With the return of market volatility, slowing global growth, increasing debt levels, and growing trade and political tensions, it is time to take another look at Corporate Risk Management. It’s been 2+ years since the OCC Bulletin 2016-05 that formalized the regulatory requirements for the three lines of defense, i.e. Front Line, Independent Risk Management, and Internal Audit. The same bulletin discussed the importance of board-level risk appetite as the defining edge of tolerance for the institution’s risk governance framework.
Since 2016, the independent risk management function has been categorized by financial institutions and regulators as an oversight control function complementing compliance and internal audit. Second line risk management is best described as the thin layer of risk management that manages enterprise risk reporting, executes challenges on model risk, and manages corporate policies over credit, market, and operational risk within the economic and regulatory capital capacity of the financial institution.
Over the last two years, I have seen improvement in risk controls at large financial institutions because of the split between the first line risk controls and the second line of defense. However, I see gaps going forward as the first line is focused on attaining annual financial growth goals and less on sustainable risk-adjusted returns and the second line of defense is too far removed from the changes in the net income.
Why does that matter?
As I mentioned in the first sentence, risks are rising driven by debt levels, margin pressures, financing costs, and uncertainty in government actions.
Debt Levels by the US Government and Corporate America are so high that every 25 bps increase in interest rates increases the risk of crowding out the better corporate and consumer borrowers.
Total corporate debt has swelled from nearly $4.9 trillion in 2007 as the Great Recession was just starting to break out to nearly $9.1 trillion halfway through 2018, quietly surging 86 percent (Cox, 2018). Former Fed Chair Janet Yellen, recently stated, “I think a lot of the underwriting of that [corporate] debt is weak.” (Franck, 2018)
Federal Debt has grown from 10 Trillion in September 2008 to 21.5 Trillion in September 2018 (US Department of the Treasury, 2018). For 2019, the US government debt levels will increase by 1.24 Trillion, which is greater than the projected 2019 deficit of $984 Billion. Looking at the next five-year projected budget deficits, one realizes that the Federal debt will grow by at least $1 Trillion a year (Chantrill, 2018).
The United States had the third highest debt to GDP (105%) of developed countries in 2017, following Japan (253%) and Italy (132%) (Trading Economics, 2018). With projected rising US debt levels, long term rates may rise even if the economy slows. If China stops buying our debt, interest rates will rise, and money will further shift from the Stock Market to the Bond Market.
When the 10-year interest rates are above 3% or when the Fed increases interest rates by only 25 bps, why is that so impactful? The answer is simple. The size of the debt is so large that a small change is significant. The debt is so large that every 25 bps Fed Funds rate increase causes an increase of 50 bps of US debt relative to the GDP due to interest expense.
What should risk management do?
The next recession could be driven by the level of government debt and exacerbated by increased corporate financing costs causing a material decline in profitability.
Risk Management needs to take a more strategic view to manage various interest rate and political outcomes that could have on adverse effect on yield-based assets. The US Banks are vulnerable to net margin declines in 2019 (Ensign et al., 2018). My next Blog will review how banks are saddled with lower yielding assets. Now is the time for Risk Management and Finance to carefully consider how to improve the future risk-return profile of the balance sheet.
Chantrill, C. (2018). Federal Deficit Analysis . Retrieved December 17, 2018, from https://www.usgovernmentspending.com/us_federal_deficit.php
Cox, J. (2018, November 21). A $9 trillion corporate debt bomb is ‘bubbling’ in the US economy. Retrieved December 17, 2018, from https://www.cnbc.com/2018/11/21/theres-a-9-trillion-corporate-debt-bomb-bubbling-in-the-us-economy.html
Ensign, R., & Prang, A. (2018, December 16). Small Banks Brace for Deposit Wars as Interest Rates Rise. Retrieved from https://www.wsj.com/articles/small-banks-brace-for-deposit-wars-as-interest-rates-rise-11544976000/
Franck, T. (2018, December 11). Former Fed Chair Yellen says excessive corporate debt could prolong a downturn. Retrieved December 17, 2018, from https://www.cnbc.com/2018/12/11/janet-yellen-says-excessive-corporate-debt-could-prolong-a-downturn.html
Trading Economics. (2018). United States Gross Federal Debt to GDP. Retrieved December 17, 2018, from https://tradingeconomics.com/united-states/government-debt-to-gdp
U.S. Department of the Treasury. (2018). REPORTS. Retrieved December 17, 2018, from http://www.treasurydirect.gov/govt/direct.gov/govt/reports/pd/histdebt/histdebt_histo5.htm