Risk Appetite

Risk Appetite

Best-in-class firms consider the design and implementation risk management as an integral part of strategy design and execution, not as an isolated add-on process. New strategic initiatives may open enticing opportunities but the expected rewards have to be balanced against the related risks.

To integrate a risk dimension fully in its strategy, a firm needs to know how much risk it is willing to take and how it wants to balance risks and opportunities. Defining this risk appetite is an essential element of a firm’s enterprise risk management.

Understanding a firm’s capacity for risk

When deciding on its risk appetite for each category of risk, the firm should consider its risk capacity. This includes the amount and type of risk a firm is able to support in pursuit of its business objectives, taking into account its capital structure and access to financial markets, as well as its ‘non-financial equity’, for example the flexibility and loyalty of its work force.

If a firm decides on a strategy and related risk appetite that sits uncomfortably with its financial risk capacity, it may decide to increase the risk level it is prepared to accept. In this way, the risk appetite of a firm establishes a direct link between its strategy and performance management, its risk management and its capital structure.

A well-defined risk appetite forces a firm to include the risk factor in any major strategic or tactical decision, always asking the question: Is this course of action compatible with our risk appetite?

Defining the risk appetite

Defining risk appetite is a task for the partners and senior management, as it is strongly linked to defining the overall strategy of a firm.

Discussions on risk appetite will usually cover a variety of topics such as:

  • Solvability, liquidity, earnings and earnings volatility
  • Credit rating
  • Reputation and brand
  • Expansion into new services, customer groups or regions
  • Acquisitions
  • Environmental impact
  • Governance and compliance
  • Human resources

In this balancing act, the firm should take into account the expectations of partners, regulators and other stakeholders. The risk appetite should also be consistent with the culture of the firm and with the capacity of the firm to manage risks inherent in its business activities.

It can be useful to look at reactions inside and outside the firm to recent risk events to determine the true appetite. It may also be appropriate to test the risk appetite through scenario games of possible risk events.

Qualitative and quantitative risk elements

A meaningful description of a firm’s risk appetite will use qualitative as well as quantitative elements. On various issues, it may include definitions of what is acceptable and what is not.

Once the firm’s overall risk appetite has been clearly defined, the firm should communicate it broadly to ensure all actions of the firm are in line with the risk appetite. At the same time, risk appetite should be operationalised in various processes and procedures and for all relevant risks.