Banking is a regulated industry precisely because a failure in this sector does not exist in isolation. Recognising this potential domino effect, regulators aim to uphold stability by mandating that banks demonstrate both financial and operational resilience. But how can banks make sure they have this resilience, and prove it to the regulator?
In this series, we explore what it takes to become a bank, drawing on insights from experienced experts. Our earlier articles covered the fundamentals of building a successful banking business, the importance of people, and why treasury is the financial heart of a bank.
In this instalment, our expert panel Ivan Frampton, Founder and MD at TriFidus; Vishwas Khanna, Partner at Avantage Reply; and David Bowles, an independent risk advisor, discuss:
why a single bank failure can have a ripple effect across sectors
what regulators expect from banks on financial crime
how financial models can help prove your resilience.
Why banking is a regulated industry: "The failure is not your own"
“Banking is a utility, much like electricity or water – it is essential for the functioning of society,” says Khanna. “When a bank fails, the ripple effects immediately reach the real economy.”
As well as being connected to all other sectors, the banking industry has unique interdependency. “Banks not only provide essential services to individuals and businesses but also rely on one another through services like clearing and interbank lending. It is a hugely ‘incestuous’ industry."
Banks also play an important and unique role in disincentivising and disrupting financial and non-financial crime. Regulators recognise that, by enforcing strict anti-money laundering (AML) standards and other safeguards, banks can prevent the funding of activities that would erode trust in the system and have a negative impact on society.
In short, regulators want to see banks demonstrate they can manage liquidity and capital risks effectively, avoid operational lapses, and prioritise outcomes that benefit the customer. They must also ensure there are no proceeds flowing across their channels that fund or are derived from criminal activity.
The primary objective of the regulator is to ensure banks are trusted institutions and that any single bank failure does not become a systemic threat that undermines trust in the entire economy.
Regulatory intervention hits new banks hardest
Regulatory investigations and interventions are not just aimed at new banks. Established banks including HSBC, Lloyds, Barclays and Royal Bank of Scotland, for instance, have all faced scrutiny.
However, as Bowles explains, the difference is that established banks can often absorb regulatory interventions due to their robust reputations and sizable capital buffers. This instilled public trust and deep financial and non-financial resource can help them weather missteps.
In contrast, newer banks might face greater risks when regulatory scrutiny arises, as they lack the brand strength and historical credibility of more established players.
Recognising this fragility, Bowles argues: “Regulators like the PRA [Prudential Regulation Authority] now require aspiring banks to establish comprehensive systems and controls before granting them licenses, ensuring they can operate reliably from the outset.”
This contrasts with the early- to mid-2010s period when some challenger banks emerged with simply a strong vision or commitment to reduce risk. “Today’s regulatory environment demands that new banks are fully operational and prepared for potential risks before they can serve the public,” Bowles adds.
Key takeaway: New entrants need to be aware that the Bank of England’s desire for a more diverse banking sector is being tempered by the pressure to monitor a growing number of new banks.
How financial modelling can help you stay compliant
In today’s regulatory climate, financial models have evolved from mere strategic tools to essential components of risk management and compliance.
Bowles emphasises the crucial role that financial models play in shaping the bank's risk management strategies. He explains that these models form the foundation for frameworks that help the board and senior management make informed decisions about the bank’s risk appetite.
According to Frampton, the value of a financial model goes beyond just numbers – it reflects the underlying drivers of the bank's operations and products, allowing the simulation of various scenarios. This helps to assess the financial impact of setting specific risk appetite levels, as well as the consequences of breaching them. Frampton also highlights the model's ability to provide early warning signals, helping the bank anticipate potential breaches before they occur.
Bowles adds that, once risk appetite levels are clearly defined within the financial model, the business can stress-test its strategies, examining how the bank would fare under challenging economic conditions. This proactive approach ensures the bank is not only prepared for the worst but also capable of navigating through it with greater resilience.
Regulators require banks to demonstrate that they can withstand shocks, not only to secure a license, but to operate sustainably. “Because of the dynamic nature of risk, new entrants’ financial model must cover the entire lifespan of their strategic plan, projecting far beyond the initial years to show long-term resilience,” adds Bowles.
Key takeaway: With a thoughtful approach to modelling and a commitment to regulatory compliance, new banks can lay the groundwork for a stable and resilient future.
Summary
Financial modelling plays a critical role in addressing the challenges faced by new banks, particularly in a tightly-regulated industry. They are not just strategic tools; they form the backbone of risk management process, guiding decisions on risk appetite and forecasting how banks will perform under adverse conditions.
A well-developed financial model can simulate the impact of financial shocks, breaches in risk thresholds, and help identify early warning signs. In this way, banks can anticipate and mitigate risks. This is essential as regulators demand that new banks demonstrate both short-term reliability and long-term resilience.
Look out for our next and final article in the ‘What it takes to become a bank’ series, taking a close look at risk management in the banking space.
If you need advice on navigating banking regulation and risk, TriFidus can help. Contact our specialists today.
All views expressed are personal and do not necessarily represent the views of interviewees’ organisations.