What's first strategy or risk appetite?
A regular feature in the Investors Chronicle is a column called “Portfolio Clinic”, it evaluates a reader’s investments, appetite for risk and their retirement plans. Often the reader gets a shock - their assumptions about risk and return do not match and they are forced to adjust their plans. In this way investment strategy and risk appetite are inextricably linked.
Businesses too have strategies that are closely connected with the risk they are prepared to assume. Firms that need to operate with tight safety, (nuclear power, refining, aircraft manufacturing), have strategies that recognise this as failure is costly - Tokyo Electric, BP, Boeing.
In entrepreneurial sectors (technology, pharmacology, alternative energy) the strategy recognises greater variance in returns and the risk appetite accommodates.
On this scale I’m sure we would agree that building societies are “conservative”. But does risk appetite drive strategy or vice versa? (A thought-provoking question for any NED).
On the "edge"
The strategy surely identifies the “edge” your business has and how best to exploit it. It is only after defining your strategy to benefit from your perceived advantage that you can really see what it means in terms of risk.
If you start with the risk appetite and attempt to fit the strategy around it, you are likely to miss out on identifying and exploiting the franchise your business has to offer. To be clear, I’m not suggesting an aggressive lending strategy that overrides risk but by putting the strategy before risk and using iteration to make sure that both work together you end up with a better outcome. It’s about recognising the idiosyncrasies of your business and where possible exploiting them within a risk appetite you are comfortable with.
Notwithstanding I recognise that risk appetite in some Societies does drive the strategy and this leads to a further engaging question. How do you determine what your risk appetite is?
You could respond with reference to solvency, profitability, franchise, resources, skill, expertise and experience – all sensible starting points. However what matters is the process. Does top down direction work with bottom up insight, to agree an appropriate risk limit?
You can now see that by linking member value and the need to operate for extended periods under difficult conditions NEDs can explain how the risk limit(s) supports the strategic objective(s) of the society.
What do I see?
I’m not privy to what happens in all the sector’s forty plus Board rooms however I know Boards don’t find this easy. Published documents show that some Societies could do more to link strategy and risk together.
Furthermore, I’m sure you can find instances in your own firm where it’s hard to determine the role strategy and risk take in driving what you do. When this happens, a common underlying factor appears to be regulation or the fear of falling foul it.
As a consequence, sometimes we are guilty of trying to gauge the regulator’s appetite for risk (a bit like spoof). Whilst this may give NEDs some personal comfort it’s not what the regulator intends and what’s more it isn’t benefiting members per se.
In Portfolio Clinic, it’s akin to holding only Gilts – great in the short run but ultimately a lot riskier than a balanced portfolio mainly because the return will be sub-optimal.
It may seem unfashionable but making money is still important.
Summary
Strategy and risk appetite are closely linked. My view is that to get the most out of your business strategy comes first;
There is an iterative process that connects strategy to your risk appetite and in this way a sensible balance is the outcome;
I acknowledge that some Societies may put risk appetite as the driving force – if this is you, where does the risk appetite come from, is it the Regulator?
NEDs may feel personally comfortable keeping risk to a minimum, but they should ask whether this is in member’s interests.