If this most recent banking crisis has pointed up the need for anything, it is that financial institution executives must understand the potential future risk consequences of strategic business decisions they make today. When many made the decision in 2004 and 2005 to grow, funding speculative acquisition, development and construction loans with wholesale funds, did they actually understand whether the institution could survive effects of a severe downturn in the real estate market and a prolonged recession?

To survive and thrive in the future, financial institutions must consider the future risks of strategic decisions made today. In short, they must be able to define the institution’s “risk appetite”.

On the face of it, this seems easy to do. Isn’t it simply the institution’s capital structure and solvency needs which determines its ability to withstand shocks and therefore represents its risk appetite? For some smaller firms this approach may well be enough, but for others risk appetite is a more complicated affair at the heart of risk management strategy and indeed the business strategy.

But defining a financial institution’s risk appetite goes beyond just considering the potential future losses of a single strategic decision. Other issues must be considered as well. How, for example, would the planned growth be funded, for example? What were the implications of the chosen funding strategy.

Beyond consideration of the growth and funding issues, did the institution manage risk effectively? Did Directors and management believe credit underwriting and risk management practices were sufficient to protect the institution if the real estate market turned against them with a vengeance? Did they develop appropriate contingency funding plans?

The risk appetite statement goes beyond a simple projection of losses and assessment of capital adequacy. Properly crafted, a financial institution’s risk appetite statement sets the boundaries between strategic decision-making, day-to-day business decisions and risk management.

Ken Proctor, Managing Director, Risk Management

Twitter: @JediRiskManager