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Federal Reserve Lists Third-Party Risk Management in Supervisory Priority Report

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On May 7, the Federal Reserve Board of Governors released their semiannual Supervision and Regulation Report. The report serves to inform the public about its supervisory and regulatory policies and the state of the banking industry. This blog will highlight and summarize the report's "need to know" content specific to third-party risk management in the financial services industry.

Note: Italicized type represents content directly from the report.

Third-Party Risk Is a Priority

Beyond the safety and stability of the banking system in general, the Federal Reserve (Fed) is also reviewing the risks created by the increasing use of technology by financial institutions. And, the Fed is enhancing its supervisory approaches in response to these risks.

Third-party risk is high on the list of supervisory priorities, both directly and in parallel with other urgent concerns such as cybersecurity, operational resiliency, international sanctions, new technologies and the evolving fintech space.

The Federal Reserve is strengthening its supervisory programs so examiners are equipped to evaluate these risks, notably, the third-party service provider program and the review of fintech used by supervised institutions.

 

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Advancing Technology Continues to Present New and Emerging Vendor Risks

The banking industry is exploring and embracing technology such as artificial intelligence, data analytics and cloud computing. While these advancements can benefit consumers, banks and the financial system in general, these technologies bring new and additional risks that must be managed.

Many organizations rely on third-party service providers to manage their operational and technology infrastructure. Also, services provided by third parties have become increasingly crucial to maintaining the operational resilience of financial institutions and financial markets.

The interconnectedness of the financial system, service provider concentrations, and the lack of substitutes for these services make these third parties critical.

Cybersecurity Remains a Top Concern

The pandemic triggered increased cyber threats and attacks and geopolitical unrest continues to pose a concern. Since ransomware attacks are rising and U.S. banks have raised their security alert levels, cybersecurity remains a top risk identified at supervised institutions. Cybersecurity will be a top priority for the Fed this year, according to the report.

One focus area will review controls in place to manage access to a firm’s systems and information. Another focus area will review a firm’s processes and tools used to detect and respond to ransomware attacks.

Bank Services Company Act and Third-Party Supervision

The Fed supervises institutions to ensure they understand and manage their third-party risks appropriately, but the agency also has the authority to supervise organizations (and their affiliates) that provide services covered by the Bank Services Company Act (BSCA). Services like check and payment processing, back-office services, accounting and data processing are included in the BSCA.

When a service is covered by the BSCA, the agencies can regulate and examine the activity to the same extent as if the financial institution performed the service.

The banking agencies conduct examinations of the service providers that pose a significant risk to client financial institutions and the financial sector. Examinations of technology service providers focus on the management of technology, integrity of data, the confidentiality of information, availability of services, and compliance. Examination results are provided to the service provider and to client financial institutions. The examination results can help financial institutions with their ongoing monitoring of third-party service provider risk.

The interagency program for supervising technology service providers has been in place for several years. However, the use of third-party service providers and technology-based products and services is expanding and evolving quickly. The number, type, and concentration of providers are also changing and, as a result, third-party service providers continue to play an important role in the financial sector.

Fintech Vendors and Associated Risks

In the financial technology space, companies may provide alternatives to traditional credit-risk assessment methods or develop computer software that integrates bank services with non-bank ones, such as account authentication and payment processing. There are several factors contributing to the recent boom in fintech activities like plentiful data, greater connectivity, cheaper computing power and consumer demand for convenient, customized and low-cost financial services.

Consumers and the financial system both benefit from these advances. Nevertheless, these benefits have risks that might compromise consumer protection and bank safety.

Risks stemming from fintech activities are not unique but reflect traditional banking risks (e.g., operational, cybersecurity, liquidity, and reputational risks). As with any new activity, banks are expected to ensure appropriate controls are established to support new fintech products and services. As banks engage in these activities, they should develop and implement risk-management practices and controls at a pace that aligns with their growth.

The regulations and supervision report emphasizes the importance of managing your institution's relationships with third parties so that avoidable harm isn't caused to your organization, customers and consumers or even the financial markets. The Federal Reserve Board requires financial institutions to have comprehensive governance, controls and practices to ensure effective third-party risk management.

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