What is your risk appetite? A disciplined approach to risk taking
The systemic risk miscalculations that caused the global financial meltdown have created a crisis of confidence among business leaders everywhere and have made many of them so cautious that they are missing opportunities for returns. What’s needed is a fresh, more disciplined overall definition of the appropriate level of risk that a company should take: in short, the articulation of a company’s risk appetite. Companies must adopt new risk management strategies, such as a risk appetite architecture. Ultimately these strategies will help companies better understand risk, rebuild confidence, and steady the pendulum.
A tale of two banks
Think of the aftermath of the credit crisis as a “tale of two banks.” Both are real financial institutions — both large, well-known, and diversified — that cannot be identified by name. Both were hit hard in the first months of the crisis. Indeed, there was concern that they might not survive. And they had very different ways of approaching risk as they struggled to rebuild their businesses.
The first could be called “the Cautious Bank.” Its leaders retrenched. They dramatically cut back new loans, and they established very high capital reserve requirements, trying to anticipate future regulatory requirements. After a month or two, upper management pushed for more risk taking, but individual traders resisted. The Cautious Bank garnered a great deal of praise, at first, for its responsible and prudent behavior.
The other bank might be called “the Intrepid Bank.” Its leaders chose from the outset to take on more risk, despite the crisis. They set ambitious loan and profitability targets, and they encouraged their traders to continue looking for high-return investments.
The result was two very different financial outcomes. The Cautious Bank posted a quarterly loss. Its executives privately admitted that their timid risk policy was largely to blame. The Intrepid Bank, meanwhile, posted a record quarterly profit in the second quarter of 2009 and set aside a substantial amount of reserves for both future loans and year-end compensation.
The Cautious Bank’s example is a textbook case of management oscillation after a crisis. The pendulum of corporate policy swings to extremes, first embracing risk excessively and then pulling back with sudden force from the perceived cause of trouble. The story also shows how difficult it is for senior management to align its risk-taking expectations with the attitudes of rank-and-file employees, and the serious competitive implications for a company shifting its practices so readily. This problem is pervasive today in a variety of industries. The systemic risk miscalculations that caused the global financial meltdown have created a crisis of confidence among business leaders everywhere and have made many of them so cautious that they are missing opportunities for returns.
Why should this sudden wave of prudence and caution be troubling? Because well-considered risk taking is critical, not just for the individual success of particular companies but also to enable a properly functioning economy. For example, business-to-business lending always involves a certain level of risk; curtailing it can hobble entrepreneurship, deprive deserving businesses of capital, and reinforce deflation.
Though the need for risk taking is well recognized by both businesspeople and economists, the complex web of risks in today’s global economy severely tests many companies, both in their judgment about how much risk to take and in their controls for tracking and managing it. And it doesn’t help when many senior management teams are not practiced at discussing risk in the context of strategic decision making or articulating those expectations to the organization.
What’s needed is a fresh, more disciplined overall definition of the appropriate level of risk that a company should take: in short, the articulation of a company’s risk appetite. Besides asking how much risk to avoid and how to prepare for the downside, corporate leaders should be asking how much risk they want — and how much capital they are willing to put at stake for how much of an up-side gain. These considerations should be discussed and made clear to the organization before the moments of truth in a trade or deal, so that traders and deal makers understand the risk appetite of the company as a whole and the part that their individual deals might play in the overall picture.
Benefiting from clarity
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 risks being taken align with the business agenda set by senior management and the board of directors. It empowers employees to make the necessary trade-offs between risk and caution on behalf of shareholders and the future of their enterprise, and it gives them the support they need to understand what they are doing.
Creating and implementing a risk appetite architecture involves a continued multidimensional look at the business. It means delving deeply into day-to-day practices to understand the interplay of all the different kinds of risk — market, credit, investment, operational, reputational — within and across different lines of business and how they affect the whole. It also means monitoring the risks that are being taken and identifying trade-offs across the enterprise and ways to keep risk at an optimum level, neither overextending the firm nor missing opportunities.
Each company in every industry should develop a clear risk appetite, especially in this time of financial instability and government oversight.
Each company in every industry should develop a clear statement of 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 charged political environment, the government representatives even considered it risky for these companies to make significant short-term profits from potentially risky transactions.
The government therefore defined a single risk appetite for the group and embedded it across the various enterprises. This profile included 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 newly acquired banks to shut down some of its more highly leveraged businesses.
Setting risk appetite is a valuable exercise not only for financial institutions 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 of 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 isn’t clear what risks are worth taking. Second, decisions about speculation and hedging are typically made within one 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, when in fact the larger company’s natural diversification over its 20 units could net the risk to zero and make the hedge unnecessary.
Also, consider the benefits for an energy company that can articulate its risk appetite. The share prices of multinational oil companies typically track the price of oil, but shareholders generally dislike volatility in earnings and share prices. Therefore, oil companies tend to be undervalued, and their leaders spend a lot of effort trying 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 efforts to smooth out earnings, 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.
The risk appetite exercise
Whether a company wants a better handle on its own risks or is mulling an acquisition and needs to understand how the target company’s risks interact with its own, there are five basic components to defining a corporate risk appetite.
The first order of business is to establish a risk baseline by cataloging all the current risks — 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 failed to the greatest plausible extent? 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 largely quantifiable set of metrics and measures for everyone to work with. The exercise involves a series of questions designed to tease out a firm’s preferences and pain barriers for all types of risk. A company should evaluate risk from three angles:
- 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?
- The mix of businesses (judging the risks and benefits for each). Executives considering specific units might 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?
- 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’s 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 might 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 others not risky enough, or the risk level might 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, ensuring that the institution is meeting expectations and can make adjustments when necessary.
The adaptable appetite
Even after all this work has been done and a company’s risk appetite has been defined, 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 these changes easily and rapidly, and the changes must be 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 sometimes discover that they’ve made a mistake. So they swing too far toward 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.