Introduction

In the quest for enterprise risk management, several banks have recently undertaken radical reorganisation efforts to integrate different risk teams into a more collaborative whole. However, any permutation of reporting lines and designation of roles can prove to be an expensive – and ultimately, desultory – exercise in the absence of a sound and communicable risk culture. Mitigating this situation requires a top-down approach to setting the risk appetite of the business, which can be mediated by risk factors collected through a bottom-up approach.

Key Findings

• Setting the Appetite – Banks generally follow a top-down approach that is mediated by the bottom-up perspective. Limits are initially prescribed by business heads in collaboration with senior risk officials, which are then assessed for their potential impact on the balance sheet before being presented to the board of directors.

• Methodology – As expected, stress testing and VaR are the primary methods through which limits are determined, with the confidence level generally set at 99%. The focus is on target debt ratings, future earnings and, most importantly, the capital ratio. As market risk is easily quantifiable, qualitative judgements are rare.

• Role of Stress Testing – Serving as the central measure for risk appetite, stress testing is typically conducted over an average of 10 days but varies by asset class. All risk variables, from volatilities to sensitivities, are stressed.

• Cascading the Appetite Downwards – Allocation of limits across desks are based on interdependencies. Uniquely, one bank has no specific market risk limits as it is moving towards enterprise risk management.

• Role of Past Performance – Past performance is mainly considered in terms of unutilised limits and earnings. While there are no capital penalty charges, limits are reassessed every year and may be lower if they had previously remained unused. Similarly, measures akin to the Sharpe Ratio are not key determinants, but past earnings do guide future projections for stress tests.

Conclusion

Transparency of the risk appetite setting process and seamless communication to lower levels of the organisation will be key criteria on which performance will be monitored by regulators. At the participating banks, even though the top-down perspective has gained ascendancy, the bottom-up perspective also holds considerable weight. Involvement from the C-suite is expected, but decisions are made in consultation with individual business heads and the Finance department for assessing the impact on the balance sheet. Increasingly, it is apparent that the importance of stressed quantitative measures is being appreciated throughout the organisation.

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Tagged with: market risk, risk, risk appetite, risk management, Risk Research Report, top-down