How Hungry Are You for Risk?
The answer to this question is the name of the game. Think very carefully before you decide how much risk is the right amount for the company.
Very few companies, if any, can succeed without taking any risks. The results of well-chosen risks often separate highly successful from mediocre companies. At some point, you will want to take some risk—even if you are risk-averse. Define, describe, and articulate the amount of risk with your risk appetite statement.
Chances are that most company leaders already have a feel for their risk appetites, but they may not have articulated their feelings—certainly not formally. Have you ever tried to write down your personal feelings about risk?
Pinning down and committing your risk appetite to a formal document is difficult but necessary. Think about how you would describe your risk appetite. Are there examples in your industry that invite comparison? Are there sectors of customers, products, or other elements that allow you to create a clear risk message? Can you think of the types of risks to take—or not take? Some companies clearly state that they will not involve themselves with certain types of risk.
Best Bets
Establish a position for your risk-taking relative to competitors and other companies in your industry. Are there companies that you admire whose approaches you can model? Are there direct competitors? How do you compete? Where are you better? What is the key to that success? Is it because you are aggressive? Careful? Because you make more informed decisions? Do you excel in one area, your core competency? Are there aspects of your industry that might prompt you to change your past strategies and forms of risk-taking? Any new competition breathing down your neck or new regulations forcing you to be more careful? How about changes in the supply chain? Use these questions to gain perspective on your overall conduct in the marketplace and what you believe your company requires to successfully meet its goals and objectives.
The next step is to broadly size your risk appetite. Are you aggressive, risk-seeking? Or are you careful, risk-averse? How do you see your company as a whole?
If you are considering strategic planning, then build these questions about risk directly into the process. Every new strategy comes with an objective—and a set of risks, whether small or large. Consider your outlook on those risks as you work through the process.
What Is the Right Amount of Risk?
This is a tough question, possibly the toughest for any company to answer. It haunts senior executives everywhere. The answer offers little comfort: the right amount differs for each company.
Nevertheless, someone must guide the company through the myriad decisions that create a sum total of risk. The idea is to shift the focus from risk appetite as a general concept to establishing specific quantitative anchors. These are described either in economic capital or the confidence interval. As you may recall from Chapter 10, the confidence interval is a set of numbers that reflects the overall riskiness of the company. It is often derived from its target debt rating. To arrive at these numbers, spell out the total risk-taking behavior of the company. After that, understand each of the company’s core risks and their relative values. How much of each would you carry?
Risk management experts have identified two ways in which companies can think about their risk appetite quantitatively. These are best described using the following questions:
What is the maximum loss you could sustain and still survive?The answer will certainly establish one clear boundary. It shouldn’t reflect a comfortable pull-through, but a situation in which the company barely survives. If you need to hold additional capital for investment or dividends, consider those in your final number. That will leave you with an established maximum economic capital figure for your risks.
What is your own company’s default probability?Instead of considering your customers’ likelihood of defaulting on their loans, think about your own likelihood of default. In other words, if someone were to lend you money, how would they perceive you? Could you pay them back? Or would you become the bad debtor we’ve been talking about?
More on Credit Ratings
When you determine your company’s default probability, you also reveal its likely credit rating. If you have a credit rating for your company already, perfect!
To assess risk appetite, seek the relationship between credit ratings and confidence intervals. If you don’t have a credit rating, try a couple of other approaches. First, identify a competitor and check out its credit rating (if it has one). Chances are that your rating will be similar, particularly if your businesses include similar products, similar strengths and weaknesses, and so on. You can also look at companies you admire, particularly within the industry. Check their credit ratings. That may be a starting point for you.
When using this approach, remember that the concluding number is the target credit rating. It’s where you want to be someday; it could differ from your current position. Of course, you can always evaluate the definitions for each credit rating and go from there. Since you’re shooting for a target rating, your final figure will not necessarily be the rating an agency would give you. The important thing is to identify how you want to run your company and be perceived.
Remember that most companies would like to be rated more highly than junk bond status (99.9 percent safety rate). However, those same companies recognize that the AAA rating (99.99 percent) may be too squeaky clean of risks to achieve the growth and profitability they seek. An AAA rating also implies large amounts of capital to be held as buffer, which may be beyond your means and intentions as a firm.
At this point, your risk appetite numbers should correlate directly to the confidence interval. Your risk management people, or outside consultants, will build the measures and buffers to meet the target you set. In so doing, you provide consistency across the organization and through the risk process.
Target Risk and Return
Part of the risk appetite must also consider the reward side. After all, you are in business to make money for the products or services you provide. And your ability to make money depends on how well the risk versus reward relationship runs in your company.
Start by considering how your return target aligns with your capital target. If you merely align these targets, will you be satisfied? Some industries set benchmark returns that need to be topped. Often investors expect some sort of return for their capital investment. How well do these expectations line up with the risk-adjusted return (implied by the economic capital threshold described in the previous section)?
def•i•ni•tion
A hurdle rate is the rate of return the company will try to meet or exceed. It is especially handy if you have a company with multiple departments or sales people. It allows you to set a rate in line with the risk-adjusted return implied by your risk appetite.
Use budget and forecasts to set up risk-return expectations. How much revenue do you expect to achieve this year? This should be based on your forecasts. Will there be any reserves required? Work this out to achieve a risk-adjusted return number. Next, divide by the economic capital implied by these activities. At this time, set the hurdle rate for the company.
How Do I Take Control?
Once you have quantified key aspects of your risk appetite, take control. Begin to adjust your company to meet your risk appetite. Set thresholds that can be monitored. Establish a target view of economic capital (and possibly reserves, in line with risk appetite expectations) for the year. Then, monitor the risks as they accumulate through the year. You can monitor qualitative statements of risk as well, if you use that approach.
When establishing risk appetite, view the company as a whole. Determine your steps to monitor individual departments or risk classes. These often set the starting point for additional risk limits and controls you may enact for more specific aspects of your business. Companies can monitor risk groups or departments at a high level through the reporting process to make sure that the broad standards set up by the risk appetite are continually being met. You can even set up a formalized limit structure on these high-level targets and build it into your regular reporting, particularly at the board level.
If you take this path, be sure to set up a buffer or trigger point before the limit or target is reached. This will give you time to react and respond to risks. This is important for most limits, but especially true of anything that touches or involves the absolute company limit. If it nudges the absolute limit, it might signal or precipitate a serious issue that could threaten the company’s survival.
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