Top 4 Internal and External Risks Impacting Community Banks

Community banks operate in a progressively complex financial landscape, facing various risks that can impact their stability and growth. As these institutions serve local economies and small businesses, understanding and managing key risks is essential to ensuring long-term resilience and operational efficiency.

The evolving banking environment presents external and internal risks requiring careful monitoring, strategic response, and effective small-business banking solutions. External factors such as rising funding costs, regulatory pressures, decreased net interest margins, and core deposit growth challenges pose significant financial performance risks. These risks are influenced by broader economic trends, policy changes, and shifts in consumer behavior, making it imperative for banks to adopt adaptive community bank risk management strategies.

Internally, cybersecurity risks, the rising cost of technology implementation, liquidity pressures, and workforce retention challenges continue to shape the risk profile of community banks. This blog will discuss the survey insights on the top external and internal risks impacting community banks.

External Risks Impacting Community Banks

Community banks face a challenging external environment shaped by economic conditions, regulatory shifts, and market volatility. The 2024 CSBS Annual Survey of Community Banks highlights four significant external risks:

Cost of Funds

Cost of funds is the most pressing external risk, with nearly 89% of respondents ranking it as either “extremely important” or “very important.” This concern remains at the forefront, as financing costs have significantly increased due to the Federal Reserve’s restrictive monetary policy. Compared to 2022, when only 48% of bankers cited cost of funds as a significant concern, the current heightened focus reflects the prolonged impact of rising interest rates.

Growing competition for deposits further compounds the challenge. For community banks, higher rates are needed to retain customers, squeezing profitability. Effective community bank risk management policies can help balance deposit costs and stability.

Regulatory Challenges

Regulatory compliance is also a critical external risk, with 89% of small business banks marking it as an essential concern, nearly tying with the cost of funds as the top-ranked risk. The increase from 81% in 2023 and 77% in 2022, reflects heightened uncertainty and regulatory burdens following recent banking disruptions.

Policymakers and regulators have tightened oversight of liquidity management, capital adequacy, and risk governance, increasing banks’ compliance costs.

Net Interest Margins

Net interest margins (NIM) ranked as the third most crucial external risk, with 88% of community banks citing it as a significant concern. While NIM was previously the top external risk in 2023 and 2022, its significance remains high due to ongoing margin compression challenges. The most extended inverted yield curve in U.S. history, which began in 2022, has created difficulties for banks by keeping short-term interest rates elevated while long-term lending rates remain lower.

This has significantly affected earnings, as loan repricing lags rising deposit costs. The survey underscores the need to explore alternative revenue sources while strengthening community bank risk management strategies to mitigate margin pressures.

Core Deposit Growth

Core deposit growth remains a key external challenge, ranking fourth in the survey, with 84% of respondents highlighting it as critical. This has persisted since 2022 when rising interest rates began driving depositors toward higher-yield alternatives. The prolonged yield curve inversion has strained core deposit growth, as competition for funds has intensified.

The survey also found that community banks are increasingly turning to wholesale funding sources, with 56% of respondents planning to use or continue using such sources, an increase from the previous year.

Internal Risks Affecting Small Business Banks

Community banks must manage internal risks impacting operational stability, regulatory compliance, and long-term resilience. Effective community bank risk management is essential to navigate these challenges. The 2024 CSBS Annual Survey of Community Banks highlights four primary internal risks:

Cybersecurity Risks

Cybersecurity remains the top-ranked internal risk, with 96% of respondents citing it as either “extremely important” or “very important.” The growing reliance on cloud banking has made institutions more vulnerable to ransomware attacks, phishing schemes, and data breaches. The cost of a cyber incident can be devastating, leading to financial losses, reputational damage, and regulatory penalties.

In response, community banks are investing in advanced threat detection systems, AI-powered small banking business solutions, and employee cybersecurity training. However, as cybercriminal tactics evolve, maintaining robust security protocols remains a continuous challenge.

Technology Implementation and Operational Costs

As the demand for digital banking rises, community bank risk management must address the high cost of technology adoption and operational upgrades, which are significant internal risks. 80% of banks cite this as a primary concern. Implementing cloud-based infrastructure, AI-driven analytics, and digital payment systems is essential for competitiveness but requires significant upfront investment.

Smaller community banks often struggle to match the digital capabilities of larger institutions due to budget constraints and limited IT resources.

Liquidity Pressures and Emergency Funding

Liquidity pressures continue challenging small business banks, particularly as interest rate volatility and deposit outflows create funding uncertainties. While liquidity risk dropped from 84% in 2023 to 78% in 2024, it remains a significant concern. The survey found that 40% of banks hesitate to use emergency liquidity facilities, mainly due to the stigma associated with borrowing from government-backed programs and concerns about regulatory scrutiny.

Additionally, rising loan delinquency rates put further pressure on liquidity management. To mitigate these risks, banks are strengthening their contingency funding plans, diversifying revenue sources, and optimizing cash flow strategies.

Staff Retention

Talent retention remains a key aspect of community bank risk management, though concerns have eased slightly in recent years. According to the survey, 75% of banks cited staff retention as a critical risk, down from 77% in 2023 and 85% in 2022. While this indicates some improvement, workforce shortages remain a concern, primarily as community banks compete with larger institutions and fintech firms for skilled professionals.

High turnover rates can disrupt bank operations, increase training costs, and reduce institutional knowledge. To address this risk, banks are enhancing employee benefits, providing career development opportunities, and adopting flexible work policies.

Leverage Tech-Based Small Business Banking Solutions to Strengthen Risk Management

Managing risks effectively requires a structured, technology-driven approach that allows mid-scale banks to enhance risk oversight, standardize risk management processes, and streamline operations. Predict360 Essentials is designed specifically for community banks and growing institutions, providing them with preconfigured tools for managing risk assessments that simplify complex regulatory and operational challenges.

With comprehensive risk libraries and standardized assessments, Predict360 Essentials provides risk assessment for banks across key areas such as BSA/AML compliance, cybersecurity, fair lending, and vendor management. Instead of relying on manual spreadsheets and decentralized processes, community banks can utilize real-time issue tracking and AI-driven insights to strengthen their risk management framework.