The Risk Appetite Exercise
Whether a company wants to get a better handle on its own risks or is mulling an acquisition and needs to understand how the target company’s risks might interact with its own, it must consider five basic components in defining a corporate risk appetite.
1. Establish a risk baseline. Catalog all the current risks in financial terms to better understand 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 as well as across the enterprise to illuminate aggregate risks and diversification benefits.
2. 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 the following angles:
- The overall group tolerance for risk. When looking at the overall company, management might ask itself these questions: What level of financial risk are we willing to maintain? 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. 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?
3. Supplement the internal view with an external perspective. Look 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, yields inadequate returns when benchmarked to the industry.
4. Implement the implications. 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.
5. Keep an eye on the dashboard. 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
It is important to keep in mind that 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 therefore be prepared to make changes easily and rapidly, and the changes must be transparent: visible, shared with key constituents, and monitored to prevent confusion.
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 significant mistake. They swing too far toward overexposure, 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.