8
The Financial Risk Mandate: Developing a Philosophy and Loss Tolerance
In our experience defining an appetite for risk, and then managing to that appetite, is the single most important action a risk-taking firm can undertake. It sets the tone and posture toward the management of risk and, if implemented correctly, limits potential losses. As usual, this is often easier said than done.
The discipline begins by defining the operating risk parameters of the firm. A firm has to consider how risk relates to the rest of its activities (e.g. are particular risks important, not important, irrelevant, integral to strategy, performance and valuation), the intended focus of risk activities (e.g. will risks be taken proactively, or as a by-product of other operating activities, as a specialized “niche” player or as “all things to all people”, will a particular product or market focus be emphasized), and the internal and external perception of the firm’s risk business (e.g. do regulators, lenders and shareholders know what risk the firm is taking, believe it is empowered to do so, and so on). Defining these factors leads to the development of arisk philosophy. Every firm also needs to understand how much money it is willing to lose through such risk activities, whether it has the resources for this and whether it is being properly paid for taking such risks. These allow the expression of arisk tolerance for the organization. We consider each in greater detail below. A philosophy and tolerance together give rise to arisk mandate– the firm’s risk operating parameters. To be useful, the board of directors should sanction the mandate and executive management should approve and implement it – this is vital as it ensures that everyone understands the risk-related “rules of the game”. If large, unacceptable losses occur within the risk mandate, directors and executives cannot blame others – they have to accept responsibility. If the losses are not within the scope of the mandate, directors and executives are still responsible, as it is up to them to ensure that violations of controls or flaws in the process are identified and dealt with immediately. The mandate should be fluid rather than rigid – revisited regularly and updated when necessary. In the same way that companies often publicly express earnings growth targets, we believe the risk mandate should similarly be publicly announced. Figure 8.1 summarizes the suggested make-up of the risk mandate.
Risk philosophy
Risk mandate
Risk tolerance
Figure 8.1 The risk mandate
8.1.1 Financial risk and corporate goals
Before doing anything else, a firm needs to understand what risk means to its business operations – essentially knowing if risks complement, enhance or harm its activities, and whether they form a significant part of revenue generation. A typical bank, for instance, is in business to take risk and generates revenues based on extending risk; risky activities are consistent with its overall goals, so its philosophy should encourage initiatives related to the prudent management of risk exposures. An industrial firm, in contrast, generates more earnings from industrial production and might only want risks that are a by-product of its core business lines (e.g. commodity risks, product risk, and so on) instead of those coming from financial sources. If risk exposures are not consistent with its goals then they should be realigned, elim- inated or dealt with cautiously. So, for example, the oil company that focuses on managing its commodity exposures should not actively position equity or interest rate derivatives, as this would be contrary to its corporate imperatives and not part of its core expertise – in short, not part of its risk philosophy. Where it has no choice but to take risks that are not part of core competency (e.g. the management of a pension fund), it should only do so with expert advice and under very conservative accounting policies.
8.1.2 Focus of “balance sheet” risk activities
Focusing sharply on contemplated risk activities is critical in developing a risk philosophy.
A firm seeking risk must consider whether it should do so actively or passively, if it should be proprietary or client-focused, in which markets and products it wishes to be active, and so on. Some firms might favor proprietary trading, while others might wish to emphasize client-driven risk businesses. Some might want to keep risk activities closer to home and their area of expertise, while others might be willing to take risk in different local markets and products. Establishing this focus is important as each approach features unique characteristics that will impact risk tolerance. Identifying which risks are then being run, per the classifications summarized in Chapter 2, is very important. This allows a company to consider whether it will be taking credit and market risks (willingly or as a corporate by-product), if it will be exposed to model or client suitability risks, whether it will encounter liquidity, process or legal risks, and so on. In our experience, firms that focus on taking risk where they have a
comparative advantage, rather than those trying to be “all things to all people”, are often the most successful.
8.1.3 Stakeholder expectations
Knowing what shareholders expect of a firm is an important – though often overlooked – ingredient of the process. Internal parties (business managers, control managers and employees) and external parties (debt and equity investors, bank creditors, regulators, rating agency analysts) may think a company is in business to take certain risks and have an interest in ensuring that corporate actions coincide with these expectations. Management alone cannot unilaterally decide to assume or reduce risks – actions that they take have to be consistent with what others believe or have been informed the company is, or is capable of, doing and empowered to do. When views diverge managers need to resolve the issue quickly – there should be no surprises about the nature of a firm’s risk-related business. Regulators, for in- stance, do not like to see an institution losing money in markets or products that it was not authorized to deal in or from activities that are far broader in scope than they believed were being undertaken. Shareholders also buy a company’s stock based, among other things, on a belief that a particular level of risk is, or is not, being taken; companies that do not take much risk appeal to a certain class of investors, while those that take a great deal of risk appeal to others. A company taking risk that is not seen by shareholders as part of strategy, and that subsequently loses money, will pay a heavy price through a lower stock multiple. One that runs significant proprietary risk may have lots of earnings volatility, but the fact that its activities are consistent with its philosophy, and well known to investors, may not translate into a lower multiple. Within the financial community some firms are associated with large proprietary risk taking (e.g. Salomon Brothers (before its acquisition by Citibank), Goldman Sachs). Large and systemic risk-related losses at these firms might disappoint investors, but would not be unexpected and should not necessarily be reflected in a lower multiple. Other firms are not considered big risk takers (e.g. Merrill Lynch and Smith Barney in the early 1990s) and large risk losses are more likely to result in lower valuations.
Figure 8.2 summarizes the suggested make-up of the risk philosophy.
Definition of a risk philosophy Financial risk in
light of corporate goals
Focus of financial risk activities
Shareholder expectations
Figure 8.2 Definition of a risk philosophy