A version of this article was originally published in the RMA Journal

Articulating risk appetite may be the most important activity for any financial institution to get right. Clearly defining the nature and level of risk it is able and willing to accept in pursuit of its business strategy is particularly critical for a bank, which is ultimately in the business of risk transformation. A bank’s risk appetite statement is a guide and boundary to risk-taking behavior and plays a crucial role in informing its broader approach to risk management. In many ways, it is a covenant between the board and management, a guide for employees, and the central point of connectivity for key firmwide processes.

In partnership with the Risk Management Association, we organized a working group to understand the banking sector’s recent evolution and future ambitions regarding risk appetite. This group included representatives from nearly all US banks with assets above $250 billion as of 2023. The full article summarizes learnings from the working group, including the results of a survey of the group that provided an up-to-date view on risk appetite practices and actions banks can consider to advance their risk appetite framework going forward.

Adapting to a changing landscape and driving action in risk appetite

Over the past decade, most banks have worked to articulate their risk appetite and to establish necessary monitoring through risk metrics, reporting, and associated processes. Now, as customers, the industry, and the economy continue to evolve, banks are transforming their risk appetite perspectives and practices. They view risk appetite less as a static risk management statement and more as a living, breathing risk management tool that adapts to a bank’s circumstances and acts as the connective tissue within the broader risk management apparatus.

Lessons learned from bank failures and systemic shocks

When it comes to risk appetite, institutions have realized the importance of not only what they write down but also how it is used to make important business decisions. Recent events have brought this realization into sharp relief. In spring 2023, as noted by regulators in postmortem analyses, imprudent and weak risk appetite practices contributed to a series of bank failures. They included unreported or unaddressed risk appetite breaches and risk appetite statements that weren’t adequately comprehensive. The banking industry took notice — not just of the failures, but of the complexity and interconnectedness of the risks that led to them, including interest rate risk, deposit concentrations and correlations, and the impact of social media. Even before the turmoil, other shocks to the system such as COVID-19, geopolitical conflicts, and extreme climate events highlighted the importance of an appropriately articulated, dynamic, and well-governed risk appetite.

A renewed focus on risk appetite banking

With that in mind, boards, management teams, investors, and clients are asking tough questions and inspiring a revisit of risk appetite. Meanwhile, the heightened supervisory focus on risk management has included risk appetite frameworks. And proposed regulations — notably related to capital adequacy — are further prompting banks to rethink business mix, risk measurement, and limit frameworks, particularly at the large regional banks that face the biggest regulatory changes.

All in, this presents a daunting backdrop against which risk appetite frameworks are reassessed and enhanced across the industry — and a call for action.

Read the original piece, here.