Risk Appetite Frameworks for Corporates
Do You Know What Is on Your Plate?
by Lex Kriel, Associate Director, Monique de Waal, Senior Manager and Gerber Schnetler, Manager, Deloitte
Brexit. A looming sovereign credit downgrade. Nene-gate. Weak commodity prices. These are only a few examples of recent events that have rocked the local market to such an extent that risk management has to be a key priority for corporates. With continued uncertainty in key markets such as the USA, EU and China showing no signs of abating, the days of dressing up sporadic hedges as a risk management approach are over. Volatility is here to stay.
Are risk appetite frameworks really relevant to corporates?
In this environment, as in any other, the board and senior management are expected to manage their companies in the best interest of all stakeholders by maximising shareholder value and honouring commitments. This is a tough assignment at the best of times but even more demanding during the volatile environment of today. A strong risk framework will assist the board and management to weather the storms that could otherwise sink the company.
In their risk management frameworks, most corporates tend to focus on operational risk, as it relates closely to their primary business operations. More often than not, financial risks arising from exposure to foreign exchange rates, interest rates or commodity prices are either tolerated or mitigated on an ad hoc basis. However, the prevailing volatility of local and global markets and the impact on the financial results, as well as the budgeting and forecasting process, can no longer be brushed aside as a temporary state of affairs, exogenous to the core business. The board and senior management need to have a clear view on how much risk the business is exposed to and, importantly, how much risk it is willing to accept, or in other words, have appetite for.
Businesses are built by taking on risk in one form or another - the old adage “no risk, no reward” rings true for all companies. The key to creating a sustainable and successful business is to fully understand the set of risks to which the business is exposed (i.e. defining the risk profile) and to decide what the maximum level of risk is that the business is willing or able to accept in pursuit of its objectives (i.e. defining a risk appetite). By understanding and managing risk, the board can capitalise on opportunities, avoid pitfalls and create a competitive advantage during difficult market conditions. As noted by the esteemed risk management author James Lam, “the only alternative to risk management is crisis management – and crisis management is much more expensive, time consuming and embarrassing”.
For most corporates, ‘risk appetite‘ is a somewhat foreign concept. On the other hand, banks and insurers have been developing risk appetite frameworks extensively over the last decade (although the maturity and embeddedness can be debated). These developments have been accelerated by the 2007/8 financial crisis and subsequent increased regulatory focus on early detection and pro-active recognition and mitigation of risk. Corporates, however, are largely left to their own devices when it comes to risk management, which all too often results in most companies having inadequate risk management functions. These are typically exposed only after adverse financial impacts have already realised (i.e. crisis management). As Warren Buffet famously said, “only when the tide goes out do you discover who's been swimming naked”.
Components of a risk appetite framework
This article gives insight into the establishment of a risk framework in corporates with emphasis on risk appetite. To enable boards and executives to make decisions that will benefit stakeholders, they need to have an understanding of what the risk implications of those decisions are. At the same time, executives need to have risk parameters within which they should manage the organisation to ensure the longer-term strategic objectives are met. These parameters are set by the board in terms of the risk appetite.