Risk Appetite ....is back, at least in the soul-search!

There is new market-wide focus on the creation, adoption and implementation of appropriate Risk Appetite statements for financial firms. The key challenges in this include but are not restricted to: How to define it (top-down, generically and at level of portfolio/marginal risk), How to dimension and communicate it, How to monitor it (reporting issues, common metrics, creation and artistry of a “risk dashboard”), How to test it (potential loss and limits architecture and monitoring, scenario analysis including non-quantitative “what-if” tests), How to reconcile business strategy with it (including acquisitions and divestitures) and not least How to align incentives with it (compensation issues).

Many companies are currently working on detailed statements of Risk Appetite. Boards have begun to insist that they see one and actively discuss the same with the CEO, CFO and CRO. The process includes Dimensioning Risk Appetite, formulating a Statement/s of Risk Appetite, Communicating this all the way along and down the organization.

Risk Appetite dimensions of a firm typically should include a Quantitative and a Qualitative component/s. Quantitative Risk Appetite is articulated at the level of the firm overall, and usually also at one or more subsidiary levels such as key businesses, regions, products, and risk-types as well. Dimensions include

- Economic and Regulatory Risk Capital
- Value-at-Risk, Earnings at Risk, and the requirement that these be related to both the Risk Appetite overall and to the subsidiary structure of product and risk level Limits
- Scenario Analysis & Stress-Testing Results at portfolio and transactional levels.

Some leading banks have operational-ized the Risk Appetite statement - at a portfolio/transaction level, risk-takers and risk-managers must justify, approve, monitor, and report on Stress Returns, and Returns on Capital i.e. RAROC, RORAC, RORC, NIACC etc..

Qualitative Risk Appetite includes some range of acceptable risks and boundaries across
- Businesses that the firm will do and How
- Unusual, Unintended, and Unacceptable risks
- Approach to Legal and Regulatory grey areas
- Ethics and Conflict of Interest Policies/statements
- Loud clarity on unacceptable behavior (articulating policies on, say, sexual harassment and discrimination are relatively easy as they belong in the zero-tolerance zone. Firms seem to find things so-very-difficult once you go beyond these simple examples)


Will be back with more on this as also on Risk Principles, Policies, processes....

Jaidev