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 everyday 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. Defining the risk appetite 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 make decisions with confidence, especially in this time of financial instability and government oversight.
Creating and implementing a risk appetite architecture requires conducting an ongoing, multidimensional analysis of the business. It means delving deeply into company 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, to avoid both overextending the firm and missing opportunities.
Just having a risk appetite process and framework 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, acquiring controlling interests in some commercial banks, insurance companies, and small investment banks in the process. The government was very sensitive to the reputational risks that it might face as it restructured the portfolios of these institutions. Given the charged political environment, the government representatives even considered it dangerous for these companies to make significant short-term profits, especially from transactions that could be seen as risky.
The government therefore defined a single risk appetite framework for the group and embedded it in the various enterprises. This profile included a number of specific metrics, reflecting both the government’s desire for gain and its concern about limits. For example, the top gross leverage ratio was set between 20 and 40. Simply having this limit in place forced one of the newly acquired banks to shut down some of its more highly leveraged businesses.
Though it might seem only relevant to financial services, defining risk appetite is a valuable exercise for companies in any sector. A multinational chemical company, for instance, might perceive a need to hedge commodity risks and guarantee the supply of some incoming raw materials by speculating on their prices. But this creates two problems. First, in many cases, the company’s management does not know how much risk to underwrite. Given the strategic goals of the business, it isn’t clear what level of exposure is worthwhile. 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, the local management might hedge against the risk of high prices in a certain commodity, without being aware that the larger company’s natural diversification over its 20 units has already compensated for this risk, reducing it to zero and making the hedge unnecessary.
Similarly, 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 devote significant effort to trying to give the impression of stability in the face of fluctuating oil prices. Instead, companies could articulate their appetite for earnings volatility to 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 share prices overall. The financial performance of airlines is also tied to oil prices, and airline executives can only gain from a clear statement of their threshold of discomfort. Is it US$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.