A recent working paper from the Federal Reserve has examined how financial institutions manage potential risks in their credit card portfolios. The study, titled “Managing Risk in Cards Portfolios: Risk Appetite and Limits,” finds that firms typically employ a consistent approach to risk assessment, constantly monitoring potential risks against predetermined limits or thresholds.
The paper's co-author, Claire Labonne, a senior financial economist at the Federal Reserve Bank of Boston, stated that understanding how firms manage business risks is crucial for bank supervision. She emphasized the importance of appropriately managing risks in credit card portfolios for maintaining firms' safety and soundness.
Labonne collaborated with Tiffany Eder, a senior financial institution analyst at the Federal Reserve Board; Caitlin O’Loughlin, an economist at the Federal Reserve Bank of Chicago; and Krish Sharma, a former research associate at the Boston Fed.
The authors scrutinized how banks handle the risks associated with their credit card businesses. They found that banks regularly monitor these metrics by color-coding their risk levels. For instance, "green" might indicate an acceptable proportion of high-risk credit card customers. However, if this share increases faster than expected, it could escalate to "amber," indicating potential payment delinquencies and unexpected losses for the firm.
If delinquency rates continue to rise unchecked, this metric could reach the "red" threshold, prompting immediate action from the bank. According to Labonne, multiple individuals within a firm are responsible for monitoring these metrics, including risk committees. If issues persist despite these measures, they can be escalated to the firm's board of directors.
Data for this study was sourced from monthly reports provided by four large consumer banks between 2014 – 2021. The researchers discovered that these risk appetite frameworks contain anywhere from 40 – 150 metrics.
Interestingly, these frameworks were found to be "sticky," meaning firms seldom change their threshold limits. Labonne explained that stability is key in risk management, and simply raising threshold limits does not address the underlying causes of unexpected risk increases.
The researchers found that banks typically do not raise threshold limits as a quick fix after breaches, which were found to be rare. Instead, they take other actions such as adjusting their portfolio strategy to reduce risk.
Read the full paper on bostonfed.org.
