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Thursday, September 6, 2012

Understanding risk appetite

Over the last week, there have been a lot of discussions on risk appetite in the G31000 forum and while ISO 31000 refers to risk appetite as risk attitude, broadly the concept is not fully appreciated by many risk analysts in the market place.

In this blog we look at risk appetite; what it is, where it has been used and why it is important.

What is risk appetite?
Risk Appetite is loosely defined as "the affinity a person has for taking risk when attempting to meet a specific objective".

This concept of risk appetite differs from person to person or business to business and interestingly you will find that a person's risk appetite changes as they age. The Nobel Laureate Kahneman and Tversky proved that framing the same information differently on any specific situation, is likely to alter a person's risk aversion to it and over the last century, the science for measuring or tracking risk appetite in the world of banking is now fully engineered.

In the finance sector, the history of modelling risk appetite is so long and convoluted that entire novels have been written on the subject. One such book is Capital Ideas [LINK], authored by Bernstein and within its pages, he elegantly describes the private club of those that invent new measures for risk appetite and the internal go-betweens required for chasing another Nobel prize. This race for creating the best measure of risk appetite has been debated across the better part of the century and has focused mostly on risk appetite for investments in the markets.

In finance, there is actually a huge array of measures for risk appetite and to name a few we have:
Risk Adjusted Return on Capital RAROC and a more mature measure known as Risk Adjusted Return on Risk Adjusted Capital RARORAC. But it doesn't stop there.
There is the Efficient Frontier of course and an extension of it, Sharpe ratios, Calmer Ratios, Jensen's Alpha, Portable Alpha, Roy's Safety-First Criterion, Treynor Ratio, Sortino Ratio and there are others as well as extensions of these.
G31000 | Martin Davies
But why has the concept of risk appetite been trapped in the domain of finance?

The world of compliance
The first reason is that endeavors such as risk compliance generally have a zero tolerance for risk, more risk equating to increased returns is simply an unacceptable concept for compliance people to take on. Consequently, risk appetite falls immediately to zero when they look at controlling any hazard. Imagine a company that had a compliance policy that stated rogue trading was fine on Mondays and Tuesdays because we have found that it lifts our profits but to be compliant 3 days out 5, rogue trading is strictly forbidden Wednesday through to Friday.

Box ticking methods for risk management simply have no room in their none paradoxical structure to entertain risk appetite as a range of numbers.

The ability to price risk
Away from finance, the next problem that holds back the wider acceptance of risk appetite is the ability for analysts to price risk. If you can't value risk and return together; the ability to form a decision space between the two is lost. Even to think about risk appetite without a price becomes a subjective decision and to formalise or frame it will then lend the entire process to gaming.

Can we put a value on a human life for example? Attempting to do so, is so morally cheap that activities which actually select risk appetite in this manner are rarely written about. Even utilitarian aspects of risk appetite and return are so controversial that when they are applied to problems outside the military realm, the process becomes extremely confidential. 

Example of risk appetite
Risk appetite can be found in many forms but is usually and should be knowingly; a chosen additional exposure to what already exists in a business objective. A business analyst actually selects more risk to increase their yield and they can do this in many ways. I have taken to list three common ways in which risk appetite can be dialed up or scaled down below:

[1] A business analyst may select leverage to buy additional exposure on an existing objective, this leverage could come in the form of a simple loan or channeled through a notional contract.

[2] Risk appetite can also be selected in the form of a non-equal contract for delivery, where one party takes on more risk than another to increase their profits or sometimes just to win the contract.

[3] The mixing of assets may have correlation between the assets. This results in the risk of return and loss widening with the combination of assets in a portfolio, rather than when the single assets are held alone.

The use of leverage | An economist example

If we take the example above, you can see three business scenarios presented in a spread sheet. These business scenarios are actually the same business operation in nearly every way; they have the same amount of total funding, even the same operating profit and the same amount of physical uncertainty. All this aside, if you take a look at the return on equity for investors and compare this value between each business scenario, you will notice the number differs wildly.
Why is this?
In short we have different appetites to risk and in business scenario 'A' we are investing 250 million but 750 million is being added to the firm from a debt line. In this scenario, you are in effect borrowing money and earning from it and the notional size of your investment has been scaled up, along with your risk. If business scenario 'A' totally fails, you could lose 250 million but you will still have to repay 750 million back to the bank; consequently your losses could be greater than your original investment.

If you have ever heard of the statement "Cash is king" and believed it, then you might have been fooled. The real king is in fact debt and this couldn't be further from the truth with our first business scenario (scenario 'A') above.

Measuring risk appetite is absolutely important as we can see because it artificially increases the prevailing uncertainty that would normally be expected. In many respects, the credit crisis was brought about because of leverage and some managers in financial institutions chose to lever up because their rewards would be handsome. On the other side of the equation, their tail losses were covered by the government rather than themselves, so they had an unlimited appetite for loss. This skewed payout model lead to inappropriate risk taking or appetite in banks before the crisis took hold and fueled a property price bubble.

Going forwards in a post crisis banking environment, regulation is changing for banks that use leverage and the Basel III accord has introduced a new leverage ratio to bring about a greater transparency to how much gearing and leverage each business model is taking on.
In a future posting, we will look at how to construct a framework for risk appetite outside the finance sector.

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