Banks Mustn't Let Risk Appetite Statements Gather Dust

Banks Must State Their Risk Appetites on the Basis of Metrics That Turn These Statements Into Steering Wheels

- DEEP MUKHERJEE

The term 'risk appetite' (RA) gained currency after the 2008-09 financial crisis that began in the U.S. In 2013, the European Banking Authority (EBA) and Financial Stability Board (FSB) were the earliest regulators to include RA in formal regulatory asks. The Reserve Bank of India (RBI) in its 2014 Master Circular on Basel III Capital Regulations articulated the need for banks to document their RAs clearly. Bank boards and their managements are expected to set risk limits and lay down the types of risk exposure they plan to take in pursuit of profits. This is to be formally documented as a Risk Appetite Statement (RAS) and monitored for any breach. It calls for an upfront resolve that the bank will not take certain types of risk and keep those taken within the ambit of its stated risk appetite. Since some forms of lending are highly profitable in times of an economic boom but can erode more capital than the profits made if and when the cycle turns, an RAS encourages thinking beyond the short term. The act of stating what level of risk the bank's board acknowledges as being borne by the business heightens the awareness of risks and ensures capital planning to cover them. To achieve their objectives, RAS limits and thresholds must be unambiguous, granular and quantitatively robust. However, that is often not the case.