Banking remains strong, but cybersecurity, prime brokerage services, credit risks (and more) continue to bedevil, report finds

Though the banking system remains strong overall, with robust capital and liquidity and improved asset quality, issues such as cybersecurity, prime brokerage services and credit and other risks either remain or are emerging as concerns for banks and other financial institutions, the Federal Reserve said in a report issued Friday.

In its Supervision and Regulation Report for May 2022, the Federal Reserve said that the financial conditions for both large and community banks is strong, with improving asset quality metrics in the second half of 2021, solid profitability (despite pressure on net interest margins (NIMs), and loans expanding.

However, the report singles out some concerns. For large institutions, the report states, cybersecurity remains a high priority. “Cyber threats and attacks increased with the onset of the pandemic and are an increasing concern resulting from geopolitical unrest,” the report states. “Increasing ransomware attacks are a risk in the financial sector.”

In addition, the report states, the Fed is also reviewing risks created by the increasing use of technology by financial institutions. The agency is enhancing its supervisory approaches in response to these risks, the report states.

Along those lines, the report notes that interagency examinations will continue during this year, with focus on two areas: review of controls that are in place to manage access to a firm’s systems and information, and review of a firm’s processes and tools used to detect and respond to ransomware attacks. “Particularly while the Russian invasion of Ukraine heightens geopolitical tensions, examiners will continue to regularly monitor firms’ efforts to maintain effective cyber defenses,” the report notes.

The report also singles out prime brokerage services as posing significant liquidity and credit risks. “These risks are heightened by the complexity of prime brokerage services and lack of transparency into the trading and investing activities of the investment fund clients, particularly trading activities with other counterparties,” the report notes. “Strong risk management and controls are critical to the safety and soundness of a bank that provides these services.”

The Fed report contends that liquidity shortfalls and credit losses from prime brokerage activities occurred during the financial crisis of 2007–08. The report claims that, since then, these services have grown in complexity, resulting in other risk-management failures. The report points to the default of Archegos Capital Management as highlighting gaps in bank risk management. Archegos was an investment firm with large exposures to a small number of U.S. and Chinese technology and media companies, the Fed said, adding that it defaulted last year, causing losses of more than $10 billion across several large banks.

For community (and regional) banking organizations (CBOs and RBOs), the report highlights two risks: credit and operational. Though the report points out that neither risk has yet resulted in specific issues, “uncertainties continue to persist.”

On credit, the Fed said its examiners have noted that risk may be increasing at community and regional banks because of their exposure to certain sectors particularly affected by the pandemic. “CBOs and RBOs are often more concentrated than larger banks in commercial real estate lending, a loan category that has been particularly impacted by the pandemic,” the report states.

On operations, the report states that risk issues can arise from dependence on or increased activities with third-party technology providers. “Smaller banks can also be vulnerable to cyberattacks and outages, as they may have less robust information technology infrastructure than larger institutions or may be more reliant on third-party vendors for their services,” the report states. “Additionally, small banks report challenges with hiring and retaining qualified information technology and cybersecurity staff.”

Federal Reserve Supervision and Regulation Report, May 2022