Risk Appetite – Part 3
Risk Appetite: Risk is a Finite Resource
When I was a child getting an allowance, my parents taught me I had to make choices regarding how I would spend it. I realized early on that I could not buy everything I wanted with my limited resources. I had to make trade-offs between the various things I wanted, versus what would maximize my childhood bliss. Did I want the baseball bat first or the baseball? If I got the bat, hopefully a friend would have the ball.
Businesses operate using the same basic trade-off decisions regarding how they deploy capital to optimize return to their stakeholders. A business must recognize that optimizing return is different from maximizing return. Optimizing return infers achieving the best possible result given limited capital, and other constraints being imposed from both internal sources (e.g., the board and defined “risk appetite”) or external (e.g., regulatory requirements). When budgeting, companies view resources as finite. 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.
When it comes to defining a company’s risk appetite and allocating risk capacity, it tends not be viewed as a finite resource nor specified accordingly. Often time “appetite” limits are established independently from one another, where a 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 an overall risk appetite that is consistent with corporate risk and performance objectives.
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, appetite or perspective that risk capacity is a limited resource. When it comes to the allocation of risk, the intuitive premise of considering trade-off decisions between competing uses is often forgotten.
Three major shortfalls I have observed resulting in the failure in recognizing risk as a finite resource are:
• Risk decisions and limits are often established on a one-off basis
• Portfolio implications and trade-offs between businesses are not considered, and
• Once risk is allocated, the effectiveness of its use is not measured, and in some instances discouraged
Stand Alone Risk Decisions
In many companies, risk decisions and limits are made on a one off basis for a particular business or project without consideration of its impact on other parts of the business. Often times decisions involving risk considerations, are made by different committees. In companies where trading activities exist, a risk oversight committee may be responsible for establishing a trading limit, whereas an investment committee may be responsible for approving capital projects.
Both of these processes are making decisions regarding the allocation of a common pool of risk capacity, but the explicit recognition of risk and the integration between the two are seldom considered. Additionally, capital investments often ignore the risk capital associated with the uncertainty of the investment’s outcome over the long term, while risk committees often establish trading limits without the consideration of the necessary capital to achieve desired outcomes.
Since risk capacity is finite, this could easily result in a company-wide level of risk that far exceeds capacity, or available risk capacity is not being fully utilized. Without proper recognition and quantification of the amount of risk capacity consistent with a defined risk appetite, there is no way to determine whether stakeholder value is being optimized, or to affirm whether or not the company is operating within the defined appetite.
Risk is capital and the allocation of risk needs to be considered in the same context of any other capital deployment decision. When a decision is made to allocate risk, there should be an expectation that it will be used effectively, and achieve a targeted return that exceeds the cost of the associated capital. It is at this point where tradeoffs between competing uses of capital need to be considered.
Failure to Consider Portfolio Implications
The application of portfolio considerations is essential to recognizing that risk is a finite resource, and ensuring that the value created for stakeholders is optimized. Unlike revenue, which is additive across business activities, allocated risk capacity is not. As we know, correlation plays a major role in the calculation of risk recognizing offsets between business activities, established asset positions, and transactions which facilitate business activity.
While calculating the correlations between various business activities and positions can be analytically intense, it doesn’t necessarily have to be. At one of my former employers, an assumption of diversification between the various trading businesses was assumed to aggregate risk. This assumption of diversification or zero correlation was also stress tested.
Stress testing allowed management to understand the potential impact on risk capacity performance under extreme circumstances where markets that typically behaved in a diversified way, became highly correlated during a crisis, e.g., financial crisis of 2008. Under a most conservative approach to enforce the notion that risk capacity is finite, an additive approach can also be adopted. This assumption however, will leave available risk capacity underutilized and a failure to optimize value to stakeholders.
Of all the shortfalls that can occur within the risk allocation process, that I find most frustrating is when risk capacity is allocated, but then is viewed as a limit or boundary to be avoided. Recognizing risk as a finite resource implies a company allocates a scarce resource to activities that can create the most value for stakeholders at a point in time. In businesses with active trading or hedging activities, this allocation is manifested in the form of a limit.
Many companies view a limit as something to be avoided and not capital to be used, along with expectations of a return to be achieved. At many companies, Alarms go off if somehow the limit is utilized, or in many cases, if the full allocated capacity is close to being used. I rarely have heard management complain to a trader that he wasn’t using his limit, or allocated risk capacity.
Optimizing value implies that capital needs to be fully deployed to the most promising investments and opportunities. Unused risk capacity means a scarce resource is being underutilized. The full utilization of risk capacity was embraced at a bank I once worked for. Questions were asked if the allocated capital/limit was not being fully utilized. Often times it meant that those managing the specific activities didn’t feel appropriate opportunities existed to achieve adequate return. In these instances, this risk capacity would be redeployed. This type of redeployment is easier to accomplish regarding trading activities, but can also be addressed for asset based investments over a longer time horizon. While the allocation of risk should not be viewed as a simple summation of deployed risk capital or limits, it is a more complex calculus that needs to be addressed. Deploying risk capacity in a way that can optimize stakeholder value requires the recognition that it must be considered in the context of the complete portfolio of available business activities and investment options. Decisions cannot be made on a one off basis without due consideration of its impact on other risks and investment options.
Finally, allocated risk capacity must be used and the performance against that allocated capacity must be measured. Perhaps this requires a mindset change on the part of the board and management, but failure to think of risk capacity in this context will result in a failure to effectively manage this critical and finite resource of risk.
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.