The recent developments in the international financial system have ushered in something akin to a Gutenberg moment. In the face of this defining point in time, the banking landscape finds itself at a crossroads in many ways than one — regulation soul-searching to redefine social media and artificial intelligence (AI) usage to environmental, social, and governance (ESG), etc.

In the past, the banking industry faced challenging times plagued by inaccurate credit decisions. This time, it is a victim of taking exposure to the most secured asset class: sovereign fixed-rate debt instruments.

Unprecedented rise in interest rates — the largest, quickest and broadest rise since the 1980s — as a result of the commodity super-cycle, and inflation, exacerbated by the Ukraine war, posed a new complication for the banks and opened them to risks which were camouflaged before, exposing substantial challenges for banks and prudential supervisors.

Global authorities are proposing new rules to replace banks’ risk assessments with standardised measures determined by regulators. This would strengthen capital and protect against operational losses from areas like cyber breaches and fraud, as well as market losses.

AI should be expanded beyond marketing to include compliance, control, credit, and other crucial domains

In any event, while the proposals raise capital requirements for operational and market risks, they reduce them slightly for credit risks arising from lending decisions in the wake of recent unprecedented developments essentially.

There is one notable exception in which US regulators, for example, did embrace weaker standards, and it backfired. They did not require banks with less than $700 billion in assets to take into account unrealised market losses on investments available for sale when calculating capital levels. This weakened capital framework made some banks vulnerable to deposit runs when big bets on treasuries fixed income securities turned sour.

Banks should shift from an asset-focused approach to considering liabilities, such as Non-Maturity Deposits (NMDs) and their risk of flight. Longer-term assets supported by less stable funding sources pose a risk of sudden bank closure. Regulators and banks must consider new dimensions when simulating crises, as simplistic assumptions may not reflect individual bank liquidity risks.

In Pakistan, traditionally, the government securities were entirely fixed rate instruments; the floating rate bonds introduced a few years ago by the government now comprise more than two-thirds of total outstanding securities, which subsides the overarching market risk associated with fixed rate instruments in a soaring interest rate environment.

State Bank of Pakistan (SBP), being very prudent, doesn’t allow any exceptions on not taking unrealised market losses on investments available for sale when calculating capital irrespective of the size of the bank, unlike the USA. These measures kept Pakistani banking immune to the risks that the rest of the global banking industry has been exposed to.

Floating rate bonds decrease the market risk associated with fixed rate instruments in a high interest rate environment

Social media can complicate liquidity requirements by causing deposit outflows to occur quickly. This risk was not considered before and was only recently witnessed in the USA and Europe due to misinformation on social media. It led to banks going under, even though accounting pressures on equity were not a liquidity risk in themselves.

Social media caused a quick exodus of NMDs from banks due to deception about their overall health. Banks started losing deposits through digital banking from individual customers to meet regulatory capital requirements. This was misconstrued as a liquidity issue by naive social media users. Liquidity requirements are based on assumptions and may not reflect a bank’s actual risk profile.

The inclusion of ESG frameworks in banks’ strength testing is also a vital consideration from a risk assessment perspective. Pakistan has, on average, around 1 per cent contribution to global greenhouse gas emissions, yet routinely incurs approximately 30pc of the rebuilding bill in the wake of human-caused climate change disasters. This risk is very much recognised by the SBP and the roadmap for mitigation has already been rolled out.

A vital game-changing tool that has emerged in terms of use cases is AI, which is currently deeply penetrated predominantly into marketing pitches. This must be taken ahead, and the use-case scenarios of AI must be expanded beyond marketing to include compliance, control, credit, and other crucial domains.

This is indeed a defining juncture in global banking — the identification of unconventional risks and instituting quantitative and qualitative measures to mitigate the risk of a crisis of confidence seems to be the centre of the plate.

The recent market turmoil emphasised the importance of assessing whether minimum capital and liquidity requirements should be supplemented by measures to account for bank-specific vulnerabilities and the impact of some firms’ accounting policies on reported regulatory capital.

However, making the right calls at the right time on the most consequential issues that drive a firm’s overall risk profile is easier said than done. All concerned players have to work together to craft mitigating strategies jointly with an open mind, generosity in sharing information, and a forward-looking approach if we were to weather this printing-press moment.

The writer is the President/CEO of The Bank of Punjab

Published in Dawn, The Business and Finance Weekly, September 11th, 2023