What's your risk appetite?

Published: 12th June 2010 by William Webster

What's your risk appetite?

The regulator is asking boards to define their risk appetite and risk tolerance. Whilst this insistence may be reasonable it certainly doesn't make it any easier to do. Just how do you measure the level of risk you have and then how do you relate that to your firm?

In the new regulatory world the level of risk you are taking is now measured in terms of how much you can lose in extreme scenarios.

This is not the same as the amount you could lose using a 10 day 99% confidence interval. It's not the same as looking at the last 250 days of data. It's not the same as assuming that diversification will protect you. It's not the same as assuming that if all else fails the central bank will bail you out.

When you do the stress testing using quantitative and qualitative analysis of your firm's balance sheet and business franchise it's almost certain that the risk you see is much greater than that you were used to.

You have moved from high probability low loss outcomes to low probability high loss outcomes and a question immediately come to light.

Is the level of risk you have identified acceptable?

Probably not, your existing limit structures (unless designed under stress testing) will allow for a level of risk that should be outside your risk appetite.

In other words stress testing your risk will show you that a greater proportion of your profit and capital is at risk from your existing limit structure. What do you do?

That's for individual boards to decide. It's surely the quality of this discussion that determines the value of the governing body.

For many firms reducing limits and aligning the board's risk appetite with that of the regulator will be the prudent answer. In case of doubt the appetite for failure leading to regulatory intervention and taxpayer support is nil.

For the more adventurous firm that wants to take more risk it’s a matter of convincing the regulator you know what you are doing. Does this sound familiar...................?

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