LO 39.1: Describe the concept of a risk appetite framework (RAF), identify the elements of an RAF, and explain the benefits to a firm of having a well-developed RAF.
A risk appetite framework (RAF) is a strategic decision-making tool that represents the firms core risk strategy. It sets in place a clear, future-oriented perspective of the firms target risk profile in a number of different scenarios and maps out a strategy for achieving that risk profile. It also specifies which types of risk the firm is willing to take and under what conditions as well as which types of risk the firm is unwilling to take.
An RAF should start with a risk appetite statement that is essentially a mission statement from a risk perspective. This statement should cover some or all of the following elements: Desired business mix and balance sheet composition (i.e., capital structuretrade-off
between debt and equity).
Risk preferences (i.e., how much credit or market risk to take on or hedge) Acceptable trade-off between risk and reward. Acceptable limits for volatility (based on standard deviation). Capital thresholds (i.e., regulatory and economic capital). Tolerances for post-stress losses. Target credit ratings. Optimum liquidity ratios. The benefits of a well-developed RAF are as follows:
The inherent flexibility allows firms to adapt to market changes, especially if appropriate
It improves a firms strategic planning and tactical decision-making.
opportunities arise that require adjustments to the RAF.
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Topic 39 Cross Reference to GARP Assigned Reading – Senior Supervisors Group
It assists firms in preparing for the unexpected; requires business line strategy reviews and maintains an open dialogue regarding the management of unexpected economic or market events in particular geographies or products. It focuses on the future and sets expectations regarding the firms consolidated risk profile after performing relevant stress tests and scenario analyses. Thus, it helps the firm set up a plan for risk taking, loss mitigation, and use of contingency measures.
D e v e l o p i n g a n d I m p l e m e n t
i n g a n E f f e c t i v e RAF