Risk appetite frameworks - How to spot the genuine article | Whitepaper
The regulatory landscape for banking and insurance firms – be it speeches, working papers and draft or final regulation – is full of references to risk appetite, its benefits, uses, applications and case studies of failed firms whose weak risk appetite frameworks played a part in their downfall.
When firms are criticised for shortcomings in their risk governance and management, an appetite framework is commonly prescribed as a cure by regulators. And yet, there remains a surprising variety of opinion about what it actually means to establish and embed a proper risk appetite framework.
While the concepts and themes discussed in this paper will be of interest to all financial institutions, this paper is particularly focused on the banking sector. Our goals in this paper are five-fold:
(1) To summarise the arguments in favour of risk appetite frameworks.
We see tremendous practical benefit in adopting and embedding risk appetite within financial institutions (and indeed more widely across corporates and governments, but that is for another time). We believe that, on this occasion, received wisdom has it right: risk appetite frameworks support conscious and profitable risk-taking and help avoid catastrophic failures.
(2) To highlight the emerging consensus on the core concepts of risk appetite between regulators and firms within the financial services industry.
After a period of some uncertainty, a consensus is now emerging around the definition of key terms in the risk appetite approach. Although specific risk appetite language will need to vary from firm to firm (reflecting internal communication needs), the building blocks are taking shape for a common set of notions that will allow a meaningful dialogue between financial institutions and regulators.
(3) To illustrate what we think ‘good’ looks like for a risk appetite framework.
A risk appetite framework is good to the extent that it allows the people who set a firm’s strategy to accept in a conscious way the risks that correspond with that strategy.
It’s good to the extent that people within a firm who take risks on its behalf know what strategic objective they are supporting in their risk-taking; and keep within agreed limits. It’s good to the extent that all of a firm’s material risks are understood, along with the drivers of those risks.
And it’s good to the extent that risk appetite language and culture permeate the firm, its decision-making processes and the understanding of its own performance.
(4) To suggest ways to spot a ‘genuine’ risk appetite framework, by giving examples of the sorts of hardheaded questions we would expect regulators and Non-Executive Directors to be asking firms about their risk appetite frameworks.
It is relatively easy for a firm to relabel or rebadge existing risk management limits and present them for approval to its Board and regulators as a ‘risk appetite framework’. Given the large array of competing demands on management attention, this may seem to be enough. And it may also buy time with the regulator.
But such an approach is a long way from our understanding of a genuine risk appetite framework. Because it is a pale imitation of the real thing, it will naturally deliver only a fraction of the benefits. To test if a particular risk appetite framework is genuine, executives or regulators should probe how deeply the concepts and language of risk appetite have taken root up and down the firm.
(5) To suggest what risk appetite might look like in three to five years’ time, based on the trajectory of regulation and trends in the banking and insurance industries.
Following our review of regulatory pronouncements, policy papers, speeches and both draft and final regulation, we suggest that risk appetite may well become the primary lens through which the quality of a firm’s risk management framework, governance and culture is assessed.
From capital planning to data quality, from governance to strategy, sustainability, remuneration and public disclosure, the applications for risk appetite are far and wide. Firms should expect to be judged on the strength of their risk appetite framework. Executive and Non-Executive Directors should be preparing for the heightened prominence of risk appetite. This is becoming a ‘must-have’ not a ‘nice-to-do’.
Page Last Updated