Summary RSK4802 RISK APPETITE AS CORE ELEMENT OF ERM: DEFINITION AND PROCESS

RISK APPETITE AS CORE ELEMENT OF ERM: DEFINITION AND PROCESS Andrea Cremonino* Abstract Risk appetite represents the decision of how much risk an organization is willing to assume consistently with its strategy. As a matter of fact each business strategy implies some amount of risk, in term of uncertainty with regard to the results will be achieved. Therefore risk appetite represents a fundamental element of ERM as it allows to frame the current risk profile. The goal of this paper is to describe the general idea of risk appetite, its implementation framework, the process to set it within a bank with a strong focus on the interactions with other processes such as planning and control, performance evaluation and communication. Even if risk appetite is a managerial tool, it should comply with regulatory requirements that are shortly described. To provide a full understanding of the risk appetite implementation, it is described how it could be implemented in two other industries: an oil company and a manufacturing one, for instance a car maker. Paper Type: applied Key words: risk appetite, ERM, planning, capital adequacy, performance evaluation, corporate governance, risk control, stress test, banking regulation Introduction Risk cannot be eliminated from the corporate management because it stems from the unpredictability of the future outcome of the business decisions taken. Consequently each company has set up, or it is supposed to set up, an Enterprise Risk Management (ERM) framework, i.e. a set of processes, methodologies and tools to ensure the risk is kept within acceptable levels. The recent crisis and the subsequent amount of company defaults, above all in the financial service industry, strengthened the importance of a proper and effective ERM. The amount of acceptable risk should be set by the company and strongly depends on market conditions and above all by its risk tolerance. Therefore risk appetite represents the core of ERM as it represents the yardstick to compare the current risk profile to. Its full effectiveness is ensured if and only if it is embedded into the planning processes in order to have a “forward looking” ERM that is not a mere reporting or controlling framework. Furthermore there is a growing trend of greater transparency to the markets about the current and target levels of risk as are represented in the risk appetite. The goal of this paper is to describe the general idea of risk appetite, the process to set it within a bank and the interactions with other processes plus some example of application besides financial services. The paper is organized as follows besides this foreword: a section to present the risk appetite framework and its components. Sections 2 and 3 respectively deal with the process and the governance while the following one regards the regulatory requirements. The example to other industry is described in section 5 while the last one summarizes some implementation pitfalls. Andrea Cremonino: Risk Appetite as Core Element of ERM 2 1. Risk appetite framework The risk appetite is a widely spread concept that needs to be structured in a dedicated framework for being implemented in a financial institution. In a more detailed fashion, this framework is made by: the definition of risk appetite itself analysis of the relevant stakeholders and their expectations set of metrics purpose of the risk appetite and its usage the process to set risk appetite interactions with other bank processes, mainly the planning one governance The first two topics are going to be addressed in the following subsections while the process and governance respectively in sections 2 and 3. 1.1. Risk appetite definition Risk appetite represents the decision of how much risk an organization is willing to assume consistently with its strategy. As a matter of fact each business strategy implies some amount of risk, in term of uncertainty of the results that will be achieved. Even if risk appetite is quite a widespread concept, the starting point of the risk appetite framework is the bank define risk appetite itself consistently with its culture and business model. This steps could sound trivial but it is needed to set a common ground to avoid any misunderstanding. In this paper a broad definition is proposed as follows in order to be applied not only to banks or financial companies, but across all industries: “risk appetite is represented by the losses the company is willing and able to stand in order to reach the target results, where potential losses could be also represented by their drivers”. This definition could be reshaped in a more extensive way where risk appetite is expressed in term of maximum tolerated deviation of actual results from the target ones, having losses as extreme event. It is appropriate to underline that the definition of risk appetite both in term of variables included as well as their amount depends on the bank strategy. 1.2. Analysis of stakeholders The risk appetite must then be compared and set consistently with the stakeholders’ expectations and requirements because it is a key component of the bank strategy. As a matter of fact all the stakeholders deem as a core issue the amount of risk held by a bank as well its evolution over time. Here the following categories of stakeholders are considered: Debtholders Shareholders Regulators and Supervisors Governments Andrea Cremonino: Risk Appetite as Core Element of ERM 3 1.2.1. Debtholders The debtholders are those that provide the bank with its funding and are mainly interested in the solvency of the bank, i.e. the capacity to fully and timely keep all the obligations. Even if all of them are bank’ creditors, it is appropriate to part them in three groups: Depositors Interbanking (or wholesale) funding Bondholders First of all as long as there is deposit guarantee scheme that refunds depositors in full, they could be uninterested in the bank management, including risk appetite. As in the crisis many government provided blanket guarantees (e.g. Germany and Ireland), that exceeded the scheme underpinning the banking system, in this paper the focus is on the last two groups. With this regard, the decision making process of the bondholders often relies materially on the evaluation of the issuer as expressed by its rating. That means the primary focus of bondholder is on capital and liquidity strength as proxy of the bank solvability, as also represented by the rating agencies and their evaluation mechanisms. 1.2.2. Shareholders Shareholders profit is defined in a residual way, i.e. what is left from the bank income after all the other stakeholders have been paid back, that could also mean suffering a loss. Therefore shareholders are interested mainly in the bank profitability and its variability over time because their decision making criteria is if the bank expected profit are ad