Risk Tolerance

At the governance level, the risk appetite of the organization must be established. Risk tolerance identifies the extent to which the organization is prepared to experience losses or opportunity costs in the effort to achieve organizational objectives.

Risk Tolerance Determination

The risk tolerance decision requires the integration of an “inside” and an “outside” view. A determination must be made on the internal shortfalls of an organization which may cause failure as well as the external and sometimes, uncertain risk drivers.

Determination of the risk tolerance level is not straitjacket affair. Rather, it depends on a number of factors. The ability to respond dynamically to changing trends, the capacity to withstand losses and remain afloat, the competitive landscape, and the regulatory environment all shape the risk tolerance level of an organization. On the contrary, personal motivations and beliefs, the agenda of board members, short-term pressures, and management compensation are inconsequential to risk tolerance determination.

The appropriate risk tolerance level should be selected and communicated prior to a crisis and should serve as a strategic response template for the management team. Risk-taking and strategic goals should center around the core competencies of the organization.

Once the risk tolerance is determined, the overall risk framework should be tuned to manage, monitor and communicate the risk tolerance.

Question

Which of the following factors should be considered in determining organizational risk tolerance?

A. Management and employee compensation and bonus schemes

B. The business-critical cash flow requirements over the medium-term

C. Delivering strong performance over the subsequent quarter by increasing leverage

Solution

The correct answer is B.

Organizations should not focus on short-term profits or excessive leverage which may actually either lead to long-term failure or work for management compensation. The risk tolerance should focus on the creation of long-term enterprise value.