Explain the concepts of risk appetite and risk tolerance with examples.
As regulators and the industry take a closer and harder look at risk appetite, the definitions of risk appetite and related concepts need to be clarified. There is not one single authoritative definition of risk appetite, for example. However, there are commonalities across definitions offered by key regulatory and industry standard-setting bodies. In its consultative document, “Principles for An Effective Risk Appetite Framework,” the FSB sets out to establish common definitions “to facilitate communication between supervisors and financial institutions, as well as within financial institutions.
Risk appetite
The FSB defines risk appetite as “the aggregate level and types of risk a financial institution is willing to assume within its risk capacity to achieve its strategic objectives and business plan.”8 The SSG definition is similar, yet somewhat more detailed: “Risk appetite is the level and type of risk a firm is able and willing to assume in its exposures and business activities, given its business objectives and obligations to stakeholders. Risk appetite is generally expressed through both quantitative and qualitative means and should consider extreme conditions, events, and outcomes. In addition, risk appetite should reflect potential impact on earnings, capital, and funding/liquidity.
As an emerging practice, some firms use not only an upper-risk appetite limit but also a lower risk appetite limit, providing a range of the desired risk-taking. The use of a range of the desired risk-taking expands the application of risk appetite from a risk control concept to one that also incorporates strategic risk-taking. In practice, for some risks, the firms may not have set a lower risk appetite limit (e.g., in particular, for operational and other non-financial risks where a lower limit may not be considered useful).
There are several key concepts closely related to risk appetite that we would like to highlight, namely risk tolerance, risk capacity, risk limits. Some of these concepts will not be discussed here. We will focus on risk tolerance. Risk tolerance There are several definitional and usage variations in the marketplace, such as:
- The maximum level and type of risks at which a firm can operate and remain within constraints of capital as well as obligations to stakeholders (SSG 2010 report)
- The levels of variation the entity is willing to accept around specific objectives.
- Amounts of acceptable risk as they relate to individual risks or groups of risk
- The amount and type of risk an organization is able and willing to accept (i.e., risk appetite) with respect to unrewarded risks (e.g., operational, reputational, etc.)
- Risk tolerance being synonymous with risk appetite.
- Not used in the risk appetite framework at all.
Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand in their financial planning. Risk tolerance is an important component in investing. You should have a realistic understanding of your ability and willingness to stomach large swings in the value of your investments; if you take on too much risk, you might panic and sell at the wrong time.
Risk tolerance is often associated with age, although that is not the only determining factor. However, in a general sense, people who are younger and have a longer time horizon are often able to and are encouraged to take on greater risk than people older with a shorter-term horizon. Greater risk tolerance is often synonymous with equities and equity funds and ETFs, while lower risk tolerance is often associated with bonds, bond funds, and ETFs. But age itself shouldn’t determine a switch in asset classes. Those with a higher net worth and more disposable income can also typically afford to take greater risks with their investments.