Risk Appetite

Institute of Risk Management

South Africa

Gert Cloete
David Goldsworthy
Prelude
2

Ask yourself these questions:

• Would you ever take up hang gliding? What

about base jumping?
• Would you drive a car if the seat belt was
broken? To get to an important meeting
maybe?
• Would you post a potentially compromising
picture of yourself on Facebook?
• If you were down to your last R1,000, would
you bet R10 on a horse after a hot tip? R100?
Your whole R1,000?
• At age 65, would you invest 25 per cent of
your pension fund in the share market? 50
per cent? 100 per cent? Or none at all?
• Would you jaywalk at a busy intersection to
save a minute?
 Contents
3

1. Defining Risk Appetite

2. Risk Terminology
3. Objectives of an Effective Risk Appetite Statement
4. Risk Appetite and Strategy
5. Responsibilities of the Board
6. Risk Appetite and Stress Testing
7. Difficulties in Implementing Risk Appetite
8. Example Case Study
9. Final Word - Risk Appetite and the Credit Crisis

References:
- ‘Risk Profile Workshop’, Discussion Noted for Workshop, True North Partners
- ‘Defining Risk Appetite’, Early Mover Series, Protiviti
- ‘Risk Appetite and the SAM Risk Management System’, Quindiem Consulting
- Implementing robust risk appetite frameworks to strengthen financial institutions’, Institute International Finance
1. Defining Risk Appetite
4

•Defining and characterizing “risk appetite” remains a vexing challenge.

•The term “risk appetite” rolls easily off the tongue, and it is even simple to
define at a high level.
•The UK’s Financial Services Authority (FSA) states:
o “Risk appetite is the amount of risk that one is prepared to accept,
tolerate, or be exposed to at any point in time.”
•Easy to say, perhaps, but the idea is not so easy to translate into practice.

“People know risk

appetite is important, “There’s no
and they think they’ve “Our challenge as non- ‘hitchhikers’ guide’ to
got it. But the industry executives is there is no risk appetite, and no
is still falling short on definition. We are agreement there
how to think about it. dealing with words, not should be one.”
We don’t have a well-understood and
paradigm yet.” agreed concepts.”
 2. Risk Terminology
5
Risk capacity
If risk
profile
Risk The maximum amount of risk an entity is able to falls in this
Buffer, if
Capacity support within its available financial resources . area, we
applicable are in
breach of
risk
tolerance
Risk tolerance limit
Risk The maximum amount or type of risk the entity is Forward
If risk
profile
tolerance prepared to tolerate above risk appetite. Risk Profile
falls in this
(Expected
area, we
and
are in
Stressed)
breach of
risk
appetite
How much and what type of risk the bank is but within
Risk

Budget/ Stress
generally prepared to accept to achieve its risk
appetite tolerance
financial and strategic objectives.
Risk Appetite Trigger
If risk
profile
Current risk profile is the amount or type of risk falls in this
the entity is currently exposed to area, we
are within
Risk Forward risk Profile is forward looking view of how risk
Current Risk
profile the entity’s risk profile may change under both profile appetite
expected and stressed economic conditions
2. Risk Terminology
6
Risk capacity
If risk
profile
falls in this
area, we
are in
How much and what type of risk the bank is breach of
Risk
appetite generally prepared to accept to achieve its risk
tolerance
financial and strategic objectives
If risk Risk tolerance limit
profile
falls in this
area, we
are in
Risk Refers to the specific amount or percentage breach of
appetite risk
trigger appetite
Serves as an early warning indicator but within
risk
tolerance
Risk Appetite Trigger
If risk
profile
falls in this
area, we
are within
risk
appetite
3. Objectives of an Effective Risk Appetite Statement
7
There are many reasons for building a risk appetite statement – these are some:

A. MESSAGING

• A CEO or Board that operates without any boundaries signals that

they are unfocused strategically.

B. REAL WORLD VIEW

• What risks do we seek and why?

• What risks do we want to avoid and why?
• What risks do we manage better than our competitors and can we use
this to our advantage?
• What risks do we have to reduce to an acceptable level and over what
time horizon?
• What emerging risks do we want to address?

C. STRATEGY ALIGNMENT

• Opportunity for management to clarify to the board that the company

has a strategic focus i.e. we know what we do and don’t want to do.
4. Risk Appetite and Strategy
8

Strategy and “Best-of-class companies do not discuss and design their risk
risk management as an isolated add-on process, but as an
management integral part of their strategy design and execution. New
strategic initiatives may open enticing opportunities, but the
expected rewards have to be balanced against the related
risks”

Dynamic Risk Appetite Strategic

Planning
• Risk appetite formulation is a key
element of overall strategy Risk
Monitor
• Risk capacity – a company’s ability Appetite

to take on risk – is compared

against a company’s planned risk

REVISE
profile in the self-assessment
process
• Risk monitoring is included in the Risk
Budgeting
Assessment
broader KPI’s that support strategy
• As with strategy, risk appetite needs
Self
to be dynamic and periodically Assessment
reviewed
 5. Responsibilities of the Board
9

Risk appetite “A well-defined risk appetite forces a company to include

and decision the risk factor in any major strategic or tactical
making decision: is this course of action compatible with our risk
appetite?”

Board of Directors Management

• Sets and/or approves the overall • Develops business strategy, sets
risk appetite and risk tolerances financial targets (e.g. growth,
that align with stakeholder Risk earnings, ROE)
expectations Contract
• Determines overall economic capital
• Approves capital plan needs and performs capital budgeting
• Ensures appropriate risk and allocates capital
governance • Manages business to achieve results
according to detailed business plans
and agreed risk tolerances and limits

Management develops and executes strategies and plans that are

consistent with the Board mandate on risk taking
6. Risk Appetite and Stress Testing
10

The setting of risk appetite is an iterative process

involving the group’s strategy and stressed forward risk profile

Capital buffer
Liquidity position

Mitigating actions
(formalised in
IRP)

Stress testing and RA supports communication with internal and external stakeholders
7. Difficulties in Implementing Risk Appetite
11

Magic Number

There is no one metric that captures risk appetite

Embedding

Difficult to drive risk appetite down

Qualitative statements

Focus has been on quantitative statements thus far

Interlude – Brain Teaser
12

When the Board is required to formulate risk appetite for their

company, how is ‘risk appetite’ best defined?
1.A calculation of a set of limits of risk exposure that is
acceptable to the firm.
2.The amount the firm decides to spend on risk management
programs.
3.The extent and the types of risk that are acceptable to the
organisation.
4.How much the firm decides to spend to transfer or mitigate
their risk.
Interlude – Brain Teaser
13

When the Board is required to formulate risk appetite for their

company, how is ‘risk appetite’ best defined?
1.A calculation of a set of limits of risk exposure that is
acceptable to the firm.
2.The amount the firm decides to spend on risk management
programs.
3.The extent and the types of risk that are acceptable to the
organisation.
4.How much the firm decides to spend to transfer or mitigate
their risk.
 8. Example Summary Case Study
A. Define the Risk Appetite Approach
14
Monitor and revise risk appetite as appropriate

Define Appetite, Reconcile Risk Profile

Risk Appetite Planning Finalisation
Tolerances and limits and Appetite

Develop Risk Mandate Risk Appetite Statement Risk Profile Risk Appetite Statement
• Mandate from senior Design • Measure current risk profile • Obtain board approval for
management for each risk statement
• Broad organizational Risk Appetite • Aggregate individual risks to • Roll out and implement
representation • Propensity to take risk produce overall risk profile • Monitor and report
• Risk Appetite framework • Develop companywide risk
appetite Profile vs. Appetite
Business Environment • Compare aggregate
• Understand Group’s Risk Tolerances appetite and profile
strategy and risk profile • Propensity to exercise • Adjust risk profile and/or
• Identify Risk Appetite control appetite as necessary to
Stakeholders (internal and • Identify risks to manage bring them into agreement
external) • Allocate risk appetite to set
• Understand stakeholder risk tolerances
Risk Appetite expectations • Measurement

Develop Risk Appetite Risk Limits/Targets

Governance mechanisms • Define limits and /or targets
• Risk Appetite accountability for each risk
and reporting • Monitoring
• Risk Appetite filters
Measure risk and define appetite in terms of current risk quantification capabilities
Enhance risk quantification capabilities and revise statement as necessary
Current progress
8. Example Summary Case Study
B. Define the Risk Appetite Framework for Operationalisation
15

A Framework within which Risk Appetite has context and can be operationalised
 8. Example Summary Case Study
C. Define Key stakeholders and Expectations for Risk Appetite
16

(b) Understand Stakeholder Expectations:

(a) Define Key Stakeholders:

8. Example Summary Case Study
D. Identify & Filter the Feasible Risk Universe
17

Desirable
Risks

UNIVERSE REGULATORY
FILTER
OF BUSINESS
DECISION
POTENTIAL FILTER
RISK 1
Un-
desirable
REQUIRED
Risks RETURN
FILTER

Does company have

available capital to Feasible
allocate? Opportunities

Does company have

available capital to
AVAILABLE CAPITAL
allocate? 2 FILTER

YES – allocate capital NO – utilise

and set tolerance levels shareholder Feasible
according to decision approved capital 3 Risks
process below injection budget
 8. Example Summary Case Study
E. Capital Allocation Considerations
18

Feasible Higher ROE- set high

Risks tolerance levels
Return on Equity
(ROE)
Lower ROE - set lower
tolerance levels

Feasible Risks within

defined Risk Appetite
Propensity to accept risk: Allocate more capital
and set higher
PROPENSITY E.G. tolerance level for risks
with higher RORAC
AVOID Regulatory Available Capital
Risk Allocate less capital
AVERSE Market Risk and set lower tolerance
level for risks with
higher RORAC
CONSERVATIVE Credit Risk

RECEPTIVE Underwriting
Risk
UNLIMITED None
 5. For consideration – Risk Appetite and the Credit
Crisis
19

• The clip to be shown explains some of the key drivers

behind the precursor to the credit crisis – namely the
sub-prime crisis in America. The Crisis of Credit
Visualised:
• Consider, as you view it, in light of this presentation
and what you know if risk appetite, how an effectively
designed and implemented risk appetite framework
might have helped in answering the following
questions before-the-event:
o Did organisations take more risk than their
capital, liquidity and risk capabilities could bear?
o Did firms take risks that their management and
Boards did not properly understand?
o Was there a disparity between the risks the
Board perceived the firms to be taking and the
risks they actually took?
“Three years after the crisis, …., there is now consensus between supervisors and the Industry that a
clearly articulated statement of risk appetite and the use of a well-designed risk appetite framework to
underpin decision-making are essential to the successful management of risk”.
Implementing robust risk appetite frameworks to strengthen financial institutions - IIF