Success with bite: Setting the menu for risk appetite
So, how hungry are you? In the financial context, this question extends far beyond the usual banking bill of fare. In fact, the recipe relies on the most important aspects of your bank’s lending strategy.
Your “risk appetite” refers to the amount of risk your institution will accept in pursuit of loan growth. Defining the metes and bounds in a risk appetite statement helps your bank set the direction of its lending program and bolster its long-term health.
Consider this: Your lending program is the five-star dish of your credit union or bank. While it may look appetizing on the outside, we all know that if it actually consists of a steady diet of fast food and soda, serious negative consequences will manifest down the line.
Rather than wait for your primary regulator to serve as the catalyst for meaningful and consistent changes to your institution’s lending practices, assess your risk appetite. It empowers you to take authentic action now—before there’s trouble.
Setting the menu: Steps to craft a risk appetite statement
Once you have identified the key metrics—which we’ll discuss below—follow these steps and answer the associated questions to create a guiding Risk Appetite Statement that wins.
Step 1: Create your risk appetite statement
- What is your growth term? (3 years? 5 years?)
- Which industries would you like to pursue?
- In relation to capital, what should be your maximum exposure per industry or loan type?
- What loan terms and pricing are we willing to extend in pursuit of loan growth?
Step 2: Set risk tolerances
- Discuss the level of financial statement exceptions, past dues, and charge-offs you are willing to accept per portfolio. For example, a bank may state that when their commercial and industrial (C&I) past dues reach a certain percentage of total loans, they will pause and reassess their loan approval perimeters.
Step 3: Memorialize risk tolerances in your policies and procedures
- Update your risk appetite statement annually.
- Revisit it quarterly to ensure your results match your risk appetite.
- Ensure your policies and procedures support and match your risk appetite
Hours of business: When’s the best time to assess risk appetite?
This guiding statement outlines the institution’s risk capacity and risk tolerance to create a comprehensive document that will guide your institution’s loan decision making over the next year. Without it your bank can potentially look up three years from now and wonder how its commercial real estate portfolio grew to 300 percent of Tier 1 Capital.
While risk appetite refers to the amount of risk your institution is willing to accept in pursuit of loan growth, risk capacity quantifies the maximum risk that the firm is able to withstand. Risk capacity is based on metrics such as capital, liquid assets, borrowing capacity, etc.
Include an assessment of your institution’s target profile and actual risk profile as well. Target risk profile represents the allocation of appetite to risk categories (e.g. how many home equity or car loans you will grant?). Actual profile represents risks that are currently assumed.
When gathering the information that will eventually become the Risk Appetite Statement, it’s important to engage and incorporate the input of parties such as the board of directors, CEO, CFO, lenders and internal auditors.
Food for thought: What’s the benefit of creating a risk appetite statement?
When done right, a comprehensive risk appetite statement sets the tone for both day-to-day and macro-level decision making. By translating risk metrics into business decisions, you can trust that your strategy, target setting and risk management align.
A matter of taste: Whose hunger sets the menu?
Within any organization, risk appetites will vary across departments; incorporate and synthesize these many different viewpoints for the sake of strategy. Ultimately, however, the BOD, CEO, CFO, lenders and internal auditors should all participate in developing the risk appetite statement. Effective implementation requires common goals, planning and language.
Order up: I have a risk appetite statement, now what?
The risk appetite statement represents a living document. You will need to update the statement annually and revisit it quarterly to ensure your results match your risk appetite.
In sum, defining risk appetite—and memorializing it in a risk appetite statement—helps any institution reach the goal of finding a healthy balance within its portfolio that matches actual risk tolerance and rewards managed risk, all while driving earnings.
And so, Bon Appétit! Prepare something fit for a king, which in French is the word roi—and in banking vernacular, the initials for return on investment.
Mr. Cooley serves as an examiner for the BAI Loan Review Certificate Program.