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1 Risk-taking should be aligned with other corporate priorities, directives and initiatives

1 Risk-taking should be aligned with other corporate priorities, directives and initiatives

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Figure 2.1 General risk process



Risk Identification

Risk mandate

Risk aversion

Risk appetite

Required returns

Risk-bearing skills

Management expertise

Financial resources

Technical resources

Risk Managing

Risk Monitoring/


Risk Measurement/


Risk Governance and


Boundaries defined by

philosophy of risk:


The Simple Rules of Risk

Philosophy of Risk


within) the risk arena is consistent with corporate directives — and whether it will enhance, or

detract, from other operations. For instance, if executive management of an auto manufacturer

feels that establishing a dedicated, risk-taking treasury unit to actively manage the firm’s

exposure to interest rates and currencies would benefit corporate operations, it should determine

whether the goal is consistent with its internal priorities and acceptable to corporate managers,

directors and shareholders. Managers in the auto division may feel the initiative will detract

from corporate resources, create unnecessary profit and loss volatility, consume management

energies and divert attention from the core auto business; investors might feel the same way, and

express dissatisfaction by selling the stock. If, in contrast, managers (and external stakeholders)

feel the venture will provide greater financial expertise and diversify revenues, proceeding

might be a wise course of action. Risk-taking ventures must therefore always be considered

in the context of broader corporate imperatives. Taking risk for the sake of taking risk is never

an advisable course of action; even if financial and technical resources are available to support

such activity, risk-taking must still be consistent with a firm’s business focus.




Though actual management of risks tends to occur at a desk, treasury or business unit level,

a firm should review the totality of its risks when seeking to define a risk philosophy. By

examining how aggregate risks — across broad risk classes — might act to help, or hurt, total

operations, it can define its tolerance levels with greater accuracy and seek efficiencies in the

management process. For instance, if a company is trying to create appropriate risk boundaries

it should consider all of the financial and non-financial risks that might come into play. These

might include commodity risk, interest rate risk and currency risk from a financial perspective

and catastrophic property and casualty risk, business interruption risk and director’s liability

risk from a non-financial perspective. By understanding enterprise risks, the company might

decide that some exposures can be mitigated while others cannot, some should be retained and

others hedged away, and so forth. For institutions seeking to eliminate as much risk as possible,

an enterprise view might reveal opportunities to improve on risk pricing through combined risk

management mechanisms. An enterprise risk review can reveal important macro considerations

during a critical point in the risk philosophy phase.




Defining a philosophy of risk means ensuring that the requirements necessary to create a

sound risk-taking environment are well understood. If a firm decides that it wants to actively

assume risk it must be prepared to devote resources to the creation of a solid and effective risk

management process. It can be financially damaging to underestimate the requirements needed

for a strong risk process. A firm that does not fully appreciate the complexities might ignore

particular stages in order to implement a framework more rapidly or cheaply. For example,

a firm that wants to trade derivatives might hire a few experienced derivative traders and

risk professionals, establish a risk committee, and mandate the creation of risk policies and

limits. However, it might not invest in robust technology and data platforms and may thus


The Simple Rules of Risk

develop a process weakness that could impact operations in the medium-term (e.g. perhaps

the technology platform it purchases is not flexible or scalable, meaning that new products

cannot be accommodated and will have to be managed and monitored in an error-prone “offsystem” environment). A central component of any risk philosophy must include a definition

of the resources needed to create a risk framework. When vital resources (e.g. time, capital,

personnel, technology) appear inadequate, a firm may wish to reconsider its decision on risktaking. Assuming risk without the correct risk process may ultimately lead to broader risk

management problems and financial losses.




A firm wishing to enter the risk-taking arena (either as a major risk participant or as one

comfortable retaining, and managing, risk exposures generated by other core businesses) must

ensure that it has proper commitment from key stakeholders and possesses sufficient financial

resources to support the activities. In the first instance, a firm’s board of directors and executive

management should be convinced that risk-bearing is in the best interests of the firm and

provide explicit support through a written corporate mandate. Determining whether risk-taking

is appropriate is likely to occur after extensive analysis of core businesses, competitors, relative

need for risk management, advantages/costs/benefits of participating, and so forth. Once a case

has been made, the mandate received from internal governance parties, including the board of

directors and executive management, must be explicit. The nature of the mandate should also

be made known to those that have an external interest or stake in the firm’s success — including

bank creditors, rating agencies, investors and regulators. External stakeholders do not want to

be surprised about a company’s risk-taking activities — it is far better to advise them in advance

rather than after the fact. The same should apply if a firm is already active in risk-taking but is

changing its scope meaningfully.

As noted above, a firm must be certain that it has sufficient financial and technical resources

to support risk activity. Risk-taking can be a capital-intensive business and those participating

must understand precisely how much capital will be needed to support business during normal

and stressed market conditions. It makes little sense to define an approach to risk, create a

mandate, advise external stakeholders and then discover that during the first significant bout

of volatility, insufficient capital exists to continue business. Resource requirements based on

scenarios that reflect the seemingly “unthinkable” should be defined in advance.




Though risk is sometimes depicted in a negative light — often as an uncontrollable variable that

creates losses and problems — the reality is far different. Properly managed risk can generate

significant economic profits and serve as an important source of revenues. While “bad risk” —

or risk that can expose an institution to loss without a proper level of compensation — is

clearly not desirable, “good risk” — or risk that is properly valued and creates an appropriate

economic return — can form the core of a valuable line of business. An industrial company that

manufactures a product must manage all parts of the process efficiently in order to maximize

Philosophy of Risk


profits; it attempts to control input prices, production costs and sales prices. If the company

is successful it creates a good product with a good return; if it mismanages the effort by not

charging enough for the product or paying too much for raw materials or labor, it has a bad

product with a poor return. A risk-related business is no different. The risk-bearing company

gets paid to take risks. In order to create good risk, it must charge enough for the product it

delivers — in this case, risk capacity; such charges are the return on its “product.” In addition,

it must control its input costs (e.g. human resources, technology, product development efforts)

and operate in a controlled manner; this, again, is no different than the industrial company.

The key is to ensure that risk can be valued correctly and accommodated within a proper

management framework.


The ability for a firm to assume risk is limited by the amount of economic capital it has at

its disposal. A firm cannot simply decide to be a large risk taker, enter the financial arena,

assume risk and continue to do so without limit. Shareholders supply a firm with capital by

understanding the nature of the firm’s business, how it makes money and how it plans to do

so in the future. Capital is then allocated to risk activities. Shareholders will not, however,

continue to provide equity capital without limit; though a firm may wish to access the equity

markets in order to obtain more economic capital for risk-taking purposes, it cannot do so

continuously. At some point the marginal return on risk will be inadequate, shareholders will

become too diluted, the stock price will decline and it will no longer make economic sense to

issue more capital. Accordingly, capital in support of risk-taking activities must be regarded

as a finite resource. In deciding whether to enter the risk-taking arena, a firm must determine

how much capital it can access and how it can best allocate it in order to maximize returns. The

process must be reviewed on an ongoing basis to ensure that risk-taking, capital allocation

and risk/return are proceeding according to plan. Thus, a firm entering a risky business by

allocating an initial $10MM to the effort expects to earn a return on its allocation. If the business

is successful, the firm may be able to allocate a further $10MM by accessing the public or

private markets; again, it should receive an appropriate return for the capital employed. If the

business remains successful, and the firm wishes to continue expanding but is unable to do so

through the capital markets, it may then be required to divert existing capital supporting other

businesses or curtail its risk-taking activities — it is simply unable to expand risk capital without


Various concepts of capital exist and an institution must determine how to measure and

manage its resources. At least two measures of capital — regulatory and management — can

be considered. Regulatory capital is the total amount of capital a firm is required to maintain

in order to fulfill regulatory requirements. Regulators impose minimum capital requirements

on institutions operating in their jurisdictions in order to ensure a sufficient level of financial

security to cover risks; this helps minimize the chance that institutions will take risks in excess

of their financial resources. Firms identify the amount of regulatory capital required for the

entire institution (e.g. based on pre-set formulas, percentage of risk assets, and so on), and then

sub-allocate through a “top down” approach to individual businesses. Management capital, in

contrast, applies the actual capital of the institution to individual businesses, often through a

“bottom up” risk-related process. This helps ensure that each business has enough financial

resources to cover the risks it is taking. Since allocations tend to be additive, and certain risks

might be negatively correlated with others, an excess capital allocation can result. While these

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