The ultimate goal of risk management is generation of efficient income. The aim is to generate the maximum return for a unit of risk taken or to minimize the risk taken to generate the return expected, i.e., it is the optimization of a financial institution’s strategy. Therefore, by measuring its exposure against its appetite, a financial institution is assessing its coupled risk-return. But this task may be difficult as banks face various types of risks, for instance, operational, market, credit, and liquidity, and these cannot be evaluated on a standalone basis; interaction and contagion effects should be taken into account. In this paper, methodologies to evaluate banks’ exposures are presented along with their management implications, as the purpose of the risk appetite evaluation process is the transformation of risk metrics into effective management decisions.

Paraphrasing Warren Buffet, “Risks arise by not knowing what you are doing”, the recent events and the popular prosecution led governments, authorities and regulator to ask the following questions: Do the financial institutions understand the risks they are taking? Is this one properly measured? Regulatory requirements (BCBS, 2013; and FSB, 2013) arose demanding banks to assess their risk appetite in order to answer these questions. However, the discussion around the terminologies and their implications are still ongoing, for example, it is complicated to talk about appetite in operational risk.

In this paper, the risk appetite is defined as the level of risk a bank is ready to accept (assuming the risk is measurable) to generate a particular rate of return. In this sense, it may be regarded as the inverse function of the risk aversion in the traditional sense (Arrow, 1971). The risk management role is to build a framework allowing to reach the return expected through the appetite. Therefore, the risk department of a financial institution cannot be considered anymore as a support function as it mechanically becomes a business function. Actually, a bank can be represented as a portfolio of multiple risks; therefore, it is clearly possible to draw a parallel between risk appetite measurement and the more traditional portfolio theory such as the efficient frontier (Markowitz, 1952), the Capital Asset Pricing Model (CAPM) (Sharpe, 1964) or the Arbitrage Pricing Theory (APT) (Ross, 1976).

Financial Risk Management Journal, Marginal Distributions, Credit, Market, Operational, Risks Risk Appetite , Practice, Vulgaris Mathematica, Risk Measurement, Tools, Capabilities.