2 Risk appetite

There are risks you want to take and risk you don't want to take, risks you cannot afford to take, and risks you cannot afford not to take. Risk appetite defines the level and types of risks that you're prepared to take in order to achieve your strategy. The aim for companies not to remove all risks but to ensure that the level of risk being taken is appropriate given the level of return being received, they are aiming to operate in their desired risk-or-return sweet spot.

Companies will typically start by understanding their maximum amount of risk that they are prepared to take. This is called their capacity. They will then set their appetite at a level below their risk capacity.

It is good practise to have trigger levels to give early warning signs if too much or too little risk is being taken. The company will then assess its current risk profile against their risk appetite and capacity. Let's look at an example of this.

Risk lower than capacity, more risk can be taken to increase returns. Risk between triggers, this is the desired range or sweet spot for risk taking and reward. Risk in appetite but above upper trigger. Level of risk would be escalated so that the action can be taken to reduce the risk level before appetite is exceeded.

Risk above appetite level. Immediate action needed to reduce the risk level. Risk above capacity. The firm is not viable. The level of risk exceeds the firm's capacity to absorb the risks. This clearly sets out the targets and measures and allows companies to take appropriate steps so that they can take their desired level of risk.

Risk appetite- so it sounds a little bit like it's about how much can you eat. And actually, that's a really good description of appetite. It's how much risk can you take on as a company.

So risk appetites is one of these terms that I know has recently appeared in lots of material and lots of literature. If you google it, for example, you'll find pages and pages and reams and reams of information, much of which is quite confusing. For me, risk appetite is all about saying how much risk am I prepared to take. What level of risk do I want to take, and what level of risk is too much?

If you're dealing with a supply chain for an organisation, for example, you could say that, OK, if we're not happy with risk appetite, we could do something like purchase additional stock so that if we had some form of crisis, we could draw on that, certainly, in the short term.

So we can have, say, safety compared to financial. So safety- in the rail industry, it's a safety industry. Safety is paramount. We don't want to take any unnecessary risk around safety, so we have a really low appetite for any safety risk.

Financially, again, no business can not have a low appetite for financial risk because you've got to take risks to move the business on. But there's also a limit. You've only got a finite capacity financially. So there's still limits, but you've got- you'll take more risk. You're prepared to lose some money in order to gain somewhere else.

So risk appetite is just about trying to explain to the organisation there's some areas we do not want you to take any risk, and there's other areas where we do want you to take some risk. There are boundaries within them. But ultimately, don't do anything that's going to be risky there. But within reason, fill your boots. We want you to do something over there. And ultimately, risk appetite is- that's all it's trying to do.