Fundamentals of Risk Management

Risk analysis and evaluation
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faced was greater than its risk capacity. Having acknowledged that situation, the
financial institution then released a statement to shareholders.
In this example, the bank is clearly stating that its risk exposure exceeded the risk 
appetite of the organization and even its risk capacity. Many circumstances will arise 
where organizations are faced with risks that could destroy them if those risks
materialized. For some organ izations, there may be several individual and even
independent risks, each of which could destroy the organization.
In these circumstances, the challenge for the risk management function will be
to focus on the circumstances that could trigger one or more of these risks. In the 
example in the box, the bank was lucky enough that circumstances did not arise that 
would trigger the event(s) that would have destroyed its balance sheet.
Risk capacity is the level of risk the bank considers itself capable of absorbing, based on
its earnings power, without damage to its dividend paying ability, its strategic plans and, 
ultimately, its reputation and ongoing business viability. It is based on a combination of 
budgeted, forecast and historical revenues and costs, adjusted for variable compensation, 
dividends and related taxes.
Risk exposure is an estimate of potential loss based on current and prospective risk 
positions across major risk categories – primary risks, operational risk and business risk.
It builds as far as possible on the statistical loss measures used in the day-to-day operating 
controls. Correlations are taken into account when aggregating potential losses from risk 
positions in various risk categories to obtain an overall estimate of the risk exposure. The risk 
exposure is assessed against a severe but plausible constellation of events over a one-year 
time horizon to a 95 per cent confidence level or a ‘once in 20 years’ event.
Risk appetite is established by the board, which sets an upper boundary on aggregate risk 
exposure. A comparison of risk exposure with risk capacity serves as a basis for determining 
whether current or proposed risk limits are appropriate. It is one of the tools available to 
management to guide decisions on adjustments to the risk profile.
The risk exposure should not normally exceed risk capacity, but in the recent extremely 
difficult market conditions this relationship has not held. The bank recorded a large net
loss, showing that the risk exposures remained greater than its risk capacity. Risk exposure 
remained high as a result of a lack of liquidity in the markets for securitized assets and due
to significantly increased volatility levels in global markets. The reduction in risk exposure 
that was achieved through sales in addition to the significant write-downs incurred on risk 
positions was offset by a simultaneous decrease of risk capacity due to downward revisions 
of earnings expectations as a consequence of the deteriorating economic outlook.
risk capacity of a bank

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