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Published: February 23, 2010
 / Spring 2010 / Issue 58

 
 

What Is Your Risk Appetite?

To avoid swinging between over-exuberance and excessive caution, set a disciplined target for your desired investment outcomes.

One story of the credit crisis can be told as a “tale of two banks.” Both banks are real financial institutions — 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. But they had very different ways of approaching risk as they struggled to rebuild their businesses.

The first could be referred to as the Bank of Caution. Its leaders deliberately 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 Bank of Caution garnered a great deal of praise, at first, for its responsible and prudent behavior.

The other bank might be called Intrepid & Company. 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: two very different levels of financial performance. The Bank of Caution posted a quarterly loss. Its executives privately admitted that their timid risk policy was largely to blame. Intrepid & Company, in contrast, posted a record profit in the second quarter of 2009 and set aside substantial reserves for both future loans and year-end compensation.

The Bank of Caution’s case is a textbook example of management oscillation after a crisis. In many companies, 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. This story also shows how difficult it can be for senior management to align its risk-taking expectations with the attitudes of rank-and-file employees, and it suggests serious competitive implications for a company that shifts its practices so readily. The problem of excessive caution is pervasive today in a variety of industries. The global financial meltdown has made many business leaders so risk averse that they are missing opportunities for returns.

Why should a sudden wave of prudence be troubling? Because well-considered risk taking is critical, not just for the success of individual 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. Moreover, for any business, the calculation of risk should assess not only potential damages, but also potential rewards and gains — and an overly cautious mind-set makes that more difficult to do well.

Although the need for risk taking is recognized by both businesspeople and economists, the complex web of risks in the 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. It doesn’t help when senior management teams are not practiced at discussing risk in the context of strategic decision making or at articulating their expectations to the organization.

To overcome this problem, many companies need a fresh, more rigorous definition of the appropriate level of risk to take: in short, the articulation of their 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 stake for how much potential 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 corporate-wide performance.

 
 
 
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