Case Study | Title: Risk Appetite and Risk Tolerance - GRM Institute

Case Study | Title: Risk Appetite and Risk Tolerance

By Meet Hirani, PGDRM Batch July’20-21

 

Risk Appetite

Risk Appetite is a recent inclusion in the world of business and there is no consensus as to what it exactly means. Risk appetite is often confused with terms such as risk tolerance, risk propensity, risk attitude, and so on, particularly with, risk tolerance. 

There are consultants, schools, researchers, etc., that define risk appetite differently. Some of them are:

  1. According to ISO 31000, a risk appetite definition is the amount and type of risk that an organization is prepared to pursue, retain or take.”
  2. COSO’s Enterprise Risk Management — Integrated Framework defines risk appetite as follows: The amount of risk, on a broad level, an entity is willing to accept in pursuit of value.”
  3. PwC defines risk appetite as “An articulation of the tolerance levels for risk, that an enterprise is prepared to accept in the execution of its strategic and business objectives.”

 

The Physical Analogy

What is Appetite?

  • A desire to satisfy a need for something.

Humans have an appetite for all sorts of things like food or drink including non-physical appetites, where desired results are intangible, such as an appetite for fame or excitement. But appetite is not the same as hunger. Appetite is a desire, a psychological need that demands to be met. The external expression of appetite is hunger, which we experience as a lack of something, and which motivates our behavior to attempt to satisfy the internal desire.

What might influence appetite in a particular individual?
 
There’s a wide range of factors, including these:

  • Physical characteristics (size, weight, age, etc.);
  • Metabolic rate (high, normal, low);
  • State of mind (anxious, calm, stimulated, etc.);
  • The underlying state of health (good, poor, diseased);
  • Lack of something that is required for good health (nutrients, vitamins, water, etc.); and
  • Last experience when appetite was satisfied (how long ago, how fully satisfied, etc.).

The physical analogy allows us to understand some of the key features of risk appetite, by comparing physical appetite with its risk counterpart. For example:

  • Just as physical appetite is an internal desire for something such as food, in the same way, risk appetite reflects our desire to take risks. How much risk do we feel that we can take on in a given situation?
  • Our appetite for risk is likely to be influenced by a wide range of other factors, just like our physical appetite, but it exists as an internal drive or desire that is not visible externally.
  • Physical appetite is expressed outwardly through hunger, and likewise, risk appetite can be seen through decisions we make about how much risk to take, which are expressed as risk thresholds.

Drawing these thoughts together, we can define risk appetite as: Tendency of an individual or group to take a risk in any given situation.”

Risk appetite is then expressed using risk thresholds, which are described against objectives, and which can be measured externally.

 

Risk Tolerance

Once an organization determines its risk appetite, it must identify the various risks it is facing and decide its risk tolerance. Risk tolerance represents the specific maximum risk that a company is willing to take for each type of risk. Risk tolerance defines the boundaries within which the firm is comfortable operating given its overall risk appetite. 

Risk tolerance can be expressed through different metrics, reflecting the unique nature of each risk. It can be defined through acceptable loss, credit ratings, KPI limits, and so on.

For example, a bank with a higher tolerance for credit risk may be willing to lend a higher amount to people or entities with lower credit ratings, taking on relatively more credit risk than a bank with lower risk tolerance.

 

Risk Appetite vs Risk Tolerance

 

 

Driving Analogy

Using a driving analogy, the speed limit that one can drive is 80 Kmph (risk appetite) with the additional 20 Kmph grace window (risk tolerance), the radar flashes if catches one driving at 101 Kmph (unacceptable risk). If you are currently driving 80 Kmph, you may decide to go faster, as long as you do not exceed 100 Kmph.

 

 

Disclaimer

Views and opinions expressed by the individuals in this case study is only for research purpose. The copyright of the content solely lies with the main research owner, links to which are added at the end of the case study.

 

References

1.PwC

2.Protiviti

3.ISO 31000

4.https://www.wallstreetmojo.com/risk-appetite/

5.https://www.coso.org/Documents/ERM-Understanding-and-Communicating-Risk-Appetite.pdf

6.https://www.logicgate.com/blog/risk-appetite-vs-risk-tolerance-what-is-the-difference

7.https://www.pmi.org/learning/library/much-risk-understanding-risk-appetite-6076

8.https://ermgovernance.com/Resources/RIMS_Exploring_Risk_Appetite_Risk_Tolerance_0412.pdf

 

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