This shows that the consequences of political upheaval can often have serious economic implications. Another example might be Egypt, where the new interim government has been motivated by popular sentiment to re-examine land deals signed under the previous regime, worth several billions of dollars. Indeed financial institutions continue to wait in many countries throughout the MENA region before reassessing new business prospects in their respective political and economic environments.
Many of these institutions require comprehensive risk management techniques that can account for the unpredictable. Fortunately, following the financial crises beginning in 2007, some risk management concepts are already undergoing re-evaluation in other parts of the world. One key example is the “risk appetite” approach – that is, how much risk banks are willing to assume in the course of doing business. Ultimately a risk appetite approach aims to quantify all types of risk to facilitate decision making by all members at all levels of a financial institution.
Traditional approaches to risk appetite have often foregone consideration of second-order risk types (such as counterparty risk) and even whole risk types such as liquidity risk, as well as interactions between risk types during a crisis scenario. For a lot of institutions, defining risk appetite centered on the goals of strengthening board oversight and giving investors a better sense of the risks the bank intended to run.
These are reasonable goals. However, putting too much emphasis on these goals alone can lead to an overly simplified “top-down” approach to risk appetite that avoids the hard work necessary to make the concept truly useful.
Indeed, banks that successfully balance top-down and bottom-up risk appetite planning and communication will be able to identify business opportunities and potential hazards more effectively. But to do so requires tackling a series of challenges.
Setting risk appetite from the top down is problematic in that it often promotes control and command when the emphasis should be on risk anticipation and dialogue. Controlling risk management in a rigid manner can lead to a set of rules that are too narrowly defined to adequately respond to risky or rewarding opportunities. Following a crisis, for example, banks currently tend to create strictly defined lists of business opportunities that are off-limits. Unfortunately, this reactive measure is often implemented when the risk/reward balance in the crisis-stricken area has returned to a healthy level due to increased transparency surrounding the relevant risks.
The irregularity of political and economic crises inevitably leads to the next crisis appearing in a different business area in a different form – dodging the rigidly defined risk limits put in place. A well designed risk appetite and supporting program of risk analysis should escape cyclicality of this kind rather than reinforce it.
The practical concerns of risk managers in implementing a risk appetite program are numerous. Although influential industry bodies have released reports tentatively setting out a range of metrics that might be appropriate for setting risk appetites, many questions have been left unresolved. These questions can only be answered in context, for example: Are there unique bank - or market-specific metrics that would be helpful; and how do these need to be adapted to suit different levels and departments of the bank?
The findings of a thorough analysis into appropriate metrics will then need to be responded to appropriately. Organization is key, and it may be appropriate to assign specific duties to C-level executives, risk committees, or specific risk appetite task forces. Top-level statements about risk appetite should factor into bank decision-making and an individual or group should be accountable for ensuring it does. All of these processes also require monitoring and evaluation.
A successful risk appetite would influence not only the risk-limit framework, but a bank’s capital management, compensation structures, business strategy, and other important functions.
To fully exploit the potential offered by a risk appetite strategy, banks need to devote more resources to fundamental business-model risk analysis, to linking risk appetite statements to business and strategic decision making, and to forecasting the evolution of risk through the cycle.
This ongoing risk analysis should be applied to identifying areas of business opportunity that can be exploited before competitors arrive – avoiding low margins and high structural risks for a time at least. For banks that appropriate this strategy in this way, risk appetite will become a tool for deciding crucial questions: Where, what, when, which price, and how much. The more common this process becomes, the more risk appetite will become a necessary part of the procedure to identify future business opportunities.
