Why does one automaker retire its sedans while another doubles down on electric cars? Why does one big box retailer nurture young families while another pushes low prices for everyone? Those are radically different strategic choices. And each can be just as successful.
Those strategies are so different, despite similar capabilities and markets, in part because boards don’t all have the same appetite for risk, nor do they have a shared view of what the risks are to the strategy. Risk is an organizational choice; different boards and executive teams take different levels of different risks in pursuing their strategies. There’s nothing wrong with that. But risk matters to strategy more than most leaders care to admit. When one group examined companies that lost the most value over a 10-year period, they were surprised to find only a few could pinpoint the cause on compliance problems, operational errors, or external shocks. Rather, they found that “strategic blunders were the primary loss of value a remarkable 81% of the time.”
“Strategic blunders were the primary loss of value a remarkable 81% of the time.”
So, a strategy that hasn’t properly accounted for risk is most likely a losing proposition. Likewise, if an executive team hasn’t communicated how much of which risks they are willing to take to accomplish their goals—not just the amount of risk but the kind of risk—their organizations will have difficulty aligning decisions with the strategy. That’s what a risk appetite provides—a structure for aligning the organization’s view of risk that the organization will take on in pursuit of its strategies.
Understanding your risk appetite
Risk appetite is critical for decisions made in the boardroom. There are financial risks, of course, but most decisions contain many other risks. A software company expanding its operations might find a financially attractive site in a remote part of the country offering considerable tax incentives. But has it factored in employee willingness to move to these remote areas with little infrastructure? The company could develop amenities within its campus that appeal to employees. But has it considered how excluding other residents may impact relationships with the community as a whole? A clearly articulated risk appetite brings to the surface the relative importance of those risks so that they can be analyzed rationally alongside financial considerations.
That same risk appetite is just as important for line managers who make the everyday decisions that drive success. Some software companies are more willing than others to “move fast and break things”—that’s risk appetite at work. Their software engineers and product managers develop products according to how that ethos has been built into the culture of their organizations.
Assessing risk appetite might not come naturally to strategists. A classic strategic approach to risk is the SWOT analysis: strengths, weaknesses, opportunities, and threats. That’s fine for what it is: identifying the high-level risks that rise to the strategic level. But it’s not enough to inform decisions. An analysis of risk appetite is much deeper and helps build an understanding of different risk considerations—including those of the risks you actually want to take (up to a point).
Risk appetite can be articulated in different ways, but some common elements:
- It builds on mission and vision. Risk appetite helps further the mission and vision which forms an impression of purpose that guides decisions on where the organization may venture—and where it may not.
- It focuses on strategy and performance, not risk. Risk appetite helps provide clarity on both the type and amount of risk an organization is willing to take to achieve its strategy and the performance it desires.
- It adopts a stakeholder view. Leadership needs to listen to more perspectives and accept that risk appetite will include natural tensions among different stakeholders. Appetite helps in understanding those differences and creates alignment across all levels of the organization.
- It reflects the organization’s risk culture. Actions, rather than words, often represent the “real” risk appetite in an organization. Cultures need to be recognized, and actions need to reflect the risk appetite. Cultures need to be managed to be consistent with evolving risk appetite.
- It points to the risks that need to be monitored. Keeping track of the right risks can keep performance from going sideways.
Developing and operationalizing your risk appetite
Risk appetite doesn’t emerge from the minds of risk analysts locked in a basement office. Rather, it’s formed by the board and senior management through discussions about strategy and changing business conditions. And while risk appetite statements are often back-tested against previous decisions, the board and management recognize that risks are likely to change.
Communications are also essential. Successful communications ensure that risk appetite can be internalized by managers and baked into practices. Key performance indicators should capture risk appetite at different levels of the organization, as well. The result is risk appetite that is fully operationalized.
Those steps are important because risk appetite ultimately helps to drive performance. Each time a bank makes a loan, for example, it takes on risk within parameters defined by risk appetite. Bank lending is a straightforward example of the relationship between performance and risk: Take on too much risk and performance is likely to suffer through loan defaults. Take on too little risk and performance is still likely to suffer, too. After all, the only zero-risk loan is a loan never made, but a bank won’t hit profitability targets if it doesn’t make loans.
The same relationship between performance and risk plays out in all organizations. The safest car ever built might be too expensive for consumers, for example, but a car unsafe at any speed is clearly risky, too. What’s the right balance to strike? A risk appetite that considers passenger safety and courtroom aversion might reveal how that performance and risk relationship should be approached. Operationalizing that risk appetite allows engineers to design the optimal performance and risk profile into future model years.
Why you should be thinking about risk appetite now
In the not-so-distant past, organizational leaders could boil all their strategic decisions down to dollars and cents. What’s the likelihood of success? How much value is at risk? What’s our expected return?
Leaders today are more sophisticated in considering other kinds of risk and performance. They recognize that stakeholders are in the mix, too. Consumers are shifting their loyalties to companies that do well by doing good. Employees at the largest companies in the world are demanding that their employers stand for more than making shareholder returns. Municipalities look more kindly on companies that are not only paying taxes but also active in their communities. There’s even a shift among investors, according to the US SIF Foundation, an association that advances sustainable, responsible, and impact (SRI) investment.
“Total US-domiciled assets under management using SRI strategies grew from $8.7 trillion at the start of 2016 to $12.0 trillion at the start of 2018, an increase of 38 percent. This represents 26 percent of the $46.6 trillion in total US assets under professional management.”
The nature of risk is changing through those stakeholders; so, too, are the objectives of organizations that are tackling their broader purpose in society. But that doesn’t mean risks should be avoided. Failure is as much a function of not enough risk as it is of too much risk. Risk appetite is a means of ensuring the risks you’ve taken are just right for you to succeed.
[1] Report on US Sustainable, Responsible and Impact Investing Trends 2018, US SIF Foundation (2018). Accessed from https://www.ussif.org/currentandpast on October 15, 2019.