Balancing risk and reward for new products and services
How community banks can manage the risk of new offerings
INSIGHT ARTICLE |
For community banks, adding new products or services can be an excellent way to solidify relationships with their existing customers or to broaden their reach into new market segments. However, offering new products or services often means taking on new risks. It is vital, therefore, that banks consider the full range of risks associated with their new offerings, especially:
Regulatory and compliance risks
Margin and cost risks
The main questions around strategic fit might seem intuitive, but are sometimes overlooked by banks that are enticed by what seems to be a profitable opportunity. By considering these key questions, you can help assure that new product or service offerings fit your market, your long-term strategy and your capabilities, and that they don’t create undue new risks.
How well does this product or service fit within your current operational capabilities? Do your existing personnel have the skills and experience necessary to manage the new offering or will you need to augment staff, either through training or hiring? What about your systems? Will your existing tools be able to capture and report the information necessary to make informed decisions or will you need to add to your IT tool set?
How proven is the product or service? Are you considering adding a proven offering with which a number of banks have had success, or is it a new, leading-edge offering? If it is a new offering, how quickly do you expect it to evolve, and what will be the expense to your institution of keeping up with those changes? Will you be dealing with new competitors?
Whether a new or proven offering, how does it improve your strategic position? By increasing business with existing customers? By attracting a new market segment to your bank? By replacing an outdated or declining line of business with a better option for your market?
Once you’ve decided that a new offering makes strategic sense, then it’s time to weigh each of the key risk categories to fully vet the offering’s potential impact on your risk profile. This should be an inclusive process that includes participation from the board down and that draws on the insights and experience of personnel from all areas of the bank that would be involved with the offering.
Regulatory and compliance risk
Regulatory and compliance risk is always a key consideration. With the tsunami of compliance changes that have swept over the industry since Dodd-Frank, keeping up with compliance concerns for your existing products and services can be hard enough, so it’s especially vital when considering new offerings to ensure that you understand and are prepared to address any new regulatory issues you need to consider. Some key questions to ask:
Is this a proven offering with an existing regulatory history, or is it a sufficiently new and different regulation that is still evolving?
An increasing regulatory focus on fairness has regulators looking outside traditional banking regulatory boundaries to also more widely consider unfair, deceptive or abusive acts or practices (UDAAP) issues and other concerns. You need to consider not just the likely opinion of traditional bank regulatory bodies, but also those of the Federal Trade Commission and the Consumer Financial Protection Bureau.
Not all regulatory impacts are obvious. Does the new offering affect your Community Reinvestment Act (CRA) profile or raise Bank Secrecy Act or anti-money laundering concerns?
Do you fully understand the information you will need to collect and report to meet any new compliance obligations? Are your current systems capable of meeting those needs or will they need to be updated?
Does the new offering involve any third parties? Have you fully vetted their compliance profile and capabilities? Some products, like prepaid cards or loan insurance, are heavily dependent on third parties.
Cost and margin risk
Considering interest rate spreads, product costs and margins is one of any bank’s core competencies, but care still must be taken any time a new offering is added to ensure that you’ve fully weighed any associated risks. Consider this example: One community bank offered a CD with a maturity of two to three years, but included a feature that allowed customers a one-time opportunity to add funds to their CD, with no limit on the addition. When interest rates dropped, suddenly making these relatively low-return investments more attractive, many of the bank’s customers took advantage by adding huge amounts to their existing CD investments. That bank suffered significant losses on that product.
Questions to consider:
How sensitive will the new offering be to interest rate changes?
What new investments in systems and personnel will you have to make to support the new offering? What ongoing costs will you incur to manage it? How do those issues affect how you price the offering?
How competitive is the market for this offering? How narrow will your margins need to be to compete effectively?
The more significant a departure a new offering is from your bank’s usual product mix, the more operational risk it is likely to entail. So it’s vital to make sure you understand how to manage a new offering and that you have the talent and systems in place to do so effectively. Some issues to consider:
Will your current systems be able to capture all the data you need to make informed management decisions, or do you need to make new investments to support the product?
Who’s going to manage the product? Do you have the right talent in place or will you need to add staff? The further the new offering falls outside your current experience, the bigger the issue. For example, banks moving into SBA lending or Accounts Receivable lending for the first time face significant learning curves due to new monitoring and oversight requirements. Unanticipated costs can be a big issue.
Do you fully understand the operational costs associated with the offering? For example, some banks bought assets and liabilities of troubled banks at a discount after entering into cost-sharing agreements with the Federal Crop Insurance Corporation (FCIC), which would share in any losses. While the down-side protection made it seem like an attractive deal, these banks often incurred significant audit and reporting costs that eroded the anticipated benefit.
Does the new offering require a special accounting or tax treatment? Are you prepared to address those issues?
Does the offering raise any new cybersecurity concerns?
The banking industry as a whole took a reputational hit during the financial crisis because of ill-considered lending practices and their ramifications for the entire economy. All of the questions in all of the categories above feed into a single question from a reputational perspective. If you fail to assess your risks accurately and the new offering fails, how will damage to your reputation compound the damage of a failed offering? A compliance failure leading to public regulatory action, a cybersecurity breach exposing customer data, charges of unfair or predatory practices—any of these could cause significant damage to your institution. Again, you have to look outside your bank’s boundaries and ensure that any third parties involved in your new activity are sound and reputable.
New products and services will always be central parts of any bank’s growth strategy. By effectively understanding and responding to all the involved risks, banks can make the right decisions about which opportunities to seize.