Budgeting for Risk – Part 1
Since I began advising clients on risk related issues, the discussion regarding risk appetite or risk tolerance has always been a hot topic. I have yet to see a corporate risk policy that doesn’t address the concept of risk appetite and tolerance in some form or capacity. Many a company’s also talks about defining the risk appetite and requiring board approval of the appetite. During this same time the sophistication and technology support to quantify and analyze risk has vastly improved.
Despite the great interest to define and approve a risk appetite, and the improved ability to calculate risk, most companies do not quantify a true risk appetite, and believe that merely establishing a limit structure is equivalent to the quantification of a risk appetite. In a recent conversation with a former CFO at a major United States energy company he stated, “There is a need for companies to establish a clear risk appetite upfront and communicate it to all decision makers so that everyone can align goals, processes, governance, risk decisions, budgets, etc. around that. Too often companies assess or set their risk appetite after their models, reports or in fact actual circumstances dictate a number, and that is not the way or order in which it should happen.”
To this I would add that even when a number is established it is usually in the form of a limit viewed as something to be avoided versus managed or optimized. Additionally, this established number is usually not defined with target earnings or risk based performance expectations taken into account.
To this I would add that even when a number is established it is usually in the form of a limit viewed as something to be avoided versus managed or optimized. Additionally, this established number is usually not defined with target earnings or risk based performance expectations taken into account. Anyone who has been around me for more than 5 minutes has heard me say that “Risk management is not something else to do, but should add value to what you need to do.”
The way many firms establish their risk appetite and associated limits is a clear indication that risk management is treated as being something else to do. Companies spend extraordinary amounts of time, money and effort to establish their budget, yet defining a risk appetite is usually an afterthought compared to the rigor attached to establishing a budget. One of the elements to make the risk management process more integral to business decisions is to incorporate rigorous risk quantification into the budgeting and capital allocation processes.
To establish a risk based budgeting and capital allocation approach a company has to address four key challenges:
• Make risk metrics meaningful to decision makers
• Understand risk is a finite resource
• Define revenues in the context of risk and performance
• Identify ranges of outcomes in budgets
Making Risk Metrics Meaningful
The first step to establish a risk based budgeting approach is to define actionable metrics than can be readily applied across various business activities, and are meaningful to management. This is particularly critical at today’s energy firms whose activities expand well beyond the trading floor.
While a value at risk (VaR) measure is an effective way to control and measure the performance of a trading group, it is a meaningless metric for the capital-intensive activities for the majority of the firm. The focus of many risk programs on metrics that were initially developed for trading activities, often creates a mentality of dismissing rigorous risk quantification as something that wouldn’t add value to decision support for other aspects of a company’s business. While the metric should be VaR
like, it needs to provide business mangers something relevant to how they think about their business.
So as an example, earnings at risk is often cited as a way to make risk management analysis meaningful to any business. Clearly the analytic and informational challenges for a comprehensive earnings at risk calculation are greater than for a portfolio of liquidly traded market transaction, however the value to the organization can be significant.
Other metrics more specific to individual business activities should then be driven off the more macro metric used to understand and mange risk across the enterprise. As an example, if an earnings at risk metric and target is established at the corporate level, the amount of risk allocated to a company’s trading activity needs to be determined, and converted into VaR based calculations for limit establishment and performance measurement.
Risk as a Finite Resource
When it comes to defining a company’s risk appetite, it tends not be viewed as a finite resource nor specified accordingly. Often time these “appetite” limits are established almost independently from one another, where a risk limit established with one business is not specified or offset in the context of what risks would need to be increased or decreased to maintain the overall risk appetite consistently with corporate risk and performance objectives.
This is particularly true in the case of working and investment capital. Trade-offs between various spending and investment options are a very deliberate part of the process and discussed extensively by management. Often times a series of limits as a proxy for risk appetite are proposed for board approval with little thought given to the total risk profile, tolerance or appetite.
While the allocation of risk should not be viewed as a simple summation of deployed risk capital or limits, it is a calculus that needs to be addressed. As we know, correlations play heavily into risk analysis and quantification. Educated guesses, (e.g., Delphi method) based on management experience and judgment regarding offsets between business activities can be a very effective
proxy, particularly when information is not readily available for deep dive stochastic analysis and calculations.
Revenues in the Context of Risk and Performance
Revenue targets and limits or risk appetites are frequently defined in two separate processes. Typically revenue and associated earning targets are defined during the budgeting process, but risk appetites are often established under a different policy and committee process. In today’s typical energy firm the two seldom meet. This results in either unattainable revenue, or an underestimation of the risk being taken to meet defined revenue targets.
We have observed that some companies take a historical look at risk based performance in light of achieved revenues. When this is done, it is typically focused on trading activities since this is the most likely area to be subject to risk “appetite” limits, and return against these limits can be readily determined. While an historical look back is a first step towards a risk based budgeting process, it needs to be applied proactively when establishing revenue targets along with appropriate levels of allocated risk capacity.
Are we merging sales leadership by identifying the best talent or are we subordinating the target sales team under our sales leadership? Either approach has merit, but it requires leadership and clarity at the highest level.
Figure 1 illustrates a process to establish risk appetites for both market and customer specific limits to achieve targeted revenue and earnings goals. During this process a discussion between desired revenue, the amount of risk allocated, and what that infers regarding expected risk adjusted performance is encouraged. We have observed that some companies take a historical look at risk based performance in light of achieved revenues. When this is done, it is typically focused on trading activities since this is the most likely area to be subject to risk “appetite” limits, and return against these limits can be readily determined. While an historical look back is a first step towards a risk based budgeting process, it needs to be applied proactively when establishing revenue targets along with appropriate levels of allocated risk capacity.
Identify Ranges in Outcomes in Budgets
The establishment of allocated risk appetite and desired earnings target should be viewed as an optimization exercise where key questions are addressed:
• Is the expected return on risk reasonable? Often earnings targets are established without appropriate consideration of the amount of risk required to achieve a target level of earnings. Without a consideration of these two factors together could result in failure to achieve targets, or behavior that results in more risk being taken to achieve defined revenue targets. Back in
business school days this was referred to as a Sharpe ratio. In a trading environment, this imbalance between allocated risk and expected return can result in the so called rogue trader outcome.
• Does more risk capacity need to be allocated to achieve targets? When consideration is given to the balance between allocated risk capacity and expected performance, informed decisions can be made. This could result in the allocation of additional capacity to a particular business, or the reallocation to alternative activities that demonstrate a higher probability for better risk adjusted returns.
• Should business targets be reassessed in light of projected returns market opportunities? This is the opposite side of the coin to allocate more or less risk capacity to achieve target revenues. The issue is how to optimize overall return based on finite capacity to take on risk and the alternative market and investment options available. The optimization of possible risk based adjusted return on deployed capital requires a thorough consideration of these factors among competing uses of deployed risk capacity.
Budgets are usually established as single line items for revenue and expense items. An effective way to build a risk based budgeting approach is to understand and quantify the risks that may impact the realization of that expected outcome. Once these risks are taken into account, a budget item can be expressed in terms of an expected amount, and a budget at risk amount. In the case of quantifying the budget distribution, we utilize the triple “S” approach: stochastics, scenarios, and sensitivities.
A stochastic approach can be used when certain criteria can be met. This requires the availability of sufficient and representative historical data, and this historical data is viewed as providing sufficient ability to predict future outcomes. Management defined scenarios can be used as a substitute for defining “worst” case events when sufficient historical information does not exist, but there is confidence and expertise to define parameters of potential scenarios, and ability to estimate
approximate likelihood of a scenario. These defined scenarios can serve as a proxy for a downside event at a particular confidence interval, e.g., 99%, which is the basis for defining economic capital for most investment grade companies. In the absence of sufficient historical data, or insight into worst case scenarios, the fall back is to perform sensitivity analysis on budgeted items.
Adopting an approach which incorporates risk quantification and analysis into the budgeting process can result in significant
benefits to a company:
• Risk appetite is quantified in a way consistent with business operations and expectations.
• Risk capacity is allocated to recognizing risk as a scarce resource and
• Return on risk can be proactively optimized.
• Integrates risk management analysis to support critical business decisions.
• Forces the creation of risk metrics and analysis that provides meaningful insight to manage core business activities.
Bob Young, Partner, TechCXO, New York
Bob Young is a New York-based partner at TechCXO, and leads TechCXO’s risk management practice. See his full bio here.