A company must accept some risk in order to make profits. This means that a risk of making a loss must be accepted in order to create a chance to make profit.
A company will take the risk if its management decides that the risk of loss is justified by the expectation of a gain. Risk appetite is concerned with how much risk management are willing to take.
Management might be willing to accept the risk of loss up to a certain maximum limit if the chance of making profits is sufficiently attractive to them.
For a market trader in the financial markets, risk appetite has been defined as ‘the amount of capital that a trader is willing to lose in order to generate a potential profit’.
Risk appetite is used to describe how willing a board is to take on risk, on a scale from willing to take on risk through willing to take some risks down to aversion to taking a risk.
A Board of directors might also have an appetite for one type of risk but an aversion to a different type of risk. The risk appetite of a Board of directors or management in any particular situation will depend on:
a. the importance of the decision and the nature of the decision.
b. the amount and nature of the potential gains or losses, and
c. the reliability of the information available to help the Board of directors or management to make their decision.
Board policy on risk
The risk appetite of a company should be decided by the board of directors, and a policy on risk should be decided and communicated by the board to its management.
Managers need guidance on the levels of risk that it would be ‘legitimate’ for them to take on with any decision that they make.
i. Managers should not be allowed to take whatever decisions they consider to be suitable, regardless of risk.
This would lead to inconsistent decision-making and could expose the company to unacceptable risks. ‘Erratic, inopportune risk-taking is an accident waiting to happen’ (HM Treasury).
ii. At the other extreme, a risk adverse culture is undesirable, in which managers are discouraged from taking any risky decisions, so that business opportunities are not exploited.
A risk-based approach
The term ‘risk-based approach’ is often used to describe risk management processes.
It is an approach to decision-making based on a detailed evaluation of risks and exposures, and policy guidelines on the level of risk that is acceptable (risk appetite).
The risk-based approach takes the view that some risk must be accepted, but risk exposures should be kept within acceptable limits.
Decisions should therefore be based on a consideration of both expected benefit and the risk.