan, CEO of Bank of America predicted at the conference that investment-banking fees would drop about 50% in Q2 from a year earlier, while trading revenue may climb 10-15%.

Banks need to adjust to an economy with real interest rates and real cost of capital, which they haven’t had to deal with in decades. Higher interest rates can drive more profits but will likely increase risk for short-term loans. Mortgage loans become riskier with a poor economic outlook. Home sales and mortgage applications have declined after the Fed’s recent interest rate hikes.

Risk appetite opens investment opportunities

Since an economic downturn often introduces investment opportunities, banks may want to take advantage. If so, they should compare possible investments against risk appetite to sift out the most promising ventures.

For example, some investments may put the bank in a stronger financial position when the economy turns around, even though they may generate a short-term loss. A good understanding of risk appetite and the bank’s overall position will help determine whether you are in position to make these long-term bets and wait for them to pay off.

Risk management builds buffers

At the same time, it is important for banks to ensure that their risk management can handle expected events and unexpected shocks in a floundering economy. For example, the leadership team can consider how changes in the current economy will change a bank’s risk profile and assess the impact on risk management policies across the company.

With a perspective on likely risks in the near future, leadership can determine what changes the bank will need to take to protect and grow business in response to different economic factors. Risk professionals will need to propagate those changes through the risk and compliance management framework.

Resilience helps you navigate the storms

Banks need to integrate risk and change management functions into their overall governance framework for the flexibility and responsiveness necessary to succeed in uncertain times.

Black swans, or unexpected economic events, can’t directly be factored in a risk analysis. Although geopolitical risk in Eastern Europe and the possibility of a new pandemic disease were both understood, the details, timing and extent of both the Ukraine crisis and the COVID-19 pandemic were impossible to predict in advance.

However, a bank can put itself in a strong position to meet whatever comes up. The role of enterprise risk management practitioners is not just to seek risk avoidance, but to position their organization to weather any storm, and seek out opportunities for growth vs. retracting to protect the firm.

Banks should assume that unexpected events will impact risk management, change management, and business decisions at once. The responses to economic shocks will percolate through the entire organization, so it’s important that risk and change management teams stay in lock step as leadership adjusts course.

A strong automated ERM function builds resilience

Accordingly, banks should strengthen lines of communication, clarify roles and responsibilities, and collect and collate data across the company, so executives have a comprehensive, real-time picture of business status. With integrated risk assessment and visibility, leaders can make better decisions faster. With broad risk performance data, they can take corrective actions quickly.

As well as providing greater visibility and decision support, automation of enterprise risk management functions can reduce the resources required to deliver – either allowing a reduction in headcount or allowing risk management staff to move from spending their days on manual data entry to conducting analysis that directly benefits the business.

There may be a hurricane-strength economic storm headed our way, but banks with strong, flexible, and coordinated risk frameworks, processes, and tools will weather it well and find themselves in the best position to sail on to calmer seas.

Next steps for your organization

Risk appetite is an enabler, providing a pool of risk to be used to create value. It helps you identify both excessive risk-taking and also where not enough risk is being taken. Watch our webinar recording on this important topic now:

20220317-risk-appetite-webinar-linkedin-1-recording

 

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