PRMIA Presentation on Risk Appetite and the Current Financial Crisis
On 30th April 2009, avantage Capita organised its latest presentation to an audience of members of the London chapter of PRMIA (the Professional Risk Managers International Association). The topic in question was the “Risk Appetite and the Current Financial Crisis”. The main theme of the event concerned the ability of financial organisations to create a viable framework for risk appetite in the current economic climate and was presented in three parts.
Toughening Up Pillar II
The presentation was introduced by Andrew Nord, Director avantage Capita Ltd. who provided the context for the discussion. He highlighted the fact that IMF have estimated financial sector credit related write-downs for the period 2007-2010 to be around US$4.1 trillion with around US$1 trillion having already been written down. It was also pointed out that of the total write downs US$2.8 trillion represents banking write down with the remaining US$1.3 trillion representing losses against insurers, pension funds, investment firms, hedge funds and other non bank financial institutions.
Andrew noted that globally, regulators have concluded that failures in corporate governance and risk management are by and large to blame for the current financial turmoil. Regulators themselves have also accepted their share of the blame in so far as they have neglected the systemic risk created by structured credit and excessive leverage and failed to emphasise macro-prudential regulation sufficiently. The response of the regulators has been to initiate measures to strengthen Basel II Pillar 2 requirements particularly those aimed at enhancing the quality and effectiveness of firm wide risk oversight ready for implementation by 1 July 2009.
Risk Appetite has thus moved to centre stage as regulators will require firms:
- to define risk appetite quantitatively, based on a number of distinct risk measures rather than a single measure such as value-at-risk or economic capital, as well as addressing risk appetite qualitatively;
- to target their risk appetite measures at the long-term, through the cycle, and not just at the current planning horizon – use of downturn stress scenarios as part of defining risk appetite will in effect become mandatory;
- to embed an effective, rigorous and dynamic risk management process that ensures the firm’s risk profile remains consistent with its risk appetite – responding quickly to emerging risks and changing business conditions.
Download a copy of the presentation ‘Toughening Up Pillar II’
Stakeholder Perspective on Risk Appetite
Tim Thompson, Head of Risk Analytics, Lloyds Banking Group then went on to provide a Stakeholder’s perspective on Risk Appetite. He explained that risk appetite is a key framework for financial institutions which enable it to comment its risk culture, control the level of risk taken and ensure consistent of decision making in risk management. He described stakeholders who include regulators, shareholders, customers and funding providers and stressed the need to consider these groupings when setting a group wide risk appetite.
The risk appetite framework must consider the following when converting Board and Senior Management objectives into principles and limits:
- Target rating
- Dividend policy
- Capital ratios
- Profit warnings
- Market share
- Performance relative to peers
- Brand value and reputation
- Funding costs.
To achieve this, the framework must encompass four aspects:
- Volatility in Profits
- Risk Tolerance
- Concentrations
- Underwriting Criteria.
Tim went on to conclude that developing a risk appetite framework above all requires a pragmatic approach which is backed up by regular performance reporting, review and clear communication as an integral part of the annual planning process.
Download a copy of the presentation ‘Stakeholder Perspective on Risk Appetite’
ERM Evaluation and Analysis
The third part of the presentation was delivered by Peter Dutton, Managing Director, Financial Institutions Ratings Standard & Poor’s. He explained that risk appetite has a role in credit rating evaluation of financial institutions, specifically of as one of the components of ERM evaluation.
Mr Dutton outlined a number of key factors in risk appetite including the need to clearly articulate and communicate risk appetite as part of an ongoing dialogue between risk managers and business units and that risk appetite needs to be expressed in quantifiable terms.
Mr Dutton highlighted the value to be gained in using the new Risk Adjusted Capital Framework tools developed by Standard & Poor’s for assessing the Enterprise Risk Management Framework of financial institutions. The new assessment process covers both strategic and tactical aspects of the target company’s ERM and opens up a number of benefits with respect to global comparison of capital ratios; specific assessment diversification; and concentration of various aspects of the company.
Download a copy of the presentation ‘Risk Appetite and the Current Financial Crisis’
Conclusion
In conclusion the current crisis has demonstrated serious weaknesses in governance and provided an opportunity for enhancement of regulations and processes surrounding risk appetite and capital controls.
