Community Banking Innovation and Risk Management in the Second District
by Dianne Dobbeck, Head of Supervision, Supervision & Regulation, Federal Reserve Bank of New York
The community bank landscape in the Federal Reserve's Second District reflects many of the thematic financial services issues we see across the United States, including increased competition, not only from traditional peer banks, credit unions, and large banks but also from financial technology (“fintech”) companies and big technology firms providing banking services. Innovation, which is a key trend in banking, will be an ongoing area of focus among community banks as they work to remain competitive by introducing new products and services and adopting new technologies to make their data analyses and operating frameworks more efficient.
In this article, I reflect on notable developments in the banking industry, the impacts on community banks, and the need for firms to maintain proper risk management to protect consumers and ensure the safety and soundness of the financial system. Banks innovate responsibly by understanding the ongoing changes to the way they do business and by establishing proper risk management frameworks and practices to keep up with emerging risks from new product offerings.
A New World — The Changing Banking Environment
How we bank is constantly evolving. Today, that evolution appears to be consumer focused, as firms make banking services more accessible and efficient through digitization. Consumers today are asking for faster banking services and more efficient products, all within a seamless omnichannel experience. Customers' desire to merge banking needs into their existing online ecosystems has piqued the interest of fintech and big tech companies, whose competitive advantage has been building out these very same digital ecosystems over the past few decades. Recently, fintech and big tech companies have more firmly moved into the banking arena, offering banking services such as credit cards, loans, and faster payments through the digital integration of virtual wallets and real-time transfers.
The increasing competitive pressure from tech companies entering the industry has pushed banks to improve their integrated digital offerings at an accelerated rate. Banks of all sizes recognize the need to innovate to retain customers and stay competitive. Community banks, in particular, have expressed concerns about their survival in the industry as they face increasing competitive pressure from nonbanks. Specifically, community banks may have relatively limited resources to invest in new technologies and innovation compared with their larger competitors who benefit from economies of scale and potentially a less structured regulatory framework. Many community banks also have noted difficulties in hiring and retaining expert talent, as they often cannot compete with their larger counterparts on salary, training, and location.
Community Banks Respond — Shifting Business Strategies
Today, community banks must respond to the changing environment by adapting, as they have in the past. In the last few years, community banks across the Second District have updated their strategic plans to emphasize investments in technology. In the Second District, we have observed community banks enhancing and modernizing their online banking platforms with services offered digitally, including corporate offerings, loan applications, and expanded real-time payment offerings. Community banks are also increasingly partnering with third-party vendors and fintech firms to boost operational efficiency and meet customer demand through technological innovation.
There are a few other notable developments among community banks in the Second District:
- First, community banks are upgrading their payments systems to support faster and more varied services for customers. They remain interested in providing real-time payment capabilities to their customers,1 and this interest has only increased given rising customer demand for digital payment options.2 To this end, our community banks view the launch of the FedNow Service3 as a way to compete with the big banks and fintech firms entering the marketplace.
- Additionally, there is an emerging impetus for banks to explore crypto-asset services and products. For example, one bank in our District announced its partnership with digital-assets provider NYDIG to offer cryptocurrency products and services to its customers.4
- Finally, several banks and holding companies have established virtual banking platforms. A few of our District's community banks are partnering with nontraditional fintech companies to offer or expand banking-as-a-service (BaaS) operations. These are partnerships in which banks provide the back-office functions that support the financial products and services offered by fintech companies to the public.
Emerging Risks and Risk Management
As banks embrace and invest in digital products and services, they must also invest in proper risk management. Community banks need to understand how their shifting business strategies affect the safety and soundness of their operations and consumer protection. Specifically, banks should consider the following:
- As community banks embark on new partnerships with third-party service providers and fintech firms, they need to keep their risk management capabilities up to date. Prior to onboarding new partners, they may need to enhance their vendor due diligence frameworks to better understand their risk exposure and mitigate emerging risks from these new kinds of partnerships. They also should enhance continuous monitoring, accordingly. For instance, banks partnering with crypto providers should understand their exposure to the crypto market. Partnering with a crypto provider seemed to be promising and highly profitable a year ago but seems less so since cryptocurrencies have become more volatile as they experienced large swings in value (e.g., bitcoin) or crashed (e.g., terra). One community bank in the Second District was partnered with Voyager, the first crypto lender to file for bankruptcy. Voyager made false and misleading statements regarding its Federal Deposit Insurance Corporation (FDIC) deposit insurance status that led its customers to believe that it had FDIC protections.5 This resulted in many customer complaints and created reputational risk to the bank. The lesson learned is that a bank should thoroughly understand and properly monitor for new market, operational, reputational, and financial risks arising from new partnerships. This is critical and remains a cornerstone of proper due diligence and risk management.6
- Additionally, as banks engage in new digital services and product offerings, they need to maintain the necessary technical expertise. In the Second District, community banks have reported difficulties in hiring experts knowledgeable in specialized fields and operations (e.g., crypto-assets and cybersecurity operations). Community banks face a challenge in hiring and retaining qualified personnel because they often cannot compete on salary, training, and location. In turn, community banks are partnering with vendors to fill hiring gaps and provide the necessary expertise. This does not relieve bank management and the bank’s board of the responsibility to thoroughly understand their products and the emerging risks to their banks and customers.
- Finally, relationship banking has historically been a strength among community banks. It allows smaller banks to thrive with fewer resources than those of their larger competitors. Technological innovation and digitization have the potential to alter the traditional approach to relationship banking as customers move beyond the traditional geographic footprint of the bank to a predominantly online presence. Community banks need to take the time to understand how customers’ banking preferences will affect the community bank business model and how a bank's future operations and financial performance might be impacted. Moreover, in addressing these questions, a community bank will be in a better position to plan for its future and to assess the possible financial implications.
The New York Fed is working to better understand the risk implications for supervised institutions adopting new products and innovative services. We are participating in Federal Reserve System-wide efforts and policy forums with other banking regulators to help inform the development of policies and regulatory frameworks to address the proliferation of technology innovation at banks and support appropriate risk management.
The Federal Reserve and other regulatory agencies have issued new guidance and resources to keep track of innovations and assist banks with these changes. Specifically, in 2022, the Federal Reserve issued Supervision and Regulation (SR) letter 22-6/Consumer Affairs (CA) letter 22-6, “Engagement in Crypto-Asset-Related Activities by Federal Reserve–Supervised Banking Organizations,”7 which requests a bank to notify its lead Fed examiner about its activities related to crypto assets or plans to engage in such activities. The Federal Reserve also published a paper in 2021 describing the landscape of partnerships between community banks and fintech companies and best practices.8
New York Fed examiners continue to work with supervised institutions to ensure they are implementing safe risk management practices as their products, services, and operations evolve.
With more of their customers online today and new entrants in the banking industry, many community banks are exploring additional technological developments to remain competitive. In this evolving industry, it is essential that banks innovate responsibly, enhance their risk management frameworks to include new emerging risks, and work to understand the impact of their shifting corporate strategies on key elements of their business models.
- 1 Tom Groenfeldt, “Community Banks Want the Federal Reserve to Create Real-Time Payments System — Fast,” Forbes, January 29, 2019, available at www.forbes.com/sites/tomgroenfeldt/2019/01/29/community-banks-want-the-federal-reserve-to-create-real-time-payments-system-fast/?sh=5efe5c6e41a9.
- 2 Eric Dotson, “Community Banks and the Adoption of Real-Time Payments,” BankDirector.com, August 12, 2021, available at www.bankdirector.com/issues/technology/community-banks-and-the-adoption-of-real-time-payments.
- 3 For more information, see www.federalreserve.gov/paymentsystems/fednow_about.htm.
- 4 See “Five Star Bank and NYDIG Announce Partnership to Bring Safe and Secure Integrated Bitcoin Investment Services to Existing and Future Checking Account Holders,” Five Star Bank, January 25, 2022, available at www.five-starbank.com/five-star-bank-and-nydig-announce-partnership-to-bring-safe-and-secure-integrated-bitcoin-.
- 5 See the joint press release from the Federal Reserve Board and the FDIC at www.federalreserve.gov/newsevents/pressreleases/bcreg20220728a.htm.
- 6 See the Board press releases at www.federalreserve.gov/newsevents/pressreleases/bcreg20210827a.htm and www.federalreserve.gov/publications/community-bank-access-to-innovation-through-partnerships.htm.
- 7 SR letter 22-6/CA letter 22-6 is available at www.federalreserve.gov/supervisionreg/srletters/SR2206.htm.
- 8 The paper, “Community Bank Access to Innovation Through Partnerships,” is available at www.federalreserve.gov/publications/files/community-bank-access-to-innovation-through-partnerships-202109.pdf.