Risk tolerance is a concept we frequently refer to, but how often do we have a serious conversation about what it truly means?
By its very nature, risk tolerance is not a fixed, static thing. It changes and fluctuates day by day, influenced by a variety of factors.
Time and time again, I've witnessed how easy it is for people to take on more risk when markets are on the upswing, and then quickly cut back on that risk when things start to go down.
Link pay to profit, and guess what happens?
Risk tolerance increases, as if by magic.
Persuasion plays a role too.
If you have a strong and powerful advocate pushing for taking on more risk, it's amazing how quickly colleagues fall in line and accept that view as well.
Accounting also gets a look in.
If you run your business in a mark-to-market environment, where everything ends up in the P&L today, it can be a remarkably sobering experience. Is it any wonder that some of the biggest losses I've seen have been in lending? The spreading out of pain over years through the loss of net interest margin seems, for some reason, far more acceptable than taking the hit upfront. But in the end, the net effect is the same - it hits capital.
All these factors increase the difficulty of pinning down exactly what risk tolerance truly is.
The techniques we use to understand market, credit, liquidity, and operational risk further complicate matters. They are predominantly quantitative measures, but you can't reduce everything to pure numbers - you need to apply subjectivity as well. I've frequently seen limit breaches, which incidentally breach the stated risk tolerance, be overridden by judgment. More evidence that tolerance is a flexible concept.
But one of my main concerns is fungibility or lack thereof.
Each category of risk has its own limits, and however you look at them, you can't easily compare. Loan exposures cannot be added to liquidity exposures to get anything meaningful, and this is a problem.
You can't directly compare individual risks with each other.
However, you can get a subjective feel for how much overall risk you are taking - is it low, medium, or high? Specifically, what is the chance that your capital will be significantly depleted from the individual risks you have?
Once you boil things down to this very basic common denominator, you are in a much better place to question what you are doing. And there are three important questions to ask:
1. Why should the market pay us to take this risk?
2. Can we correctly price this risk?
3. What experience do we have in managing this risk?
Your answers to these questions should ultimately frame your risk tolerance. By constantly revisiting these fundamental issues, you can develop a clearer understanding of your true risk tolerance, beyond the day-to-day fluctuations and influences.
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