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 organization which may cause failure as well as the external and sometimes uncertain risk drivers.
The determination of the risk tolerance level is not an exact science but depends on a number of factors. The ability to respond dynamically to changing events, the ability to withstand losses and remain a going concern, the competitive landscape, and the regulatory environment all shape the risk tolerance level. On the contrary, personal motivations and beliefs, the agendas of board members, short-term pressures, and management compensation should not factor into the risk tolerance determination.
The appropriate risk tolerance level should be selected and communicated prior to a crisis event and should serve as strategic guidance 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 geared towards managing, monitoring and communicating the risk tolerance.
Which of the following factors should be considered in determining the 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
The correct answer is B.
Organizations should not focus on short-term profits or excessive leverage which may actually lead to long-term failure or work for management compensation. The risk tolerance should focus on the creation of long-term enterprise value.
Reading 42 LOS 42d:
Explain how risk tolerance affects risk management