Articles Logan Wamsley Feb 22, 2024
Stock market gains signal better times for financial institutions. Internal auditors can help these organizations learn from history to address risks and opportunities.
The International Monetary Fund’s latest Global Financial Stability Report, released in October 2023, contains decidedly mixed findings. While the report stresses that high inflation necessitates tighter monetary policies from central banks, it highlights enough positives to be optimistic that the global economy can achieve a “soft landing” and avoid a recession. The report notes that emerging market currencies have appreciated, credit spreads remain tight, and stock markets have rallied significantly since the previous report in April 2023.
This is good news for financial services firms, but more importantly, it also presents a golden opportunity to learn from past mistakes to create more stable, risk-aware companies. Ironically, in times of positive market trends, risk to financial institutions can be just as significant as in times of strife — and often in subtler ways that can have dire consequences.
Just one year ago, the financial services industry witnessed the sudden collapse of Silicon Valley Bank (SVB). Although several factors contributed to this event, arguably the most significant was a lack of asset diversification. Amid an influx of deposits from investors who were profiting from the tech boom during the COVID-19 pandemic, SVB held the deposits in a large amount of U.S. treasuries and agency mortgage-backed securities, with few short-term investments for quick liquidity. Following a classic bank run, the bank had no choice but to start selling these assets at significant losses because of increased interest rates.
This is hardly an isolated incident. First Republic Bank collapsed soon after SVB failed, and earlier this month analysts warned about trends at institutions such as New York Community Bancorp, which saw its stock instantly drop 46% following a report of a quarterly loss.
Despite concerns about the stability of some banks, early indications show that 2024 is poised to be a year of significant stock market gains. Sam Stovall, chief investment strategist at New York-based CFRA Research, recently told Forbes that the S&P 500 index set six all-time highs in January. “Whenever the S&P 500 set a new high in January, additional new highs were set in February 74% of the time,” he explained. “What’s more, whenever there were new highs in both January and February, the full-year return averaged 15.8% — and rose in price 88% of the years.”
In times of prosperity, it can be invaluable to study the past to know how financial institutions should and should not capitalize on the situation. Long-term yield is important, but so is a diverse portfolio that can be quickly accessed for solvency.
The importance of measures such as portfolio diversification highlights the need for each financial institution to take responsibility regardless of actions or guidance issued by the U.S. Federal Reserve or other governing body. According to Nobel Prize-winning economist and University of Chicago Booth School of Business professor Douglas Diamond, in the runup to SVB’s collapse in 2023, the Federal Reserve signaled that it would keep interest rates low for the foreseeable future. Additionally, based on the benchmarks the Federal Reserve used for its February 2022 stress test, SVB likely would have passed.
“I looked at the latest stress test, and the Fed was assessing how the banks would perform at rates from 0% to 2%, as if 2% was as high as they’d ever go. So, almost any bank would pass,” said Diamond in a March 2023 interview with Fortune. “The standard should have been 0% to 7%.”
The foresight to create and follow risk management strategies that exist beyond what governing bodies require can be championed by an effective internal audit function — something SVB lacked. “The Federal Reserve’s supervisory documents … show that internal audit at Silicon Valley Bank was very weak,” wrote Maya Rodriquez Valladares, managing principal of MRV Associates, in an April 2023 Forbes article. Where SVB failed, internal audit functions today should succeed, provided they take the initiative.
One of the clearest actions internal audit can take is constant communication — even overcommunication — between the CAE and key stakeholders within the organization. As stated in Global Internal Audit Standard 11.1 Building Relationships and Communicating With Stakeholders, “the CAE must promote formal and informal communication between the internal audit function and stakeholders, contributing to the mutual understanding of … approaches for identifying and managing risks.”
“It’s imperative that the CAE and stakeholders collectively understand the organization’s approach to risk in the evolving economic landscape and the potential consequences of actions taken both proactively and reactively to address these risks,” says Andy Cook, director of Professional Guidance for Financial Services at The IIA. “Open communication between the CAE and stakeholders allows for improved insights and assessments of the organization’s risk position. To know where risks are present and how to properly mitigate these risks reduces the chance of surprises down the road.”
Establishing lines of communication can solidify all stakeholders’ trust in internal audit’s responsibilities and competence. According to a March 2023 PwC article, “Internal Audit’s Role at Financial Institutions,” these responsibilities can include:
It is easy for a financial institution to react to crises. Reacting — and establishing buy-in for those reactions — when times are positive, however, is more challenging. A sign of an effective internal audit function is its ability to help keep the institution focused on risk and opportunities through diligence, accurate audit findings, and effective communication of findings. When others are living in the present, internal audit should be looking ahead.