Even with COVID-19 dominating the headlines, biologic viruses are just one type of systemic risk to our banking system and economies. In fact, our growing dependence on information technology has made economies across the globe vulnerable to systemic risks amplified by what are often referred to as common-mode failures in which seemingly redundant or independent systems are, in fact, dependent or vulnerable to a common threat.
These kinds of failures (consider the tsunami that hobbled and destroyed the Fukushima nuclear power plant) are difficult or even impossible to predict from historical data. Nowhere is this more true than in the banking sector, where risks are continually changing and in which a reassessment of systemic risks and a new generation of risk management tools are needed, while there's still time.
Cyber Attacks Pose Systemic Risks
US banks and financial services firms are among the biggest users of cybersecurity technology. Still, they are not immune to cyber attacks or failures that can cause widespread disruption to critical services. Recent papers from the New York Federal Reserve Bank and the Bank of England highlight several key concerns. Modelling by the New York Fed, for example, showed how an attack on a single large bank, a group of smaller banks, or a widely used service provider could have "severe implications on the stability of the broader financial system in the form of spillover to investors, creditors, and other market participants."
Additionally, the financial services industry's deep network of interdependent systems and reliance on aging IT infrastructure and longstanding protocols (e.g. SWIFT and Kerberos) boost the number and variety of systemic risks within the sector.
This is no far-fetched scenario. Recent attacks on providers like Travelex and Finastra illustrate the exact scenario that regulators and security experts have warned about. Outside of the US, successful Russian denial-of-service attacks against public and private sector targets in Latvia, Estonia, and Ukraine, including the devastating 2017 NotPetya malware attack, make clear that cyber attacks are not just in the arsenal of foreign adversaries, but have been actively deployed in offensive operations, with collateral damage in the billions of dollars.
Three Steps to Better Cyber Risk Management
There are three key ways that the banking sector, regulators, and policymakers across the government can and should work together to address this problem. Let's take a close look at each.
One of the greater challenges that banks and bank holding companies face is a lack of correct information regarding the frequency and severity of incidents. While national security and competitive needs may require keeping details of some attacks under wraps, reputation concerns are not sufficient reason not to disclose cyber incidents. Disclosure helps management, boards, insurers, regulators, and the whole of government correctly understand the breadth and depth of the challenges faced. They also help foreshadow what lies ahead. In short: A more complete data set would allow cyber risk to be better measured, priced, and mitigated by all interested parties.
In the context of banks and financial services entities, correctly pricing cyber risk and broader operational risk concerns informs investments in IT systems, cybersecurity, personnel, and training. It also supports enterprise risk management, Comprehensive Capital Analysis and Review (CCAR) and other stress testing initiatives. Finally, it may also provide the FDIC and the SEC with crucial information that could guide government decision making in the event of a far-reaching sector-specific incident, as occurred in Ukraine.
Compared with two decades ago, cyber risk today poses significant liability for many organizations. That risk includes the expense related to cyber incident response, fines, lost income from business interruption, and reputational harm. Still, affirmative cyber insurance is still in its infancy. Confused coverage schemes in professional liability policies and so-called "silent" cyber risk pull insurers further from their original intent. Here also, more comprehensive incident reporting will lead to more targeted and effective cyber risk insurance, improving accountability for insureds and carriers alike. For example, the FDIC might require banks and financial institutions with holdings above a certain threshold to carry a robust cyber risk insurance policy in order to qualify for FDIC backing.
The requirements to hold such policies could focus the attention of insured entities on factors that contribute to cyber incidents like aging IT infrastructure, poor patching and IT configuration management practices, and so on. Since cyber risk can be widespread and systemic, mutualization schemes might also be considered, enabling risk-sharing in a public private partnership. Under such arrangements, insurance companies receive fair rates for portions of the coverage limit offered while the US Treasury provides a backstop. Incentivizing better practices in this way and encouraging affirmative insurance as a part of balance sheet strength will be the tide that lifts all boats.
As the world grows smaller and more interconnected, executives and boards of directors for stakeholding banks and financial institutions need to be held responsible for ensuring a reasonable standard of care on matters related to cybersecurity and cyber-risk. The attention of regulators and markets should be focused on observable phenomena: Log and sensor data; operational monitoring and response capabilities; software patches; security updates; and audits of authorization and authentication.
In many organizations, this shift will require additional authority and investment in the CISO function, including more stringent selection and education of boards of directors about best practices and terminology. At the same time, boards of directors should be expected to become conversant in the language of cyber-risk. For banks, such measures could be required as part of FDIC insurance eligibility.
The subsequent, scattershot public-private efforts to combat COVID-19 have underscored the value of organized, top-down approaches to systemic risks. As we work to restart our economies following the drastic measures taken to protect public health, we should be aware that the disruption of key sectors or Internet infrastructure by human error or hostile state or non-state actors has the potential to be just as devastating as COVID-19.
Fortunately, it is not too late for both the US government and the banking and financial services industries to act and reduce the likelihood of systemic failure. Each of the simple steps outlined above will go a long way towards giving the industry a fuller picture of the challenge it faces, the path to robust coverage, and good corporate governance for these important institutions. Together, these measures ensure that the US banking system, which backstops the world's reserve currency, can better manage systemic risks.