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By M. Isi Eromosele
The financial crisis that started in the summer of 2008 with
a sharp devaluation of U.S.
sub-prime mortgage assets has raised concerns about the effectiveness of
financial firms’ risk management.
Several issues certainly deserve specific attention,
including the effectiveness of exposure control processes, the objectivity of
credit derivatives valuation and the ability of institutions to respond to
rapid changes in market liquidity.
Risk management is difficult to define precisely, but may be
adequately summarized as the analysis, control and mitigation of risk exposure
in relation to specific business objectives.
Any business activity should deliver a return on investment
(both financial and non-financial) that at least balances the entire portfolio
of risks it is associated with. This concept of balance is essential.
Businesses need to focus on managing financial risk
intelligently so that they can realize a profit commensurate with the level of
risk. The goal, then, is to identify improvements that can be made to current
management practices that can strengthen the risk-return relationship.
Risk Appetite
Typically, risk appetite is thought of as equivalent to risk
tolerance. A more useful view of risk appetite, however, balances risk hunger
against risk aversion and is multifaceted, taking into account several
fundamental considerations.
Risk appetite reflects:
- The business strategy
- The expectations of stakeholders at different time horizons
- The characteristics of the risk-bearing entities
- The nature and characteristics of the risks undertaken
- The possible contagion of risk situations across organizational units, assets-at-risk and future time horizons
Risk appetite can and should be a key part of business
architecture. Of particular note is that:
- Risk exposure results from the business activity. It has to be controlled from a solvency standpoint and it impacts the pricing of financial products.
- Risk
appetite drives business activity. It combines anticipations in risk and
profitability with management preferences to control capital and resource
allocation as well as the distribution of exposure across activities and
portfolios.
Business performance can be increased if capital and
resources are allocated more effectively, reflecting the balance of risks and
rewards in a more integrated and dynamic fashion.
In that respect, risk appetite can be considered the
cornerstone of modern approaches to bank management, such as value-based
management (VBM) and its various implementations.
Risk Appetite And Business Strategy
Any viable business strategy involves a series of tradeoffs
that combine the assessment of uncertain business outcomes with the
organization’s objectives and preferences. The parties involved in the
formation of the strategy usually have different goals.
Any risk measure is not fully relevant if dissociated from
its strategic context. Risk appetite is a critical consideration when
evaluating strategic decisions, especially those concerning mergers and
acquisitions, product portfolio and geographical expansion.
By contrast, using risk appetite as an input to drive
transformational projects should be given a relatively lower priority. While organizational and
operational design are part of the strategy, their relationship with risk and
profitability profiles is less direct than for the other components.
Risk Appetite Should Reflect The Expectations Of
Stakeholders
The recent credit crisis highlights a particular issue that
has long been the subject of debate in business: How can both short and
long-term performance be coherently managed?
Often, decisions made to address one are not compatible with
the optimization of the other. Decisions are typically made in isolation,
either for short-term or long-term horizons. Seldom are these time horizons
being considered as a whole, which can lead
to sudden and unexpected risk exposure.
Risk measures, however, are by definition related to a
single horizon, such as the expected holding period, the financial year, etc.
Extrapolating them is generally difficult, making the implementation of
multi-horizon management a particularly ambitious goal. Not surprisingly, few
of the survey respondents are applying such practices consistently.
Risk Appetite Should Reflect The Nature Of The Risks Undertaken
Information about the magnitude of a risk alone is not
sufficient to make decisions about risk exposure. Put it differently, two
exposures with identical risk levels should be treated differently depending on
the nature and characteristics of the risk involved.
The statement may at first sound irrational, but it simply
recognizes the fact that practical
mathematical models do not capture all the complexity of
event dynamics, nor do they leave room for human judgment and preferences.
A key consideration is the organization’s ability to offset,
transfer or engineer the risk exposure, frequently referred to as risk
liquidity.
The Role Of Risk Appetite In Risk Management
Risk appetite management can have an important role in
correctly linking risk to business decisions.
Required economic capital, defined as the higher potential
loss or depreciation that a business might face over a given horizon under a
given confidence level, has emerged as the preferred normalized measure of risk.
Matching financial resources to economic capital has become the centerpiece of
the art of financial management.
Indeed, most organizations already have economic capital
allocation processes in place, with most of them presently allocating capital
across units, with sophisticated methods based on profit-and-loss correlation
as well as marginal cost of risk.
However, the linkage between capital allocation and business
decisions is not as effective as it could be. Efforts should be devoted to expanding the
granularity of economic capital allocation post-event and leveraging Basel II
infrastructures.
In the short term, institutions should implement appropriate
policies and change programs to address:
- The
responsibility of business units to estimate and disclose the comprehensive
list of risks they are exposed to, as well as the connections between
those risks and expected returns
- The
inclusion of comprehensive risk indicators (short- and long-term) into financial
plans and reports
- The deployment of a cross-enterprise enterprise risk management (ERM) framework that drives and facilitates adoption of risk-based management practices.
Risk Appetite Management
The management of risk appetite is practiced inconsistently
in most companies, but it is being more widely adopted across organizations and
its nature is evolving over time.
An important point concerns the granularity of risk
management on an enterprise wide level. As far as allocation of economic
capital management is concerned, there must be a moderate granularity of risk management
for the three major dimensions of the business structure: organizational, portfolio
and geographical.
Risk appetite is sometimes established top-down, but in most
cases a mixture of top-down and bottom-up should be used. The unit of
analysis can be a business or product line, a department or a portfolio.
Risk appetite has yet to be established at a lower
granularity level. No common practice emerges when it comes to the frequency of
analysis. Some organizations review capital on an ad-hoc basis, while others do
it annually or even quarterly.
Recommendations For Managing Risk Appetite
For those organizations seeking to better integrate risk and
finance management, risk appetite should be given a heightened emphasis. Risk
appetite involves all of the “Three P’s” of total risk management: price, preferences
and probabilities.
It cannot rely purely on conventional risk exposure metrics.
Rather, it incorporates those into the broader context of bank management.
For capital and resource allocation to be effective, risk
appetite should progressively be integrated alongside income, investment and
expenditure in day-to-day management systems.
In such a model, the degree of cooperation between risk, finance
and the business would be increased. It would in particular be:
- Continuous,
rather than cyclical
- More
adaptive, less normative
- Relying
on an increased number of shared processes and databases
Multiple benefits could be derived from this approach. Capital
and resource allocation would be better optimized (enhancing profitability as a
result), alignment between risk and finance would be improved and difficult-to-quantify
elements, as well as longer-term business assumptions, would be better captured
through an enhanced dialogue between the parties involved.
M. Isi Eromosele is
the President | Chief Executive Officer | Executive Creative Director of Oseme
Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control ©
2012 Oseme Group
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