Companies now face an entirely new landscape and have to adapt their business models to growth. This has caused risk management, the optimisation of return and shareholder value creation, to be pushed to the front of the corporate agenda. Executives are wondering: “Given our targeted return and that no return comes without risk, what is the organisation’s risk appetite?”
To answer this, start by defining all the components of an organisation’s risk appetite. Imagine the following scenario: you have strapped on a heart rate monitor and are busy running a marathon. Given your own health characteristics, your heart will only be able to function up to a certain maximum heart rate. Any rate higher than this will seriously jeopardise your health. However, there is an optimal range in which your heart rate should fluctuate to ensure peak performance.
Between these two areas, there is a band where your heart will be able to function and you will be able to compete, but you might not achieve the results you desire. As you get closer to your maximum heart rate, alarm bells will go off in your body. While you could cover more ground early on, your heart rate is not within the optimal range and you could possibly not complete the marathon.
Building blocks of an organisation’s risk appetite
Using this scenario, we can now define and connect the main building blocks of an organisation’s risk appetite. The first building block is the company’s earnings distribution. This can be equated with your heart rate and will also have a certain range within which it is expected to fluctuate over time.
Similar to the maximum heart rate is a company’s risk bearing capacity, which is the maximum amount of risk the company can bear (before it is damaged), given for instance its financial strength and available resources. The damage at this level will fundamentally change the business and could even lead to insolvency.
A company’s risk appetite is linked to the optimal heart rate. It is the range (amount) of risk the company is willing to take on in pursuit of value. The value is a direct consequence of the company’s strategy. The expectation, as with your heart rate, is that if the risk stays within this range, the organisation can function optimally. This is not a single value.
Lastly, the band between the risk appetite range and risk bearing capacity is where the risk tolerance levels are. These levels will be points on the earnings distribution where the closer you get to the risk bearing capacity, the more severe the outcome will be. These outcomes will possibly range from a profit warning to a possible take-over.
All these concepts must be combined for a clear understanding of what the target risk profile(s) looks like. It is important to ensure this profile falls within the company’s efficient frontier where risk and return is tied together. This will ensure the company’s risk appetite is in line with the targeted return. There is potentially more than one sensible target risk profile and it is imperative that Executives and Risk Managers determine which of these is best suited for the organisation.
To ensure an organisation’s targeted return is met, it is important to define the appropriate risk appetite. By doing this right, it will be able to ‘run’ faster for longer than the competition. More importantly, shareholders will be able to rest assured that there is an effective way to manage, communicate and monitor both risk and return.