Starting a bank means establishing a strong risk management framework that promotes resilience to meet both predictable and unpredictable challenges.
This series explores what it takes to become a bank, with insights from seasoned experts. The previous articles covered banking fundamentals, the importance of people, treasury as the bank’s financial heart, and the vital role of regulation.
In the final article of our ‘What it takes to become a bank’ series, we focus on managing risk as the cornerstone of securing and maintaining a banking license.
In this article, experts Ivan Frampton, Founder and MD at TriFidus and David Bowles, an independent risk consultant, discuss:
how to identify key risks to your bank
which risk management strategies are growing in importance
how you can mitigate risk with financial modelling.
Risk management frameworks for the long haul
Establishing a robust risk management framework involves identifying and quantifying key risks. This should include liquidity, credit, and non-financial risks. “Effectively understanding and managing risks is central to the risk management process. Banks must not only identify risks but also anticipate how they might evolve as the business grows,” explains Bowles.
He illustrates how risk is dynamic: “The risks a bank faces when it has only 10 employees will be drastically different from the risks it faces once it grows to 300 employees. External factors such as economic crises or global events like the COVID-19 pandemic can also alter the risk landscape.”
The regulator expects that banks will continuously update their risk management frameworks to address these changing risks. This ongoing requirement, Bowles warns, surprises many new bank applicants who may think of risk management as a ‘one-off exercise’ – it is not.
Key takeaway: Regulators expect to see a risk management strategy within the business plan that reflects the fact that risks are dynamic, changing over the lifecycle, and linked to external factors.
Managing risk, building trust
Managing financial and non-financial risks is crucial for new banks to ensure stability, regulatory compliance, and customer trust.
Financial risks, including liquidity, credit, and market risks, require strategies such as:
managing cash flow
setting strict lending criteria
diversifying portfolios
employing effective hedging.
Adequate capital buffers, stress-testing, and scenario analysis are essential for resilience.
Non-financial risks - such as cybersecurity, AI-related biases, and reputational risks - have grown in importance.
“Cyber threats have intensified as digital banking expands, and AI introduces complexities that banks must carefully monitor to avoid biases and maintain regulatory compliance,” says Bowles. “A single cybersecurity breach can shatter customer trust and bring regulatory scrutiny, making operational resilience a top priority.”
Key takeaway: Maintaining high operational standards and proactive risk management is vital for new banks to build credibility and navigate challenges effectively.
Financial modelling for more resilient banks
To reflect the dynamic nature of risk and remain relevant to an evolving business, the financial model requires future-proof functionality that anticipates risks the bank is likely to face over its planning horizon.
Frampton notes: “A solid financial model, built on drivers and with the capability to robustly flex specific key variables to reflect possible economic conditions, is fundamental to a bank's risk management framework.”
As an example of how this would work in practice, most banks would want to regularly simulate a bank run – where a macroeconomic event causes a high proportion of depositors to withdraw their money at the next available (contractual) opportunity, over a defined period – say one month, but it could be longer.
The financial model should illustrate, based on the mix of available deposit products, the financial impact of this much money being demanded by customers. With the scale of the liquidity problem quantified, the treasury team could then sequence and test their available mitigating actions using the financial model.
There will be times when the bank is more vulnerable than others to this liquidity risk event. For example, if it were to occur when a high proportion of fixed-term deposits were reaching maturity or a sizeable debt facility required refinancing, this could add to the strain on liquidity. The financial model should be used to stress test at periods of heightened vulnerability to ensure the bank is resilient to the risks it faces.
Bowles reflects that, since the global financial crisis, the financial models to support banks planning have evolved. From simple strategic tools, they have become comprehensive frameworks that safeguard against potential risks and manage regulatory compliance.
Summary
Starting a bank requires a dynamic risk management framework to handle both predictable and unpredictable challenges. Effective risk management involves continuously identifying and anticipating financial risks – such as liquidity, credit, and market risks – as the business evolves. Non-financial risks, including cybersecurity and reputational threats, are also critical, especially for new banks that lack the brand resilience of established institutions.
Financial modelling plays a key role, allowing banks to simulate scenarios, assess vulnerabilities, and plan responses to potential shocks. This comprehensive approach not only ensures regulatory compliance but also helps maintain long-term stability in a rapidly changing environment. Consistent stress-testing, scenario analysis, and proactive updates to the framework are essential to navigating financial and operational risks effectively.
We hope you’ve enjoyed our dive into the nuances of achieving regulatory approval and establishing a profitable bank – we welcome your questions and feedback.
If you need advice on setting up a bank, from your business plan to your financial model, TriFidus can help. Contact our specialists today.
All views expressed are personal and do not necessarily represent the views of interviewees’ organisations.