Risk Appetite in a Nutshell
This micro post focuses on “risk appetite” and its relations to risk bearing capacity, capital efficiency and the corresponding safety margins.
a glass well used
I use a glass to illustrate the total risk bearing capacity of an organization. In a first step, we set the total capacity of this glass to hold liquid as the organization’s maximum risk bearing capacity. The Board and Management need to have a solid, quantitative view of this capacity. For simplicity’s sake, we omit considerations of buying a second glass or putting the glass into the second larger container.
In a second step senior management and the board decide how far up they want to fill the glass. In other words, how much risk will the organization take. Theoretically, anything between empty and full is a go.
the glass is full
On the other hand, filling the glass up the top is very efficient. However, several stakeholders, such as shareholders, credit rating agencies and/or regulators might take a view that the firm should leave some buffer. Just in case anything causes turbulences to the liquid in the glass. Hence, organizations would under most circumstances leave some capacity unused.
the glass is empty
Having said that, if the glass is (almost) empty, then the company is not taking any risks. Hence, the organization is excessively risk averse and/or dormant. In other words, capacity (i.e. capital) usage is very low. This, over the long term, is inefficient.
The beauty about this concept is its flexibility. Should the business environment be very favorable, companies can decide to “fill up” the glass, ie increase revenue. Vice versa, if the environment is challenging, the glass remains less filled. Efficient capital management would then ask for a smaller glass – that is a topic of another blog.
Thank you very much for reading this post. Enjoy what you are doing and stay safe. For any questions pertaining to Enterprise Risk Management, please contact Megrow over LinkedIn or Twitter or the coordinates on the contact page.
PS: an audio/video edition of this blog: