What’s Your CU’s Risk Appetite?

CU360
February 3, 2010 | COMMENTS

Well-considered risk taking is critical, not only for the economy but for the success of individual companies. For any business, risk calculations should assess potential damages as well as potential rewards and gains. But an overly cautious mind-set makes that more difficult to do well, according to Strategy+Business magazine.

Profiles of the nation's largest financial institutions provide textbook cases in risk tolerance. Investment banks, hit hard in the first months of the credit crisis, were concerned that they might not survive. Each had different ways of approaching risk as they struggled to rebuild their businesses.

Those that took a cautious approach dramatically cut back new loans, and they set high capital reserve levels, trying to anticipate future regulatory requirements. Others chose to take on more risk despite the crisis. They set ambitious loan and profitability targets, and they continued looking for high-return investments. The result, two years later, is completely different levels of financial performance.

In a crisis, the pendulum of corporate policy swings to extremes, first embracing risk excessively and then pulling back suddenly from perceived troubles. The problem of excessive caution is pervasive today in a variety of industries, and the financial meltdown has made many business leaders so risk-averse that they're missing opportunities for returns.

Why should a sudden wave of prudence be troubling? Curtailing risk can hobble entrepreneurship, and deprive deserving businesses of capital. Business-to-business lending, for example, always involves a certain level of risk.

The complex web of risk tests many companies, both in their judgment of how much risk to take and in their controls for tracking and managing it. And senior management teams often are not practiced at discussing risk in the context of strategic decision making or articulating those expectations to the organization.

To overcome this problem, each company needs a fresh, rigorous definition of the appropriate level of risk to take. Besides asking how much risk to avoid and how to prepare for the downside, corporate leaders should be asking how much risk they want—and how much capital they're willing to stake for how much potential gain. Discuss these considerations and make them clear throughout your organization.

A risk appetite is a company-wide statement of the amount of risk desirable in day-to-day operations. Setting this goal is the first step in linking the firm's strategy directly to operations and implementation. It ensures that the risks being taken align with the business agenda set by senior management and the board of directors.

It empowers employees, and it gives them the support they need to make decisions with confidence, especially in this time of financial instability and government oversight. All told, the risk appetite helps determine the future of the enterprise.

Determining risk appetite requires an ongoing, multi-dimensional analysis of your operations. It means delving into company practices to understand the interplay of all the different kinds of risk—market, credit, investment, operational, and reputational—within and across different lines of business and how they affect the whole. It also means monitoring the risks that are being taken and identifying trade-offs and ways to keep risk at an optimum level, to avoid both overextending your operations and missing opportunities.

While it might seem relevant only to investment-oriented financial services, Strategy+Business maintains that defining risk appetite is a valuable exercise for companies in any sector. Just having a risk appetite process and framework in place can have a dramatic impact.

The Risk Appetite Exercise

Consider five basic components in defining your credit union's risk appetite:

1. Establish a risk baseline by cataloging all current risks. Use financial measures to better understand your exposures and concentrations. Review individual business units as well as the entire enterprise to illuminate aggregate risks and benefits.

2. Set a risk appetite for your credit union. Create a framework that translates your strategy into a set of metrics and measures for everyone to work with. Develop a series of questions designed to tease out your preferences and pain barriers for all types of risk.

3. Get an external perspective. Go beyond internal measures to look at risk taking in the context of your competitive landscape. Benchmark against peers and within the industry.

4. Implement the findings. After you determine your current risks and clarify your appetite, a reckoning is most likely in order. Some lines of business will continue as they are, but others will need to change or perhaps be realigned.

5. Keep an eye on the dashboard. Once defined, monitor your risk appetite regularly. A risk appetite dashboard delivered to managers' desktops can be used to track operations each day, ensuring that your credit union is meeting expectations and making adjustments when necessary.

No strategy is set in stone. In response to changing business and economic realities, new competitive conditions, or altered strategic priorities, your risk appetite will evolve over time. Be prepared to make changes, and make the changes transparent: visible, shared with key constituents, and monitored to prevent confusion.

Many business leaders grapple with the question of risk. Companies that are too cautious for too long sometimes discover they've made a significant mistake. They swing too far toward overexposure, and then they get frightened again and overshoot in the opposite direction.

To cope, companies must adopt new risk-management strategies, such as the risk appetite architecture. Ultimately these strategies will help your credit union better understand risk, build confidence, and steady the pendulum.