Common mistakes in risk appetite – Part 1: Risk Appetite Strategy

This week Tony and John discuss using operational risk software and the common mistakes made in risk appetite work.  Part 1 explores the strategic side of risk appetite.  Part 2 will go into more detail.

This exert is taken from their book Mastering Risk Management…

There are many reasons to have a risk appetite and many mistakes to be made along the way.  A risk appetite encourages management to be involved in risk management and helps define the role of the Chief Risk Officer (CRO).  In some ways, the risk appetite is one of the most crucial parts of the risk management process. 

“Many firms are confused about what risk appetite is and how it can be implemented. There is also frequent confusion between the risk appetite framework, the risk appetite statement and risk appetite limits. Often the framework and the statement are combined into a single document mixing the two concepts and leading to confusion on the subject. In addition, there is uncertainty as to the link between quantitative appetite and qualitative appetite.” Extract from Mastering Risk Management by Blunden and Thirlwell, published in February 2022 by FT International.

Confusion in purpose of risk appetite leading to appetite being underappreciated

If a firm does not have a risk appetite framework and statement, different members of senior management will have interpreted risk management to mean different things. To one person risk appetite may mean a small set of quantitative limits whereas to another there may be a focus on an overall qualitative approach. These different foci will inevitably lead to confusion and likely to lack of reports that can be used by all members of the management team or all members of the board.

Even worse there may be little understanding of risk appetite amongst senior management and therefore there is under appreciation in the firm of risk appetite.

Clarity in purpose of risk appetite leading to appetite being overemphasized

However, occasionally risk appetite may be regarded as one of the leading purposes of the firm and a great deal of time, money and resources is allocated to the pursuit of a ‘perfect’ risk appetite.  While risk appetite is of course an important topic in any firm there are many other topics (e.g. strategy, capital) that should be considered and which, when combined and interlaced with risk appetite, provide the firm with a clear business framework. An overemphasis on any particular topic may lead to a poorly managed firm.

Confusion between framework and statement

There is often confusion between the purpose of a risk appetite framework and a risk appetite statement. It is common for these two terms to be used interchangeably which may also result in confusion.  An understanding that a framework is about governance whereas a statement is about the implementation of the framework will help provide clarity to everyone involved in risk appetite.

Confusion between statement and limits

Equally often statement and limits are confused. Although of course limits are part of the implementation of the framework there is guidance that is specific to limits that should be clearly documented. A concatenation of the detailed topics in the statement with the limit guidance can be very misleading.

Lack of involvement of senior management and business lines in framework

It is sometimes the case the board, being particularly concerned about governance, will set about documenting and issuing a risk appetite framework without reference to those who have to implement and apply it. This is a significant communications mistake. In order to clearly embed risk appetite within the firm all of those affected must be involved in the primary governance document.

Statement written by risk department with minimal input from management

This occurs when the risk management department is told by senior management to produce a risk appetite statement (there is often no reference to a risk appetite framework). Clearly, there will be very little embedding of risk appetite within the management tiers of the firm as it has had little or no involvement with the vital task of designing the implementation of risk appetite.

Summary

“At first glance, risk appetite can appear either confusing or daunting.” … “a firm could be forgiven for believing that this is one step too far. However, having an appetite is fundamental to the management of risk. If appetite is broken down into its component parts and then analysed one part at a time, appetite becomes both manageable and useful for the business.”  Extract from Mastering Risk Management by Blunden and Thirlwell, published in February 2022 by FT International.

Part 1 of this appetite blog explored the strategic side of risk appetite.  Part 2 will go into more specific detail.

Taken from Mastering Risk Management by Tony Blunden and John Thirlwell and published with kind permission from Pearson Education Published.  Readers of this blog are entitled to a 25% discount on Mastering Risk Management through the following URL: https://www.pearson.com/en-gb/subject-catalog/p/mastering-risk-management/P200000003761/9781292331317   Please use discount code MSTRSK-25