Risk Management

A risk appetite is a company-wide statement of the amount of risk that is desirable in day-to-day affairs. Setting this goal, and satisfying it through day-to-day practices, links the firm's strategy directly to operations and implementation. It ensures that the tasks are aligned with the business agenda set by senior management and board of directors. It empowers employees to make the necessary trade-offs between risk and caution on behalf of the future of their enterprise, and gives them the need to understand what they are doing.

Creating and implementing a risk appetite architecture involves a continued multidimensional look at the business. It means deeply into day-to-day practices to understand the interplay of all kinds of risks - market, credit, investment, operational, reputational - within and across different lines of business and how they affect the whole. It also monitors the risks and is identifying trade-offs at the optimum level, neither overextending the firm nor missing opportunities.

Every company in every industry should develop clear risk appetite, especially in this time of financial instability and government oversight.

Just having a process in place can have a dramatic impact. For example, after the financial crisis, one government had to bail out a group of failing financial institutions: commercial banks, insurance companies, and small investment banks. The government was very sensitive to reputational risks that could stem from restructuring the portfolio of acquired financial institutions. Given the mandatory political environment, the government representatives also consider it risky for these companies to make significant short-term profits from potentially risky transactions.

The government is defined as single risk appetite for the group and embedded in the various enterprises. This profile includes a number of specific metrics, reflecting both the desire for gain and the concern about limits. The gross leverage ratio was set at between 20 and 40; this forced one of the recently acquired banks to shut down some of its more highly leveraged businesses.

Setting risk appetite is a valuable exercise during a time of crisis. A multi-national chemical company, for instance, could experience equally powerful gains. Often, there is a perceived need to hedge commodity risk and guarantee supply or incoming raw materials by speculating on their prices. But there are two problems. First, in many cases, the company's management does not know how much risk to underwrite. Given the strategic goals of the company, it is not clear what risks are worth taking. Second, decisions about speculation and hedging are typically made within the business unit, and therefore the risk is not viewed in the context of the total company.Thus, management might judge the risk of high prices in a certain commodity unacceptable and hedge against them,

Also, consider the benefits for energy company that articulate its risk appetite. The share prices of multinational oil companies are generally volatile in earnings and share prices. Therefore, oil companies, and their leaders try to give the impression of stability in the face of fluctuating oil prices. Instead, companies could articulate their appetite for earnings volatility, to both employees and shareholders at the same time. This would provide a visible rationale for hedging, and it would also add to the shareholders' tolerance for fluctuation; it would thus stabilize the share prices overall. The financial performance of airlines is similarly tied to oil prices,and airline executives have only to gain from a clear statement of their threshold of discomfort. Is it $ 75 a barrel, or $ 90? With such a marker in place ahead of time, both management and shareholders can be better prepared for the measures that will be needed when oil prices rise or fall.


Whether a company wants to manage its own risks or how to apply it needs to understand how the target company risks interact with its own, there are five basic components to defining a corporate risk appetite.


The risk appetite exercise

  • The first order of business is to establish a risk baseline by means of credit, market, investment, operational, reputational - in financial terms to develop a baseline understanding of the organization's exposures and concentrations. How much damage would be sustained if all current measures? This exercise must be conducted at the individual business unit level within a company, as well as across the enterprise to understand aggregate risks and diversification benefits.
  • Second, set a risk appetite for the company. This is done through a framework that translates the corporate strategy into a large quantifiable set of metrics and measures for everyone to work with. The exercise involves a series of questions designed to apply a firm's preferences and pain barriers for all types of risks. A company should evaluate risk from three angles:
  1. The overall group tolerance for risk. When looking at the overall company, management might ask itself these questions: What level of financial risk is the group willing to take? For example, what leverage and earnings volatility is acceptable? What level of reputational risk can we handle - and, conversely, what sort of public reputation are we seeking to create? What is our desired long-term credit rating?
  2. The mix of businesses. Executives considering specific units should ask these questions: Should this business be grown, contracted, or maintained as is? Should our oversight and controls be increased, decreased, or maintained? How does this business fit with the other units?
  3. The preferences for aggregated exposure and concentration. An executive team could ask these questions: What is our maximum acceptable level for investments in a single industry or our maximum exposure for a single investment domain? What is the maximum asset class concentration?

After a company catalogs its current risks and clarifies its appetite, a reckoning is most likely in order. Some businesses might prove too risky and others not risky enough.

  • Third, it is necessary to supplement the internal view with an external perspective, looking at the company's risk taking in the context of the competitive landscape. For instance, a manufacturer could find that its leasing business, although profitable and within its risk guidelines, yielded inadequate returns when benchmarked to the industry.
  • Fourth, after a company catalogs its current risks and clarifies its appetite, a reckoning is most likely in order. Some lines of business will continue as they are, but others will need to change or perhaps be divested. Some businesses might prove too risky and risky enough, or the risk level could be on target but the returns too meager.
  • Fifth, once defined, the risk appetite must be monitored regularly. A risk appetite dashboard delivered to managers' desktops can be used to track operations each day.


The adaptable appetite

Even after all this work has been done and a company's risk is no set, no corporate strategy is set in stone. In response to changing business and economic realities, new competitive conditions, or altered strategic priorities, a company's risk appetite will evolve over time. The company must be prepared in advance to make changes easily and quickly, transparent, shared, and monitored to prevent confusion.

In response to changing business and economic realities, new competitive conditions, or altered strategic priorities, a company's risk appetite will evolve over time.

Many business leaders grapple with the question of risk - and with their own company's confidence level. This is hardly surprising, given the turbulence facing companies, even in times of economic growth. Well-considered risk taking is critical for success; companies that are too cautious for too long to discover that they've made a mistake. So they swing too far towards overexposure for a while, and then they get frightened again and overshoot in the opposite direction. This oscillation between high risk and no risk creates a debilitating and confusing state of affairs for customers, employees, and investors alike.

To cope, companies must adopt new risk management strategies such as the risk appetite architecture. Ultimately these strategies will help companies better understand risk, rebuild confidence, and steady the pendulum.

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