Operationalization of Risk Appetite - Balance Sheet Projections of Banks

The financial crisis in 2008 enlightened several shortcomings in the performance of the banking sector. As a result of this a more rigid regulatory framework, Basel III, has been developed which raises the requirements of banks’ capital and liquidity structure and internal capital adequacy processes. This involves evaluating potential future risks related to the strategy and risk appetite of a bank. Therefore it is crucial that a bank has an understanding of how their business plan would affect the balance sheet under different economic scenarios. The goal of this study is therefore to demonstrate how this can be implemented by using quantitative projection methods, incorporating important risk factors such as yield curves, credit spreads and default probabilities. The projections involve the development of a deterministic mathematical model, based on credit migrations, under which business plans can be tested and evaluated under scenarios based on historical downturns such as the recent financial crisis. The evaluation is done by incorporating four key risk metrics into the model followed by a study of the results from the risk metrics using balance sheet data from an American bank. These risk metrics are considered under three different scenarios and four proposed business plans. Risk appetite targets and limits are defined where a breach serves as an indication to the bank that the business plan should be revised. The results show potential risks involved in the different business plans and supports a modest growth of the current balance sheet and a sound balance between trading and lending activities in order to stay within limits under severe scenarios. The conclusion is that the model can serve as a base for setting a risk appetite framework at a bank, but in order to validate key assumptions and robustness of the results a more thorough investigation with access to bank data is needed