The idea behind risk appetite is that not all risks can be completely removed, and in fact, some of them shouldn’t be avoided in the first place. When an organization plays it too safely and doesn’t take any risks, innovation halts, and soon after, stagnation sets in. In this age when technology goes through exponential changes within just a few years, stagnation for an organization can happen much earlier than usual. If a company wants to stay competitive within its industry, its corporate board has to be comfortable with a certain level of risk-taking.
But the question is, just how big should a company’s risk appetite be? In relation to investments, high-yield results call for high-risk moves. To a large extent, the same can be said for organizations: Great gains usually come from taking on a sizable risk. However, this doesn’t mean that a company should start taking risks indiscriminately. It stands to win a lot when it takes big risks, but on the flip side, it stands to lose a lot, too.
That question is not so easy to answer. When a leadership sets its risk appetite, there are different factors to be considered, such as the objectives a company wants to achieve, the nature of the industry within which it operates, and the impact a failure will have on its clientele.
Let’s take a leading smartphone maker with an ambitious CEO as an example. This company can afford to (and many would argue, need to) shoulder the sizable risks of experimenting and developing new features for the next product release. These features could either be a big hit or a huge flop, in which case means millions invested in R&D would go down the drain.
A pharmaceutical company that makes medicines, on the other hand, doesn’t have the same freedom to take big risks with regard to their finished product— not when people’s safety is at stake. Whatever medical innovation it wants to release should be thoroughly researched, reviewed, and tested so that the finished product is absolutely perfect. A few bugs in a new smartphone feature causes nothing more than minor inconveniences, but a tiny miscalculation in the formulation of a drug can have adverse effects on consumer health.
As a guide or reference, here are the different levels of risk appetite that your corporate board may align themselves with:
This refers to complete avoidance of all risks and uncertainties. The objective of an organization with an adverse stance is to take no risk at all. This risk stance is usually directed towards areas in which failure would be of tremendous consequence. For instance, all top banks have a zero-risk approach for things like fraud in their dealings.
This level is more daring than the one before it, but the undertakings of a cautious organization are still generally safe.
This was the risk appetite stance of most US banks at the peak of the 2008 financial crisis when bank lending to large borrowers, according to the Journal of Financial Economics, dropped by 47% from the previous year. However, lending for real investments (those backed by real estate as collateral) dropped only by 14%. This shows that with some guarantee, banks were still willing to extend credit.
This level is where risk-taking becomes more aggressive. Organizations open to risks consider decisions that carry higher levels of risk as things not to be avoided, but instead evaluated. Corporations open to risk consider the new ways to do things, and are not afraid to shoulder some risk of taking such action. These decisions could include adopting the latest technology for business processes, or perhaps considering expanding into another country of operations.
A hungry organization is passionate about innovation. It regularly chooses to make moves that challenge the norm and expresses the willingness to break new ground as a pioneer. These decisions raise the most eyebrows at first, but cause us to gape in amazement should they succeed years down the line.
A more recent example of this was Facebook‘s three billion-dollar investment into virtual reality (VR) through the startup Oculus – a move that it thought could establish it as a leader in a promising new platform. Although Oculus today has not truly matched the astronomical expectation places on it, it is way too early to call it a bust.
Organizations don’t necessarily need to choose just one level. Different branches within an organization may have different risk appetites depending on the nature of work they do. An organization must find a balance between the desire for innovation and the need for caution. This is where the corporate board can help the company find its footing. All directors should understand what the company stands to gain and to lose for every risk that comes along its way.
Are your company’s directors seeing eye to eye when it comes to risk appetite? If your answer is no, better get them to agree on this matter with the help of collaborative board meeting software like Convene to address communication gaps. Using only their iPad, iPhone, or Android device, directors can work on and explore documents together. They can also effectively discuss risks during board meetings using Convene’s real-time screen synchronization feature.
Remember, effective risk-taking starts at the top! Getting the foundation right leads to a healthy risk appetite for your company.