Over the past 25 years, the banking industry has matured the discipline of risk management, creating highly quantitative, analytic approaches to credit, market, liquidity, and operational risks, and elevating risk managers to powerful members of banks’ senior leadership teams.

But “strategic risk,” lofty moniker notwithstanding, remains a bit of a mystery. The regulatory community is less prescriptive for strategic risk than other risks—the OCC defines strategic risk as “the risk to current or projected financial condition and resilience arising from adverse business decisions, poor implementation of business decisions, or lack of responsiveness to changes in the banking industry and operating environment,” which to many observers sounds a bit like a long way of saying “all other” after more tangible risk categories have been defined and analyzed.

The pandemic and the fintech revolution—events that have unexpectedly and profoundly changed customer behaviors and changed the banking operating environment—have highlighted the need for strategic risk management to undergo a transformation and elevation similar to other risk types.

But strategic risk is different from other risk types in important ways. The many models that analyze credit, market, and, to a lesser extent, operational and other risks at a typical bank are mostly grounded in historical data, with an embedded assumption that events and relationships in the past can provide an informed view of the future. Strategic risk—with its underlying driver of “changes in the banking industry and operating environment”—requires banks to step away from history and consider ways in which the future will be fundamentally different. But how?

We see strategic risk as a crucial topic, and an area where banks will benefit tremendously from developing more robust management capabilities. This note will attempt to shine light on some of the common challenges and opportunities they face in doing so.

We will examine four questions:

1. Why is strategic risk important now?

It’s a truism that we live in uncertain times. But we do, and the potential consequences for banks are severe.

Banks’ core economic models are under significant pressure. Despite a decade plus of post-crisis efficiency initiatives, cost structures remain stubbornly high. In many cases, significant portions of the cost structure are tied to legacy infrastructure (dated mainframe systems) and legacy business model features (extensive physical branch distribution systems, cash handling infrastructure, and so on) which are unlikely to remain in the “banks of the future”—but which the banks of today too often feel unwilling or unable to address. Given these constraints, even aggressive institutions have often been forced to settle for marginal rather than step-change gains in efficiency. Revenues, too, are pressured. After years of waiting for interest rates to rise and reflate NIMs, the rate environment increasingly looks less like a cycle and more like a secular shift in monetary policy—with negative consequences for historically NIM-driven business models.

In sum, banks appear to have little margin for error, little “cushion” to protect them against the impact of disruptive events—and disruption is occurring. Consumer and commercial behaviors and preferences are evolving (for example, rapid growth in digital and mobile preferences) at a pace which outstrips banks’ ability to evolve their service offerings—and with further acceleration being driven by COVID. Potentially nimbler nontraditional competitors (among them neobanks, BaaS providers, fintechs, big techs) are stepping in—with the potential to offer more compelling client value propositions, with radically lower cost structures and fewer legacy infrastructure constraints, than traditional banks.

The Bank for International Settlements, in a recent consultative paper on the implications of fintech developments for banks, highlighted the stakes for banks (see figure 1).

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