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Why banks need to show a greater appetite for managing risk

Conduct and consequences Print
Most episodes of bank failure are characterized by a build-up over time in risks that have not been fully recognized and in the end become unsustainable. This was clearly a major factor in the 2007-2008 crisis"
Patricia Jackson
EMEIA Senior Advisor - Risk Governance Lead, in our Risk Governance 2020 paper, Risk appetite and risk responsibilities

Patricia explains how, since that crisis, regulators have turned their attention to making the banking industry more robust. Initially, authorities focused on requiring extra bank capital and liquidity to reduce the likelihood of failure, as well as finding a way to resolve banks should failure occur.

Now they are emphasizing risk governance and promoting internal processes within banks that prevent risk from building up excessively. Risk appetite and clear risk accountability are at the heart of this approach.

A series of Financial Stability Board (FSB) papers set out regulatory thinking on risk governance, risk culture and risk appetite, which will have a fundamental effect on the way banks are managed. A central role is required for risk appetite in all significant business decisions, as well as coverage of non-financial risks such as conduct, compliance and legal risk, in addition to financial risks.

Clearly defined roles

Indeed, to make the risk appetite approach effective, the roles and responsibilities of senior management need to be clearly defined. Under the FSB’s recommendations, the board would approve the risk appetite framework, which would have been developed in collaboration with the CEO, CRO and CFO.

The board would then have to ensure that the framework is embedded, holding the CEO and senior management accountable for its effectiveness. The intention is that the board will be presented with measures of risk capacity produced by the staff, as well as a proposed risk appetite for discussion and approval.

The management must also consider the appropriate risk appetite, within the risk capacity, which would be consistent with the current business model. This requires careful stress testing to assess what risk appetite is consistent with the current business model.

Independent assessment

The FSB also recommends that the board should obtain an independent assessment of the design and effectiveness of the risk appetite framework – either internally or from third parties.

The whole senior management of the bank must be involved in the risk appetite framework and must ensure that it is embedded in the organization through their different roles.

These changes are not about limiting risk per se, but about making sure the decisions that drive risk are taken consciously and owned by decision makers. Taking responsibility for risk appetite must start at the top.

A graphic shows EY's risk governance framework